Perfect competition is a state of a market in which there are large number of buyers and sellers engaged in the sale and purchase of homogeneous product. All the buyers and sellers have perfect knowledge of market condition, factors of production are perfectly mobile and there is no restriction upon the entry and exist of firms.
In the words of Mrs. John Robinsons, “Perfect competition prevails when demands for the output of each producer is perfectly elastic. This entails first, that number of sellers is large, so that output of any one seller is negligibly small proportion of total output of the commodity and second, that buyers are alike in respect to of their choice between rival sellers. So that the market is in perfect competition.
Price Determination under perfect Competition
Under perfect competition, price of a commodity it determined by the relative forces of demand and supply. In this reference, Demand means the demand of whole industry. Under perfect competitions, and individual produce cannot influence supply and individual producer cannot influence supply and an individual buyer cannot influence demand
Demand Force: A commodity is demanded by consumers. They demand it because it provides them utility. Even consumer wants to purchase a commodity at minimum price but the maximum price but the maximum price at which he can agree to purchase a commodity, shall be equal to its marginal utility. Demand and commodity will be more at a lower price and less at a higher price.
Supply Force: A commodity is supplied by producers. They supply it because they collect revenue by selling it. Every producer wants to get maximum price at which he can agree to supply it, will be equal to is marginal cost of production. Supply of a commodity will be more at a higher price and less at a lower price.
Equilibrium of the firm under perfect competition (Demand and price determination)
The firm is said to be and equilibrium when maximizes it profit. The output which gives maximum profit to firm is called equilibrium output. In the equilibrium state, the firm has no incentive either to increase or decrease its output. Since it is the maximum profit giving output which only gives no incentive to the firm to increase or decrease if, so it is in equilibrium when it gets maximum profit.
Firms in the competitive market are price takes. This is because there are a large number of firms in the market who are producing identical or homogeneous goods. As such these firms can no influence the price in their individual capacities. They have to accept the price fixed by the industry as whole.
In the above diagram, industry price OP is fixed through the interaction of total demand and total supply of the industry. Firms have to accept his price as given and such they are price taker rather than price makers. They cannot increase the price OP alone because of the fear of the fear of losing customers to other firms. They do not try to sell product below OP because they do not have any firms. They do not try to sell product below OP because they do not have any incentive for lowering, it they will try to sell as much as they can at price OP.
As much P line acts as demand curve for them. Thus the demand curve facing as individual firm in a perfect competitive market is horizontal on at the level of market price set by the industry and firms have to choose that level of output which yields maximum profit.
Conditions for equilibrium of a firm
A firm in order to attain the equilibrium position has to satisfy two conditions-
- The marginal revenue should be equal to the marginal cost i.e. MC. If MR is greater than MC, there is always an incentive for the firms expand its.
Production further gain by sale of additional units. If MR is less than MC, the firm will have to reduce output sine an additional unit adds more cost than to revenue. Profits are maximum only at the point where MR = MC.
- The MC curve should cut the MR curve from below. In other words MC should have positive slope.
In the diagram above, DD and SS are the industry demand and Supply curve which equilibrate at E to set the market price at OP. The firms of perfect competitive industry adopt OP price as given considers P line as demand curve which is perfectly elastic at P. As all are in the same level. MR is horizontal line equal to AR line. MC curve cuts MR Curve at two places T and R respectively. But at T. MC is cutting MR from above. T is not the point of Equilibrium as the second condition is not satisfied The firm will get benefit if it goes beyond T as the additional cost of producing additional unit is falling AR, the MC curve is cutting MR curve from below, Hence R is the point of equilibrium and OQ, is equilibrium level of output.
Important links
- Law of Diminishing Returns- Definition, Causes, Limitation etc.
- Law of Variable Proportions- Assumption, Explanation, Stages etc.
- Cost Curve: Nature, Relationship between LMC & SMC
- Market- Definition, Features & Factors Affecting its Size
- Traditional Theory of Costs- Short-run & Long-run
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