Tuesday, April 04, 2017

Market Structure - Perfectly Competitive Market

Unit – 4: Market Structure – Perfect Competition
Objectives of Business Firms – Main and Alternative Objectives
Conventional theory of firm assumes profit maximisation, as the main objective of business firms. Recent researchers on this issue reveal that the objectives that business firms pursue are more than one. Some important alternatives objectives, other than profit maximisation, are:
1)      Maximisation of Sales Revenue.
2)      Maximisation of Firm’s growth rate.
3)      Maximisation of manager’s utility function.
4)      Long-run survival of the firm.
Main Objectives - Profit Maximisation Goal of a Business Firm
According to traditional economic theory profit maximisation is the sole objective of business firms. The traditional theory suggests a number of reasons as to why does a firm want to maximize profits. All these reasons essentially fall into the following categories:
a)      Traditional economic theory assumes that the firm is owner-managed, and therefore maximizing profit would imply maximizing the income of the owner; Owner would like to have adequate return for his activity as an entrepreneur.
b)      Firm may pursue goals other than profit-maximisation, but they can achieve these subsidiary goals much easier if they aim for profit maximisation.

Under perfect competition individual firms have to maximize their profits at price determined by industry. Under imperfect competition firms search their profit maximizing price output as they are price makers. The profit can be defined as the difference between total revenue and total cost. i.e. Profit = Total Revenue – Total Cost.
A firm will maximize its profit at that level of output at which the difference between total revenue and total cost is maximum. Generally conventional price theory determines profit maximizing price-output in terms of marginal cost and marginal revenue.
Marginal Revenue: Marginal revenue is the addition to total revenue from the sale of an additional unit of a commodity.
Marginal Cost: Marginal cost is the addition to total cost from the production of an additional unit of a commodity.
The two profit maximizing conditions are:
1. MC = MR: - We take first condition
a)      If MC < MR total profits are not maximized because firm will earn more profits by increasing output.
b)      If MC > MR the level of total profit is being reduced and firm can increase profit by decreasing production.
c)       If MC = MR the profits could not increase either by increasing or decreasing output and hence profits are maximized.
d)      MC cuts MR from below: - Now we take the second condition. The second condition of profit maximisation requires that MC be rising at the point of its intersection with the MR curve.
Criticism of profit Maximisation Approach:
a)      The real world business environment is more complex than what convention theory of firm thought. The modern business firms face lot of risk and uncertainty. Long-run survival is more important than short-run profit.
b)      The other objectives such as – sales maximisation, growth rate maximisation etc. describe real business behavior more accurately.
c)       Profit maximisation objective cannot be realized without the exact measurement of marginal cost and marginal revenue.
d)      Profits are not only measure of firm’s efficiency.
e)      Profit maximisation assumption may require expansion of business which means more risks. But firms may prefer less profit instead of bearing additional uncertainties.
Alternative Objectives of Business Firms
(1) Baumol’s Hypothesis of Sales Revenue Maximisation: Baumol’s theory of sales maximisation is an alternative theory of firm’s behaviour. The basic premise of his theory is that sales maximisation, rather than profit maximisation, is the plausible goal of the business firms. The separation of ownership from management, characteristic of the modern firm, gives discretion to the managers to pursue goals which maximise their own utility and deviate from profit maximisation, which is the desirable goal of owners.
Given this discretion, Baumol argues that sales maximisation seems the most reasonable goal of managers. From his experience as a consultant to large firms, Baumol found that managers are preoccupied with maximisation of the sales rather than profits. Several reasons seem to explain this attitude of the top management.
Firstly, there is evidence that salaries and other (slack) earnings of top managers are correlated more closely with sales than with profits.
Secondly, the banks and other financial institutions keep a close eye on the sales of firms and are more willing to finance firms with large and growing sales.
Thirdly, personnel problems are handled more satisfactorily when sales are growing. The employees at all levels can be given higher earnings and better terms of work in general.
Fourthly, large sales, growing over time, give prestige to the managers, while large profits go into the pockets of shareholders.
Implications (or Superiority) of the Theory:
Baumol’s sales maximisation theory has some important implications which make it superior to the profit maximisation model of the firm.
1. The sales maximising firm prefers larger sales to profits. Since it maximises its revenue when MR is zero, it will charge lower prices than that charged by the profit maximising firm.
2. It follows from the above that the sales maximising output will be larger than the profit maxim­ising output.
3. The sales maximiser would spend more on advertising in order to earn larger revenue than the profit maximiser subject to the minimum profit constraint.
4. There may be a conflict between pricing in the short run and the long run. In the short run when output cannot be increased, revenue can be increased by raising the price. But in the long run, it would be in the interest of the sales maximisation firm to keep the price low in order to compete more effec­tively for a large share of the market and thus earn more revenue.
Criticisms: Baumol’s sales maximisation model is not free from certain weaknesses.
1. Rosenberg has criticised the use of the profit constant for sales maximisation by Baumol. Rosenberg has shown that it is difficult to specify exactly the rel­evant profit constraint for a firm.
2. According to Shepherd, under oligopoly a firm faces a kinked demand curve and if the kink is large enough, total revenue and profits would be the maximum at the same level of output. So both the sales maximiser and the profit maximiser would not be producing different levels of output.
3. The model does not show how equilibrium in an industry, in which all firms are sales maximisers, will be attained. Baumol does not establish the relationship between the firm and industry.
4. In the case of multiproducts, Baumol has argued that revenue and profit maximisation yield the same results. But Williamson has shown that sales maximisation yields different results from profit maximisation.
5. Another weakness of this model is that it ignores the interdependence of the prices of oligopolistic firms.
6. The model fails to explain “observed market situations in which price are kept for considerable time periods in the range of inelastic demand.”
7. The model ignores not only actual competition, but also the threat of potential competition from rival oligopolistic firms.
8. Prof. Hall in his analysis of 500 firms came to the conclusion that firms do not operate in accordance with the objective of sales maximisation.
(2) Maximisation of firm’s growth rate: According to Robin Marris managers maximize firm’s balanced growth rate. He defines firm’s balanced growth rate (G) as:
G = GD = GC
Where, GD = Growth rate of demand for firms product
GC = Growth rate of capital supply to the firm
(3) Maximisation of managerial utility function: According to this concept managers seeks to maximize their own utility function subject to a minimum level of profit.
(4) Long-run survival of the firm: According to this concept, the primary goal of the firm is long-rum survival. The managers, therefore, seeks to secure their market share and long-run survival. The firms may seek to maximize their profit in the long-run though it is not certain.
Perfect Competition and Its Features
Meaning: Perfect Competition is a form of market in which there is a large number of buyers and sellers. They sell homogeneous goods. Firm produces only a small portion of the total output produced by the whole industry. An industry is a group of different firms producing the same product. A single firm cannot affect the price by its individual efforts. Price is fixed by the industry. Firm is only a price taker and not a price-maker. It can sell the desired output only at the price-fixed by the industry. In such a market, price of the commodity is the same at every place. There is also free entry and exit of the firms. Both the buyers and sellers have perfect information about the prevailing price in the market. Thus perfect competition is the name given to a market in which buyers and sellers compete with one another in the purchase and sale of a commodity. No one of them has any individual influence over the price of the commodity.
According to Bilas, “The perfect competition is characterized by the presence of many firms: they all sell identically same product. The seller is a price taker.” Ferguson said, “Perfect competition describes a market in which there is a complete absence of direct competition among economic groups.”
Features of Perfect Competition
Different definitions given by different economists point out the distinct features of perfect competition. We can list various features which point out that the form of a market is perfectly competitive. In other words, there are some necessary conditions which must be satisfied if the market is to be perfectly competitive. We can explain these below:
1.       Large number of small, unorganized firms: The first condition which a perfectly competitive market must satisfy is concerned with the seller’s side of the market. The market must have such a large number of sellers that on one seller is able to dominate in the market. No single firms can influence the price of the commodity. These firms must be all relatively small as compared to the market as a whole. Their individual outputs should be just a fraction of the total output in the market.
2.       A large number of small, unorganized buyers: On the buyer’s side the perfectly competitive market must also satisfy this condition. There must be such a large number of buyers that no one buyer is able to influence the market price in any way. Each buyer should purchase just a fraction of the market supplies. Further the buyers should not have any king of union or organization so that they compete for the market demand on an individual basis.
3.       Homogeneous products: Another pre-requisite of perfect competition is that all the firms or sellers must sell completely identical or homogeneous goods. Their products must be considered to be identical by all the buyers in the market. There should not be any differentiation of products by sellers by way of quality, variety, colour, design, packing or other selling conditions of the product.
4.       Free entry and free exit for firms: under perfect competition, there is absolutely no restriction on entry of new firms in the industry or the exit of the firms from the industry which want to leave it. This condition must be satisfied especially for long period equilibrium of the industry.
5.       Perfect knowledge among buyers and sellers about market conditions: Another pre-requisite of perfect competition is that both buyers and sellers must be having perfect knowledge about the conditions in which they are operating. Seller must know the prices being quoted or charged by other sellers in the market from the buyers. Similarly buyers must know the prices being charged by different sellers.
6.       Perfect mobility: Another feature of perfect competition is that goods and services as well as resources are perfectly mobile between firms. Factors of production can freely move from one occupation to another and from one place to another. There is no barrier on their movement. No one has monopoly or control over the factors of production. Goods can be sold to a place where their prices are the highest. There should not be any kind of limitation on the mobility of resources.
7.       Absence of transport cost: Another feature of perfect competition is that all the firms have equal access to the market. Price of the product is not affected by the cost of transportation of goods. In other words, we can say that the market price charged by different sellers does not differ due to location of different sellers in the market. Thus, there is complete absence of transport cost of the product from one part of the market to other.
8.       Absence of selling cost: Under conditions of perfect competition, there is no need of selling costs. We know that under perfect competition, goods are completely homogeneous. Price of the product is also the same for a single product. Firms have no control over the price of the product. When they cannot change the price and when their goods are completely similar, firms need not make any expenditure on publicity and advertisement.
Limitations of Perfect Competition
1)      Perfect competition is a ‘Theoretical Model’. The nearest example that we can cite is some agricultural commodities where producers (farmers) and consumers are large number. Many commodities such as wheat, rice are standardized. At present, company shares of a given business firm which are identical, with its large number of buyers and sellers, with full information available thought electronic media, can be another approximate example. Otherwise perfect competition market is more a theoretical model than a practical one.
2)      Unrealistic Assumptions: All the assumptions on which a perfect competition market is based on are unrealistic ones. Even if we take a village or a local market, still many assumptions remain impractical. Equilibrium production is decided at a point where MC = MR. In reality most of the business people are unaware of this rule, and if they aware they either do not or cannot apply.

Price and Output Determination under Perfect Competition
Though perfect competition is rare, almost a non-existent situation, yet we study price determination under the situation. A perfectly competitive market is one in which the number of buyers and sellers is very large, All engaged in buying and selling a homogeneous product without any artificial restriction and possessing perfect knowledge of a market at a time.
There are two parties which bargain in such a market, the buyers and the sellers. It is only when they agree,  a commodity can be bought and sold at a certain price. Thus product pricing is influenced both by buyers and sellers, that is by demand and supply.
The demand and supply are the two forces, which move in the opposite directions. Price is determined at a point where these two forces are equal, that is known as equilibrium price. In a perfectly competitive market, market demand and market supply determine the equilibrium price.
Equilibrium of a Firm under Perfect Competition
Meaning of Firm’s Equilibrium: A firm is in equilibrium when it is satisfied with its existing amount of output. A firm in equilibrium has no tendency either to increase or decrease its output. . It needs neither expansion nor contraction. It wants to earn maximum profits.
In the words of A.W. Stonier and D.C. Hague, “A firm will be in equilibrium when it is earning maximum money profits.”
Equilibrium of the firm can be analysed in both short-run and long-run periods. A firm can earn the maximum profits in the short run or may incur the minimum loss. But in the long run, it can earn only normal profit.
Equilibrium of the firm can be studied by two approaches:
1)      Total Revenue and Total Cost Approach.
2)      Marginal Cost and Marginal Revenue Approach.
Total Revenue and Total Cost Approach: According to this approach, profits are the difference between total revenue and total cost.
Marginal Revenue and Marginal Cost Approach: This analysis is based on the following assumptions:
a)      All firms in an industry use homogeneous factors of production.
b)      Their costs are equal. Therefore, all cost curves are uniform.
c)       They use homogeneous plants so that their SAC curves are equal.
d)      All firms are of equal efficiency.
e)      All firms sell their products at the same price determined by demand and supply of the industry so that the price of each firm is equal to AR = MR.
According to this approach, a firm is in equilibrium when two conditions are fulfilled:
a)      Marginal Cost should be equal to Marginal Revenue (MC = MR)
b)      MC curve cuts MR curve from below.
 Determination of Equilibrium of the Firm: Equilibrium of the firm can be analysed in both short-run and long-run periods. A firm can earn the maximum profits in the short run or may incur the minimum loss. But in the long run, it can earn only normal profit.
Short-run Equilibrium of the Firm:
The short run is a period of time in which the firm can vary its output by changing the variable factors of production in order to earn maximum profits or to incur minimum losses. The number of firms in the industry is fixed because neither the existing firms can leave nor new firms can enter it. The firm is in equilibrium when it is earning maximum profits as the difference between its total revenue and total cost. A firm is short run equilibrium may face any of the three situations:-
1)      Super Normal Profits (AR > AC): A firm is in equilibrium when its marginal cost is equal to marginal revenue and marginal cost curve cuts marginal revenue from below. A firm is in equilibrium earns super normal profit, when average revenue is more than its average cost. It can also be explained with the help of following diagram:
In this figure, output of the firm is shown on OX-axis and cost/revenue on OY-axis. MC is the marginal cost and AC is average cost curve. PP is the average revenue and marginal revenue curve (MR = AR). Supposing OP is the price determined by the industry. At this price, firm’s equilibrium will be at point E, where marginal cost is equal to marginal revenue and marginal cost curve cuts marginal revenue curve from below.
Equilibrium output is OM. At this output AR (price) = EM and AC = AM. Since AR (EM) > AC (AM), firm is earning EA super normal profit per unit of output.
                Per Unit super normal profit = EA
                Total Super-Normal Profit      = EABP

2)      Normal Profits (AR = AC):- Normal profits cover just the reward for entrepreneurial services and are included in the cost of production. So that, a firm in equilibrium earns normal profits when its average cost is equal to the average revenue i.e. AC = AR.
In this figure, output of the firm is shown on OX-axis and cost/revenue on OY-axis. MC is the marginal cost and AC is average cost curve. PP is the average revenue and marginal revenue curve (MR = AR). Supposing OP is the price determined by the industry. At this price, firm’s equilibrium will be at point E, where marginal cost is equal to marginal revenue and marginal cost curve cuts marginal revenue curve from below. The firm earns normal profits at equilibrium output because its average cost and average revenue are equal.
Normal Profits = MC = MR = AC = AR.
3)      Minimum Loss (AR < AC):- A firm in equilibrium may incur minimum loss when the average cost is more then the average revenue and average revenue is equal to average variable cost. Even if, the firm discontinues its production, in the short run, it will have to bear the loss of fixed costs. Loss of fixed costs is the minimum loss of the firm.
In this figure, output of the firm is shown on OX-axis and cost/revenue on OY-axis. MC is the marginal cost and AC is average cost curve. PP is the average revenue and marginal revenue curve (MR = AR). Supposing OP is the price determined by the industry. At this price, firm’s equilibrium will be at point E, where marginal cost is equal to marginal revenue and marginal cost curve cuts marginal revenue curve from below.
At equilibrium point An (AC) is more than EN (AR). In other words, average cost is more then average revenue by AE which represents per unit loss. As such firm’s total loss is AEPB.
Per Unit Loss = AE
Total Loss       = AEPB
From the above discussion, We may conclude from the above discussion that in the short-run each firm may be making either supernormal profits, or normal profits or losses depending upon the price of the product.
Long-run Equilibrium of the Firm:
In the long-run, it is possible to make more adjustments than in the short-run. The firm can adjust its plant capacity and scale of operations to the changed circumstances. Therefore, all costs are vari­able. Firms must earn only normal profits. In case the price is above the long-run AC curve firms will be earning supernormal profits.
Attracted by them, new firms will enter the industry and supernormal profits will be competed away. If the price is below the LAC curve firms will be incurring losses. As a result, some of the firms will leave the industry so that no firm earns more than normal profits. Thus “in the long-run firms are in equilibrium when they have adjusted their plant so as to produce at the mini­mum point of their long-run AC curve, which is tangent (at this point) to the demand (AR) curve defined by the market price” so that they earn normal profits.
It’s Assumptions: This analysis is based on the following assumptions:
a)      Firms are free to enter into or leave the industry.
b)      All firms are of equal efficiency.
c)       All factors are homogeneous. They can be obtained at constant and uniform prices.
d)      Cost curves of firms are uniform.
e)      The plants of firm: are equal having given technology.
f)       All firms have perfect knowledge about price and output.
Determination:
Given these assumptions, each firm of the industry will be in the following two conditions.
(1) In equilibrium, its short-run marginal cost (SMC) must equal to its long-run marginal cost (LMC) as well as its short-run average cost (SAC) and its long-run average cost (LAC) and both should be equal to MR=AR=P. Thus the first equilibrium condition is:
SMC = LMC = MR = AR = P = SAC = LAC at its minimum point, and
(2) LMC curve must cut MR curve from below.
Both these conditions of equilibrium are satisfied at point E in Figure 3 where SMC and LMC curves cut from below SAC and LAC curves at their minimum point E and SMC and LMC curves cut AR = MR curve from below. All curves meet at this point E and the firm produces OQ optimum quantity and sell it at OP price.
Since we assume equal costs of all the firms of industry, all firms will be in equilibrium m the long-run. At OP price a firm will have neither a tendency to leave nor enter the industry and all firms will earn normal profit.

Short-run and long-run equilibrium of the Industry in Perfect Competition Market
Meaning of Industry: The group of firms producing homogenous products is called industry. Such firms are found only under perfect competition. An industry is in equilibrium when it has no tendency in change its size.
Conditions of an Industry’s Equilibrium: An industry will be in equilibrium when the number of its firms remains constant. In this situation, no new firm will enter and no old firm will leave the industry. Another condition of an industry’s equilibrium is that all firms operating in it are in equilibrium and have no tendency either to increase or to decrease their output. Conditions of equilibrium of firm are:
a)      MC = MR.
b)      MC curve cuts MR curve from below.
Equilibrium of an industry can be studies under two heads:
1) Short Run Equilibrium of the Industry
The industry is in equilibrium at that price at which quantity demanded is equal to quantity supplied. But for industry to be in full equilibrium, in the short run, is very rare. Full equilibrium position is possible only when all firms earn just normal profit. But in the short run, some firms may be earning super-normal profit and others may be incurring losses.
Short-run equilibrium is explained with the help of following diagram:

In this figure, DD is the demand curve and SS the supply curve of industry. They both intersect at point E. So point E, indicates equilibrium of industry. In this case OP is the equilibrium price and OQ is the equilibrium output. But it will not be full equilibrium of industry, if some firms are getting super normal profit and others are incurring losses. In Figure (B) the firm is getting super normal profit at the prevailing price OP as shown by ABEP shaded area. Figure (C) firm is incurring losses at the prevailing price OP as shown by PERT shaded area.
In short the industry is in equilibrium at that price at which the demand for and supply of its production are equal. But in the position of equilibrium of industry, the firms may earn super normal profit or incur losses. As such, industry is ordinarily not in full equilibrium in short period.
2) Long-run Equilibrium of the Industry:- In the long run, an industry is in equilibrium when its firms are earning normal profit. Long run equilibrium of the industry means that no new firm has a tendency to enter it not any old firm has a tendency to leave it. Long-run equilibrium is explained with the help of following diagram:
In this figure, DD is demand and SS is supply curve of the industry. Both intersect each other at point ‘E’. Thus E is the equilibrium point of the industry that determines OP as the equilibrium price. It indicates that firms are getting only normal profits.
Short-run and Long-run Supply curve
Short-run supply curve: The short-run is a period in which the firms can change its supply only upto a certain limit. The firms can vary its supply by changing the variable factors. The firms cannot change its fixed factors i.e. they cannot vary the scale of its plant. Moreover, no new firm can enter into the industry or existing firm can quit the industry in the short-run. Thus, the number of firms in the industry cannot change in the short-run. The firms can increase the supply by intensively using the fixed equipments with increased employment of the variable factors. Thus, the supply of the industry can be increased only within the limit set by the plant capacity of the existing firms. In other words, both the demand and the supply have impact on the price in the short-run. But the supply is not stronger than the demand in the short-run. How is the price in the short-run determined through the interaction of short-period supply and demand curve is shown in the following figure.
 


                Y
                                                SRS (Short-run Supply Curve)



                                                                E2
                P2
Price                                          E1
                P1

                                                                                                D2
                                S
                                                                                       D1

                O                                 Q1       Q2                                         X
                                          Units of goods       
In the diagram, the initial equilibrium price (OP1) is determined through the interaction between the demand (D1D1) and the supply curve (SS)
When demand increases from D1D1 to D2D2, price goes up from OP1 to OP2 and quantity from QQ1 to QQ2. Thus an increase in demand will raise both the quantity and the price in the short-run.  The short-run equilibrium price is also called the sub-normal price.
Long-run Supply Curve: Long-run is such a period enough to adjust fully the supply of the industry to meet the changes in demand. In the long-run, the firms can enlarge the sizes of the plants and thereby, increase the supply to meet the increased demand for the product. Thus, the shift in demand can be met by greater adjustment in output. In other words, the supply is more dominant force in the price-determination in the long-run. The supply curve is relatively higher elastic. The equilibrium price determined through the interaction of the demand and the long-run supply curve is called ‘normal price’. This is shown in the following figure.
                                Y                                  LRS (Long-run Supply Curve)


                                P2                                                    E2
                                                                                                                                                                                                                                                                                                                                                                                                        P1                                                                E1
                                                                                                                                                                            D2
                                                                                                             D1
                                O                                    Q1        Q2                                X
                                                           

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