Perfectly Competitive Market: Basic Concepts and Assumptions

The PPT discusses the basic concept of a market in Economics and also the assumptions underlying the perfectly competitive market. It also discusses the concept of costs in the traditional theory of the firm. It is not an advanced lecture and would be useful for those not familiar with the basics. The reference is 'Modern Microeconomics' by Koutsoyiannnis'

1. Markets

2. Students, You have learned about consumer behavior and Producer behavior I will now talk to you about markets. What do you know about markets?

3. What do you understand by markets? Does it mean only places like Ima Market, Thangal Bazaar, Paona Bazaar? If not, then what does it mean?

4. Meaning of Market: In common usage, by market, we mean a place where commodities are bought and sold. Thus, a market place is thought to be a place consisting of a number of big and small shops, stalls and even hawkers selling various types of goods. In economics, that’s not all.

5. Market in Economics

6. Does a buyer have to personally meet a seller? For the existence of a market, buyers and sellers need not personally meet each other at a particular place. They may contact each other by any means such as a telephone or telex. Thus, the term “Market” is used in economics in a typical and specialised sense. It does not refer only to a fixed location A market signifies any arrangement in which the sale and purchase of goods take place. Contact and contactless as in online buying and selling.

7. Types of Market Structures Perfect Competition Monopoly Monopolistic competition Oligopoly :- 1. Collusive Oligopoly and 2. Non-collusive Oligopoly. Today let us start with Perfect Competition

8. Perfect competition is a market structure characterised by a complete absence of rivalry among the individual firms. Thus perfect competition in economic theory has a meaning diametrically opposite to the everyday use of this term. In practice businessmen use the word competition as synonymous to rivalry. In theory, perfect competition implies no rivalry among firms.

9. Assumptions The model of perfect competition is based on the following assumptions 1. Large numbers of sellers and buyers The industry or market includes a large number of firms (and buyers), so that each individual firm, however large, supplies only a small part of the total quantity offered in the market. The buyers are also numerous so that no monopsonistic power can affect the working of the market. Under these conditions each firm alone cannot affect the price in the market by changing its output.

10. 2. Product homogeneity: The industry is defined as a group of firms producing a homogeneous product. The technical characteristics of the product as well as the services associated with its sale and delivery are identical. There is no way in which a buyer could differentiate among the products of different firms. If the product were differentiated the firm would have some discretion in setting its price. The assumptions of large numbers of sellers and of product homogeneity imply that the individual firm in pure competition is a price-taker: its demand curve is infinitely elastic, indicating that the firm can sell any amount of output at the prevailing market price. The demand curve of the individual firm is also its average revenue and its marginal revenue curve

11. 3. Free entry and exit of firms There is no barrier to entry or exit from the industry. Entry or exit may take time, but firms have freedom of movement in and out of the industry. This assumption is supplementary to the assumption of large numbers. If barriers exist the number of firms in the industry may be reduced so that each one of them may acquire power to affect the price in the market.

12. 4. Profit Maximization Goal Profit maximisation : The goal of all firms is profit maximisation. No other goals are pursued.

13. 5. No Government regulation No government regulation There is no government intervention in the market (tariffs, subsidies, rationing of production or demand and so on are ruled out). The above assumptions are sufficient for the firm to be a price-taker and have an infinitely elastic demand curve. The market structure in which the above assumptions are fulfilled is called pure competition. It is different from perfect competition, which requires the fulfilment of the following additional assumptions.

14. Additional Assumptions for Perfect Competition 6. Perfect mobility of factors of production The factors of production are free to move from one firm to another throughout the economy. It is also assumed that workers can move between different jobs, which implies that skills can be learned easily. Finally, raw materials and other factors are not monopolised and labour is not unionised. In short, there is perfect competition in the markets of factors of production.

15. 7. Perfect Knowledge: Perfect knowledge It is assumed that all sellers and buyers have complete knowledge of the conditions of the market. This knowledge refers not only to the prevailing conditions in the current period but in all future periods as well. Information is free and costless. Under these conditions uncertainty about future developments in the market is ruled out. Under the above assumptions we will examine the equilibrium of the firm and the industry in the short run and in the long run.

16. Cost curves-basics Before we discuss equilibrium, we need to have some ideas about cost curves What are total costs? TC= TVC+TFC TVC= total variable costs TFC= Total Fixed Costs

17. The fixed costs include: (a) salaries of administrative staff (b) depreciation (wear and tear) of machinery (c) expenses for building depreciation and repairs (d) expenses for land maintenance and depreciation (if any). Another element that may be treated in the same way as fixed costs is the normal profit, which is a lump sum including a percentage return on fixed capital and allowance for risk. The variable costs include: (a) the raw materials (b) the cost of direct labour (c) the running expenses of fixed capital, such as fuel, ordinary repairs and routine maintenance.

18. TFC The total fixed cost is graphically denoted by a straight line parallel to the output axis (figure 4.1).

19. TVC The total variable cost in the traditional theory of the firm has broadly an inverse-S shape (figure 4.2) which reflects the law of variable proportions.

20. Law of Variable Proportions According to this law, at the initial stages of production with a given plant, as more of the variable factor(s) is employed, its productivity increases and the average variable cost falls.

21. This continues until the optimal combination of the fixed and variable factors is reached. Beyond this point as increased quantities of the variable factor(s) are combined with the fixed factor(s) the productivity of the variable factor(s) declines (and the AVC rises). By adding the TFC and TVC we obtain the TC of the firm (figure 4.3) From the total-cost curves we obtain average-cost curves. The average fixed cost is found by dividing TFC by the level of output: AFC=  

22. Graphically the AFC is a rectangular hyperbola, showing at all its points the same magnitude, that is, the level of TFC (figure 4.4). The average variable cost is similarly obtained by dividing the TVC with the corresponding level of output: AVC=  

23. Graphically the AVC at each level of output is derived from the slope of a line drawn from the origin to the point on the TVC curve corresponding to the particular level of output. For example, in figure 4.5 the AVC at X 1 is the slope of the ray Oa, the AVC at X 2 is the slope of the ray Ob, and so on. The slope of a ray through the origin declines continuously until the ray becomes tangent to the TVC curve at c. To the right of this point the slope of rays through the origin starts increasing .

24. Thus the SAVC curve falls initially as the productivity of the variable factor(s) increases, reaches a minimum when the plant is operated optimally (with the optimal combination of fixed and variable factors), and rises beyond that point (figure 4.6).

25. The ATC is obtained by dividing the TC by the corresponding level of output: ATC= = = AFC+AVC Graphically the ATC curve is derived in the same way as the SAVC. The ATC at any level of output is the slope of the straight line from the origin to the point on the TC curve corresponding to that particular level of output (figure 4. 7). The shape of the ATC is similar to that of the AVC (both being U-shaped).  

26. Initially the ATC declines, it reaches a minimum at the level of optimal operation of the plant (XM) and subsequently rises again (figure 4.8). The U shape of both the AVC and the ATC reflects the law of variable proportions or law of eventually decreasing returns to the variable factor(s) of production(More later)

27. The marginal cost is defined as the change in TC which results from a unit change in output. Mathematically the marginal cost is the first derivative of the TC function. Denoting total cost by C and output by X we have ac MC=  

28. Graphically the MC is the slope of the TC curve (which of course is the same at any point as the slope of the TVC). The slope of a curve at any one of its points is the slope of the tangent at that point. With an inverse-S shape of the TC (and TVC) the MC curve will be U-shaped. In figure 4.9 we observe that the slope of the tangent to the total-cost curve declines gradually, until it becomes parallel to the X-axis (with its slope being equal to zero at this point), and then starts rising. Accordingly we picture the MC curve in figure 4.10 as U-shaped.

29. Short Run Marginal Cost Curve(SMC)

30. In summary: the traditional theory of costs postulates that in the short run the cost curves (A V C, A TC and M C) are U-shaped, reflecting the law of variable proportions. In the short run with a fixed plant there is a phase of increasing productivity (falling unit costs) and a phase of decreasing productivity (increasing unit costs) of the variable factor(s). Between these two phases of plant operation there is a single point at which unit costs are at a minimum. When this point on the SATC is reached the plant is utilised optimally, that is, with the optimal combination (proportions) of fixed and variable factors.

31. That’s all for today