Assumptions of Perfectly Competitive Market | Microeconomics

A perfectly competitive market satisfies a number of conditions. Each condition has an implications for the derivation of the short-run optimality condition (MR = MC = P) and long-run equilibrium condition (MR = MC = AR = AC).

The model of perfect competition bears little resemblance to this description. Perfect competition is distinguished largely by its impersonal nature.

To be most specific the following seven assumptions are made about a perfectly competitive firm. They are:

1. Profit-Maximising Conduct:

In perfectly competitive markets is it quite appropriate to assume profit maximisation on the part of the firms? Any profit realised by a firm belongs to its owner(s). For the millions of small businesses with only one owner-manager the decisions concern at to what products to produce and sell, whom to employ, what price to charge and so on are largely influenced by the way the owner’s profit is affected.

A potential problem with assuming profit maximisation is that the owner-manager cannot have detailed knowledge of the cost and revenue associated with each action that could be taken to maximise profit. Microeconomic theory, however, does not require that firms actually know or think in terms of marginal cost and revenue only that they behave as if they did.

2. Homogeneous Product:

All the firms in the industry must be producing a standardised or homogeneous product. This implies anonymity of firms and consumers. From a firm’s point of view this implies that the product of the firm is indistinguishable from the products of rival firms. In consumers’ eyes, the goods produced by different firms are perfect substitutes for one another.

So there is no reason why consumers should prefer the product of one firm to that of another. Moreover there is no selling cost because trademarks, patents, special brand, labels, etc. do not exist. The uniformity of consumers ensures that an individual firm will sell to the highest bidder.

This assumption allows us to add the outputs of the separate firms and talk meaningfully about the industry and its total output. It also contributes to the establishment and maintenance of a uniform price of the product. For example, one farmer is not able to sell corn for a higher price than another if the products are viewed as interchangeable, because consumers will always purchase from the lower-priced source.

3. Numerous Buyers and Sellers:

This means that the sales or purchases of each individual unit are small in relation to the total volume of transactions. So each buyer or seller is price-taker and quantity-adjuster. An individual firm can increase or reduce its output level without altering the market price. All buyers and sellers purchase and sell those quantities which they consider optimal for them at the prevailing price.

4. Presence of Complete Information:

Firms, consumers and factor owners must have all information necessary to make the correct economic decisions. For firms, the relevant information is knowledge of production technology, factor prices and the price of the product of the industry. For consumers, the relevant information is a knowledge of their own prefer­ences and the prices of the various goods they are interested in buying.

Moreover, the consumers, as suppliers of factor inputs, must know the remuneration (wages and compen­sation and returns) they can receive by supplying productive services. Since buyers and sellers possess complete information with respect to the quality and nature of the product and the prevailing market price, firms cannot discriminate, i.e., they cannot charge more than one price.

In other words, a uniform price prevails in all parts of the market. Since consumers seek to maximise utility they will not buy a commodity if a seller quotes a price which is slightly higher than the prevailing price. Similarly consumers cannot buy the commodity at less than the prevailing price from any firm. The horizontal (completely elastic) demand (average revenue) curve faced by the firm rules out the possibility of raising or lowering the price.

5. Parametric Input and Output Prices at the Firm Level:

The presence of numerous independent participants on each side of the market, none of whom is large enough in relation to total industry sales or purchases, normally guarantees that actions of individual participants will not affect the market price and overall industry output much.

If there are many firms in the market, each one realizes that its impact on the overall market is negligible. So it does not take other firms as potential rivals.

6. Non-Convex Technology:

Let us suppose the short-run production function is Q = f (L). Since under perfect competition the firm is a price taker in all its markets, it is too small to effect either the price of its output (p) or that of its variable factor L, which is the wage rate (w).

So the problem is:

max π = revenue – cost = PQ(L) – wL

For a unique local maximum we require:

In addition, since the firm has the option of producing nothing, we require: 

π ≥ 0 … … (3)

The second-order condition says that at the optimal output MP_L must be diminishing. This means that the production function must, at the optimal output, be concave from below as shown in Fig. 21.14. The reason for this is easy to find out.

Suppose we express the problem as max Q (L) – (w/r).L. As Fig. 21.14 shows, there are two values of L that satisfy the first-order condition (L₀ and L₁). But at L₁ profit is minimised. Only where the production function is locally concave is there a local profit maxi­mum. The profit (measured physi­cally in units of output Q) is 0π. The rest of output [πQ₀ = (w/p. OL₀)] is the wage bill.

Thus we prove the following two important propositions:

Proposition 1:

If there exists a local optimum for a profit-maximising competitive firm, the production function at that point has to be concave from below. This is what is meant by non-convexity of production technology.

Proposition 2:

Thus a profit-maximising price-taking firm will not be found producing where returns to scale are increasing.

Proof:

To prove this very important point we have to find out at what value of w/p the firm would employ L₂ units of labour in Fig. 21.14. It is not true to say that there are no ranges of output over which returns to scale are increasing. However, competitive producers do not produce there. This point may be proved in terms of cost.

Total cost = C = wL

AC = C/Q = w.L/Q

MC = dC/dQ = dC/dL dL/dQ = w ÷ dQ/dL = w/MP_L

Since Q/L ≥ dQ/dL, i.e., AP_L ≥ MP_L

MC ≥ AC

Here dC/dL is marginal labour cost, w since is L is the only variable factor.

Therefore average cost is non-decreasing [because only when AC is constant or rising MC is either = AC or MC >AC, which is implied by (4)]. This is the more general formulation in terms of costs, of the requirement of non-increasing returns to scale. Thus as a logical corollary of proposition 2, we make the following prediction;

Proposition 3:

A profit-maximising firm will not be found producing where average costs are decreasing i.e., where MC < AC. Thus we prove the important that equilibrium of a firm under perfect competition cannot occur unless MC is rising.

In addition, profit has to be non-negative, as shown by condition (3): π ≥ 0

This implies that Q/L ≥ w/p

or, average product (here average profit) ≥ real wage

But from the first-order condition (1)

w/p = MP_L

Hence Q/L ≥ MP_L = dQ/dL

L ^L dL

or, 1 ≥ dQ.L/dL.Q, where dQ/dL = Q/L = E_L= output elasticity of labour.

or, E_L ≤ 1

This implies non-increasing returns to scale. The output elasticity of labour (the only factor) must not exceed unity. When returns to scale are increasing and factors are paid their marginal product (,n units of output), the total product would be ‘over-exhausted’ in paying the factors and nothing would be left for profit.

In short, equilibrium under perfect competition does not occur unless marginal and average costs are rising.

7. Free Entry and Exit for Firms and Consumers in the Long Run:

Industry adjustments to changing market conditions are always accompanied by resources (such as labour power capital and raw materials) entering or leaving the industry. With industry expansion more labour, capital and other factors are used.

So resources enter the industry. Similarly resources leave a contracting industry. A perfectly competitive market requires that there be no differential impediments across firms in the mobility of resources into and output of a competitive industry. This condition is called free entry and exit.

Examples of barriers to entry and exit include an incumbent firm with an exclusive government patent or licence for carrying on business and economies of scale that impede the entry of new firms. This implies an unimpeded flow of resources between alternative occupations in the long run.

It assures that resources are mobile and always move into occupation from which they can make profits and leave those in which they incur losses. Resources such as labour and financial capital tend to be attracted to industries the products of which are in great demand. Inefficient firmware driven out from the market by the forces of competition and are replaced by efficient firms.

Since the demand curve is horizontal it can be tangent to the long-run average cost curve at the latter’s minimum point. This is the break-even point at which price is equal to AC_min. Free entry forces firms to achieve maximum possible efficiency in the long run and thus ensures the survival of the fittest.

Comments:

There is hardly any industry in the real world which completely satisfies all the six conditions. Trading in Agricultural commodities resembles this market very closely. Yet due to government involvement in such markets all the conditions cannot be fulfilled. Most industries satisfy some conditions but not all.

Even though the number of buyers and sellers of petrol at the retail level is large and entry into the business is fairly easy, all brands of petrol are not the same. Some brands have higher octane and more detergents and arc better for the physical environment.

Certain service stations (petrol pumps) are closer to particular consumers and thereby more convenient or offer better complements such as full service, food-marts, and the opportunity to purchase petrol by using credit cards. Moreover, consum­ers are rarely perfectly informed about the prices all retailers are charging.

The fact that only a few industries fully satisfy the six conditions does not mean that the study of perfect competition has no relevance in microeconomics. A number of industries come close enough to satisfy the six conditions to make the perfectly competitive mode quiet useful. Let us take the case of petrol retailing once again.

Although product homogeneity and perfect information may not fully apply, the extent to which an individual petrol station has some choice over what price to charge per litre is probably limited to a very narrow range of just a few paisa. Such a narrow pricing power band is very close to having no significant impact over price as predicted by the standard competitive model of analytical microeconomics.