"Price and Output Determination Under Perfect Competition" chapter:
Market Structure:
A market is a set of conditions in which buyers and sellers meet each other for the purpose of exchange of goods and services for money. Continue reading.
Perfect Competition:
The concept of perfect competition was first introduced by Adam Smith in his book "Wealth of Nations". Continue reading.
Equilibrium of the Firm:
A firm under perfect competition faces an infinitely elastic demand curve or we can say for an individual firm, the price of the commodity is given in the market. Continue reading.
Short Run Equilibrium of the Price Taker Firm:
By short run is meant a length of time which is not enough to change the level of fixed inputs or the number of firms in the industry but long enough to change the level of output by changing variable inputs. Continue reading.
Short Run Supply Curve of a Price Taker Firm:
In a competitive market, the supply curve of a firm is derived from its marginal cost curve. Supply curve is that portion of the marginal cost curve which lies above the average variable cost curve. Continue reading.
Short Run Supply Curve of the Industry:
The short run supply curve of a competitive firm is that part of the marginal cost curve which lies above the average variable cost. Continue reading.
Long Run Equilibrium of the Price Taker Firm:
All the firms in a competitive industry achieve long run equilibrium when market price or marginal revenue equals marginal cost equals minimum of average total cost. Continue reading.
Long Run Supply Curve For the Industry:
While explaining the short run supply curve for the firm, we stated that the supply curve in the short run is that portion of the marginal cost curve which lies above the average variable cost curve, it is because of the fact that when the variable casts of a firm are realized, the firm decides to produce the goods. Continue reading.
Price Determination Under Perfect Competition:
Dr. Alfred Marshall was the first economist who pointed out that the pricing problem should be studied from the view point of time. Continue reading.
Market Price:
In a market, there are two sets of forces tending in the opposite direction. On the one side, there are large number of buyers who compete with one another for the purchase of commodities at lower prices. Continue reading.
Determination of Short Run Normal Price:
In the short run, the size of a firm and the number of firms comprising an industry remain the same. The time is considered to be so short that if demand for product increases, the old firm can use their existing equipments more intensively but new firms cannot enter into the industry. Continue reading.
Long Run Normal Price and the Adjustment of Market Price to the Long Run Normal Price:
When we speak of a long period, we do not mean an interval of time in which we all may be dead. By long run is meant the period in which the factors of production can be adjusted to changes in demand. Continue reading.
Distinction/Difference Between Market Price and Normal Price:
The main points of distinction/difference between market price and normal price are as follows: Continue reading.
Interdependent Prices:
We have discussed the determination of price and output of a firm (Market Price) producing a single commodity. We will be dealing now with the pricing of interconnected commodities.Continue reading.
Joint Supply:
When two or more commodities come into existence as a result of a single process and with the same expenses, they are said to be in joint supply. Continue reading.
Fixation of Railway Rates:
The railway freights are fixed on the principle of "What that traffic wilt bear". By the phrase "what the traffic will bear" is meant the fixation of railway rates according to the freight bearing capacity of each service performed by the railway. Continue reading.
Perfect Competition:
Definition:
The concept of perfect competition was first introduced by Adam Smith in his book "Wealth of Nations". Later on, it was improved by Edgeworth. However, it received its complete formation in Frank Kight's book "Risk, Uncertainty and Profit" (1921).
Leftwitch has defined market competition in the following words:
"Prefect competition is a market in which there are many firms selling identical products with no firm large enough, relative to the entire market, to be able to influence market price".
According to Bllas:
"The perfect competition is characterized by the presence of many firms. They sell identically the same product. The seller is a price taker".
The main conditions or features of perfect competition are as under:
Features/Characteristics or Conditions:
(1) Large number of firms. The basic condition of perfect competition is that there are large number of firms in an industry. Each firm in the industry is so small and its output so negligible that it exercises little influence over price of the commodity in the market. A single firm cannot influence the price of the product either by reducing or increasing its output. An individual firm takes the market price as given and adjusts its output accordingly. In a competitive market, supply and demand determine market price. The firm is price taker and output adjuster.
(2) Large number of buyers. In a perfect competitive market, there are very large number of buyers of the product. If any consumer purchases more or purchases less, he is not in a position to affect the market price of the commodity. His purchase in the total output is just like a drop in the ocean. He, therefore, too like the firm, is a price taker.
In the figure (15.1) PK is the market price determined by the market forces of demand and supply. The price taker firm has to adjust and sell its output at Price PK or OE.
Diagram/Figure:
(3) The product is homogeneous. Another provision of perfect competition is that the good produced by all the firms in the industry is identical. In the eyes, of the consumer, the product of one firm (seller) is identical to that of another seller. The buyers are indifferent as to the firms from which they purchase. In other words, the cross elasticity between the products of the firm is infinite.
(4) No barriers to entry. The firms in a competitive market have complete freedom of entering into the market or leaving the industry as and when they desire. There are no legal, social or technological! barriers for the new firms (or new capital) to enter or leave the industry. Any new firm is free to start production if it so desires and stop production and leave the industry if it so wishes. The industry, thus, is characterized by freedom of entry and exit of firms.
(5) Complete information. Another condition for perfect competition is that the consumers and producers possess perfect information about the prevailing price of the product in the market. The consumers know the ruling price, the producers know costs, the workers know about wage rates and so on. In brief, the consumers, the resource owners have perfect knowledge about the current price of the product in the market. A firm, therefore, cannot charge higher price than that ruling in the market. If it does so, its goods will remain unsold as buyers will shift to some other seller.
(6) Profit maximization. For perfect competition to exist, the sole objective of the firm must be to get maximum profit.
Importance:
Perfect competition model is hotly debated in economic literature. It is argued that the model is based on unrealistic assumptions. It is rare in practice. The defenders of the model argue that the theory of perfect competition has positive aspect and leads us to correct conclusions. The concept is useful in the analysis of international trade and in the allocation of resources. It also makes us understand as to how a firm adjusts its output in a competitive world.
Distinction Between Pure Competition and Perfect Competitions:
For a pure competition to exist, there are three main requisites, i.e., (1) homogeneity of product (2) large number of firms and (3) ease of entry and exist of firms.
A perfect competition, on the other hand, is made up of all the six postulates stated earlier.
Equilibrium of the Firm Under Perfect Competitionor Marginal Revenue = Marginal Cost (MR = MC) Rule:
Definition and Explanation:
A firm under perfect competition faces an infinitely elastic demand curve or we can say for an individual firm, the price of the commodity is given in the market. The firm while making changes in the amounts of variable factor evaluates the extra cost incurred on producing extra unit MC (Marginal Cost).
It also examines the change in total receipts which results from the sale of extra unit of production MR (Marginal Revenue). So long as the additional revenue from the sale of an extra unit of product (MR) is greater than the additional cost (MC) which a firm has to incur on its production, it will be in the interest of the firm to increase production.
In economic terminology, we can say, a firm will go on expanding its output so long as the marginal revenue of any unit is greater than its marginal cost. As production increases, marginal cost begins to increase after a certain point. When both marginal revenue and marginal cost are equal, the firm is in equilibrium. The firm at this equilibrium point is cither ensuring maximum profit or minimizing losses. This is shown with the help of a diagram below:
Diagram/Figure:
In the figure (15.2) quantity of output is measured along OX axis and marginal cost and marginal revenue on OY axis. The marginal cost curve cuts the marginal revenue curve at two points K and T.
The competitive firm is in equilibrium, at both these points as marginal cost equals marginal revenue. The firm will not produce OM quantity of good because for OM output, the marginal cost is higher than marginal revenue. Marginal cost curve cuts the marginal revenue curve from above. The firm incurs loss equal to the black shaded area for producing 50 units (OM) of output.
As production is increased from 50 units to 350 units (from OM to OS) marginal cost decreases at early levels of output and then increases thereafter. The marginal cost curve cuts the marginal revenue curve from below at point T. The shaded portion between M to S level of output shows profit on production. When a firm produces OS quantity of output; it earns maximum profit. The point T where MR = MC is the point of maximum profit.
In case, the firm increases the level of output from OS, the additional output adds less to Its revenue than to its cost. The firm undergoes losses as is shown in the shaded area.
Summing up, profit maximization normally occurs at the rate of output at which marginal revenue equals marginal cost. This golden rule holds good for all market structures. As regards the absolute profits and losses of the firm, they depend upon the relation betweenaverage cost and average revenue of the firm.
Short Run Equilibrium of the Price Taker Firm Under Perfect Competition:
Definition and Explanation:
By short run is meant a length of time which is not enough to change the level of fixed inputs or the number of firms in the industry but long enough to change the level of output by changing variable inputs.
In short period, a distinction is made of two types of costs (i) fixed cost and (ii) variable cost.
The fixed cost in the form of fixed factors i.e., plant, machinery, building, etc. does not vary with the change in the output of the firm. If the firm is to increase or decrease its output, the change only takes place in the quantity of variable resources such as labor, raw material, etc.
Further, in the short run, the demand curve facing the firm is horizontal. No new firms enter or leave the industry. The number of firms in the industry, therefore, remain the same. Underperfect competition, the firm takes the price of the product as determined in the market. The firm sells all its output at the prevailing market price. The firm, in other words, is a price taker.
Equilibrium of a Competitive Firm:
The short-run equilibrium of a firm can be easily explained with the help of marginal revenue = marginal cost approach or (MR = MC) rule.
Marginal revenue is the change in total revenue that occurs in response to a one unit change in the quantity sold. Marginal cost is the addition to total cost resulting from the additional of marginal unit. Since price is given for the competitive firm, the average revenue curve of a price taker firm is identical to the marginal curve. Average revenue (AR) thus is equal to marginal revenue (MR) is equal to price (MR = AR = Price).
According to the marginal revenue and marginal cost approach or (MR = MC) rule , a price taker firm is in equilibrium at a point where marginal revenue (MR) or price is equal to marginal cost The point where MR = MC = Price, the firm produces the best level of output. From this it may not be concluded that the perfectly competitive firm at the equilibrium level of output (MR = MC = Price) necessarily ensures maximum profit. The fact is that in the short period, a firm at the equilibrium level of output is faced with four types of product prices in the market which give rise to following results:
(i) A firm earns supernormal profits.
(ii) A firm earns normal profits.
(iii) A firm incurs losses but does not close down.
(iv) A firm minimizes losses by shutting down. All these short run cases of profits or losses are explained with the help of diagrams.
Determining Profit from a Graph:
(1) Profit Maximizing Position:
A firm in the short run earns abnormal profits when at the best level of output, the market price exceeds the short run average total cost (SATC). The short run profit maximizing position of a purely competitive firm is explained with the help of a diagram.
Diagram/Graph:
In the figure (15.3), output is measured along OX axis and revenue / cost on OY axis. We assume here that the market price is equal to OP. A price taker firm has to sell its entire output at this prevailing market price i.e. OP. The firm is in equilibrium at point L. Where MC = MR. The inter section of MC and MR determine the quantity of the good the firm will produce.
After having determined the quantity, drop a vertical line down to the horizontal axis and see what the average total cost (ATC) is at that output level (point N). The competitive firm will produce ON quantity of output and sell at market price OP. The total revenue of the firm at the best level of output ON is equal to OPLN. Whereas the total cost of producing ON quantity of output is equal to OKMN. The firm is earning supernormal profits equal to the shaded rectangle KPLM. The per unit profit is indicated by the distance LM or PK.
It may here be noted that a firm would not produce more than ON units because producing another unit adds more to the cost than the firm would receive from the sale of the unit (MC > MR). The firm would not stop short of ON output because producing another unit adds more to the revenue than to cost (MR > MC). Hence, ON is the best level of output where profit of the firm is maximum.
A firm, in the short run, may be making zero economic profit or normal economic profit. It may here be remembered that although economic profit is zero, all the resources including entrepreneurs are being paid their opportunity. So they are getting a normal profit the case of normal profits of a firms at break even price is explained with the help of the diagram 15.4.
We assume in the figure (15.4) that OP is the prevailing market price and PK is the average revenue, marginal revenue curve. At point K, which is the break even price for a Competitive firm, the MR, MC and ATC are all equal. The firm produces OM output-and sells at market price OP. The total revenue of the firm to equal is the area OPKM. The total cost of producing OM output also equals the area OPKM. The firm is earning only normal profits. It is a situation in which the resources employed by the firm are earning just what they could-earn in some other alternative occupations.
The firm in the short rue is minimizing tosses if the market price is smaller than average total cost but larger than average variable cost. The loss minimizing position of a price taker firm is explained with the help of a diagram.
We assume in the figure (15.5) that the market price is QP. The firm is in equilibrium at point N where MR = MC. The firm's best level of output is OK which is sold at unit cost OP. The total revenue of the firm is equal to the area OPNK. The total cost of producing OK quantity of output is equal to OTSK. The firm is suffering a net loss equal to the shaded area PTSN.
The firm at price OP in the market is covering its full variable cost and a part of the fixed cost. The loss of part of fixed cost equal to the shaded area PTSN is less than, the firm would incur by closing down. In case of shut down, the firm has to bear the total fixed cost ETSF. The firm thus by producing OK output and selling at OP price is minimizing losses. Summing up, in the short run the firm will not go out of business for as long as the loss m staying the business is less than the loss from closing down.
(4) Short Run Shut Down:
The price taker firm in the short-run minimizes losses by closing it down if the market price is less than average variable cost. The shut down position of a Competitive firm is explained with the help of a diagram.
In this figure (15.6) we assume that the market price is OP. The firm, is in equilibrium at point Z where MR = MC. The firm produces OK output and sells at OP unit cost. The total revenue of the firm is equal to the area OPZK. Whereas .the total cost producing OK output is OTFR. The firm is suffering a net loss of total fixed cost equal to the area PTFZ. The firm at point Z is just covering average variable costs.
If the price falls below Z, the competitive firm will minimize its losses by closing down. There is no level of output which the firm can produce and realize a loss smaller than its fixed costs. It is therefore a shut down point for the firm. Operate When Price is > average variable cost.
"Price and Output Determination Under Monopoly" chapter:
What is Monopoly?
Monopoly is from the Greek word meaning one seller. It is the polar opposite of perfect competition. Monopoly is a market structure in which one firm makes up the entire market.Continue reading.
Conditions/Base of Monopoly Power:
The main conditions which give rise to monopoly are various. They are called collectively, "Barriers to Entry". These barriers block the entry of new firms into the industry and thus create monopoly. Continue reading.
Monopolist's Demand Curve:
Under perfect competition, the demand curve which an individual seller has to face is perfectly elastic, i.e., it runs parallel to the base axis. The competitive seller being unable to affect the market price sells its output at prevailing market price. Continue reading.
Short Run Equilibrium Price and Output Under Monopoly:
In the short period, the monopolist behaves like any other firm. A monopolist will maximize profit or minimize losses by producing that output for which marginal cost (MC) equals marginal revenue (MR). Continue reading.
Long Run Equilibrium Under Monopoly:
The monopolist creates barriers of entry for the new firms into the industry. The entry into the industry is blocked by having control over the raw materials needed for the production of goods or he may hold full rights to the production of a certain good (patent) or the market of the good may be limited. Continue reading.
Comparison Between Monopoly and Competitive Equilibrium or Perfect Competition:
The main points of difference and similarities of monopoly model with competitive modelare as follows: Continue reading.
Misconceptions Concerning Monopoly Pricing:
A question can be asked; can a monopolist charge very high price for his product? The answer to this question is not a difficult one; When a monopolist has to determine the price of his product, he has two options before him. Continue reading.
Monopoly Regulations:
A monopolist, being the sole supplier creates some undesirable aspects in the market:Continue reading.
Monopoly Price Discrimination:
While discussing price determination under monopoly, it was assumed that a monopolist charges only one price for his product from all the customers in the market. Continue reading.
Price and Output Determination Under Discrimination Monopoly:
Price discrimination takes place when a given product is sold by a monopolist at more than one price and these price differences are not justified by cost differences. Continue reading.
Assessment of Discriminating Monopoly or Price Discrimination:
Price discrimination is said to occur when a monopolist charges more than one price for an identical product and these price differences are not justified by cost differences. Continue reading.
Dumping:
Definition and Explanation:
Dumping is a special case of price discrimination. Dumping is a situation in which the price, a firm charges for its goods in a foreign market is lower than either the price it charges in its home market or the production cost. Dumping thus is the sale of surplus output of a firm on foreign markets at below cost price. Dumping also occurs when a firm sells its products at a higher price in the home market and at a lower price in the foreign market.
Reasons:
A firm may resort to dumping for a number of reasons which in brief are as under:
(1) Price discrimination: The first reason of dumping is price discrimination. If a firm has monopoly of a good in home market, but faces strong competition in foreign market, the firm will naturally charge a higher price in home market and lower competitive price in foreign market.
(2) Predatory pricing: The second major reason is predatory pricing. It is the practice of cutting prices of goods in an attempt to derive rival firms out of business.
(3) Surplus stock: A firm may resort to dumping to dispose off surplus stock.
(4) Economies of large scale production: The big firms where huge fixed capital is required for producing the goods may resort to dumping to avail of the economies of large scale production.
Dumping is illegal under international trade agreements of World Trade Organization (WTO). A nation can impose anti dumping duties only on production that are being dumped.
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