Pure Competition and Efficiency

      A purely competitive industry whether decreasing cost, increasing cost or a constant cost one should have some basic characteristics so that in long-run we may be able to talk about its economic efficiency. In a long Run a triple equation exists: P (Marginal Revenue) =MC =minimum ATC, which besides giving us information about economic profit or loss that our firm gains in short-run, tells us that in long-run a firm may get only a normal profit. This equation also suggests certain conclusions about Allocative and Productive efficiency of our economic unit in long-run.

   Productive efficiency requires goods to be produced at least costly way, but allocative efficiency requires goods to be divided among industries that yield most needed combination of products by society. Let’s see how productive and allocatice efficiency is realized in purely competitive market.
Productive efficiency: P= Minimum ATC
   In long run, pure competition forces firms to produce their goods at minimum average total costs and to charge price relative to cost of production, which is a situation that benefits consumers. If firms don’t use these least-cost production methods they may get high losses and at a point in time leave the market. In this case minimum quantity of resources is used to produce these goods.
   Let’s take for example a firm that produces 1000 kg of tomatoes. To cover all its cost of production it should sell all this quantity at price of 5$ per kg ( 5000$ totally). If another firm produces the same quantity for 9000$ then society will face a loss of 4000$ of alternative products. However, this loss can’t happen in pure competition, because this big loss may require our firm to leave the market.
Consumer benefits this kind of efficiency by paying lowest possible cost.

Allocative Efficiency: P=MC
     Productive efficiency alone doesn’t ensure to get the efficient mix of good, also least cost production must be used to provide society the most needed mix of products. But what does the products’ price means?

• Price of any product is the society’s measure of marginal unit of a good. Price of a tomato is the marginal benefit society gets from using it.
• Price of one more unit of any good is the opportunity cost society sacrifice to get it. If we produce any additional tomatoes we sacrifice growing more units of corn.

Let’s see the cases when this equation doesn’t take place.
Underallocation P>MC
     In pure competition a firm realizes the maximum profit when price of a good equals to its marginal cost. Producing tomatoes at points where MR (Price) is greater than MC (P>MC) yields less than maximum profit. This means that society is underallocating resources for producing this good, so that one more unit of tomato is valued by society higher than other products that our resources can produce.
Overallocation P<MC
   Production of tomatoes shouldn’t go beyond the price where marginal cost exceeds marginal revenue (Price). If we produce at a point where MC (marginal cost) is higher than marginal revenue, than the producers won’t obtain maximum profit. So it is an overallocation of resources to this produce. In our case by producing tomatoes at the point where (P<MC) means that we sacrifice goods used at production of tomatoes, which society values higher than tomatoes.
 Efficient Allocation
   So conclusion is that in a pure competition, firms should produce at a point where MR(Price)=MC, so that each item will be allocated efficiently in our society. To produce cucumber at a point where P>MC, means that we sacrifice production of goods, which society values very high, but at the point where P<MC it’s overallocation of resources, at production of which are used resources that may produce goods valued higher.
 Fast Adjustments
   Another important characteristic of purely competitive market is ability to change quantity output when there are some changes in consumer’s taste. So if cucumbers now become more popular initially their price will increase, so that P>MC, this fact will permit cucumber industry to take away resources from less profitable uses, let’s say potato.  So cucumber industry will expand.
   Similarly a change in supply of a particular resource will create a change in labor force, production technique or capital (machines). Thus managers have to reallocate all resources very fast until P=MC.
Invisible Hand
     Highly efficiency of allocating resources in a purely competitive market makes resource suppliers to seek to further their self-interests. This is the invisible hand which operates in our competitive market system. This kind of market system not only makes a patter to maximize profits but also maximized consumers’ satisfaction. Invisible hand operates good suppliers in such a way that society’s interests are maximized by using scarce resources.

Profit-Maximization in Short-Run (Pure competitive Market)

   Since the purely competitive firm is a price-taker, then to increase its revenue in short run it can change only quantity output.  Thus it can adjust its output by changes in amount of variable resources (materials, labor) it uses. So to maximize its revenues or to minimize its losses our firm has to adjust its quantity of resources used.
   There are two ways how to calculate the level of output for which our firm, in a pure competitive market, will get highest revenues. One of the methods is to compare total revenues and total costs, and another one is to compare marginal revenues and marginal costs. By the way, these methods can be applied not just in pure competitive market but also in pure monopoly, monopolistic competitive market and oligopoly.

Total Revenue- Total Cost Approach
       Total cost increases with output, because more production require more resources, but the rate of increase in the total cost varies with the efficiency of the firm. Specifically, the cost data reflect law of diminishing returns. Initially it increases with smaller amounts but after a point total cost rise by increasing amounts. Total revenue covers all costs (including normal profit) but there isn’t an economic profit. Economists call break-even point: an output value for which a firm makes a normal profit but not an economic profit. Any output between two break-even points produces an economic profit. The firm achieves maximum profit, where the vertical distance between Total Revenue and Total Cost is greatest.

Marginal Revenue- Marginal Cost Approach
   In this approach the firm compares marginal revenue (MR) and (MC) of each successive unit of output. The firm will produce any output for which marginal revenue is greater than marginal benefit because the firm will add more revenue from selling that item than the costs of producing it.
MR=MC Rule
   In the initial stages of production, when output is relatively low then the Marginal Revenue (MR) is usually greater than Marginal Cost (MC). So it’s profitable to produce in this range of output. But with additional units of output where quantity produced is relatively high, rising marginal cost will become greater than the marginal revenue. That’s why firms will try to avoid output quantity in this range. A point, where marginal revenue equals with marginal cost, separates these two regions.  In the short run, the firm will maximize profits or minimize its loss by producing that quantity of output where marginal cost equals with marginal benefit. This profit maximizing rule is known as MR=MC Rule.
Characteristics of MR=MC rule
    There are some important features of MR=MC rule and they can be stated as follows:

• The rule is applied only if producing is preferable to shutting down.
• The rule of profit maximization is applied to all firms whether they are purely competitive, monopolistic, monopolistically competitive, or oligopolistic.
• In pure competitive market our rule is transformed into P=MC, because demand faced by this seller is perfectly elastic. In this case marginal cost is equal to marginal revenue. So only in pure competitive market we may substitute P (price) instead of MR.

Profit Maximization Rule   
   How to determine the profit maximization output? It’s quite easy, all output values for which marginal revenue is greater than marginal cost add to total revenue, so the maximizing output is the last value for which marginal revenue is bigger than marginal cost. In Short Run the firm produces its goods until total revenue is greater than negative Average fixed Cost, however, if it is smaller, then it is better to shut down. Take care, “shut down” doesn’t mean to get off from market, because in short run a firm can’t leave the market.
   An example of Total Revenue and Total Cost -Quantity Demanded Graph(maximum economic profit is taken randomly, since no values are present) :

Characteristics of Pure Competition Market System

  Very large number of producers An important feature of this type of market system is the presence of big number of sellers that act independently and offer their products to large national and international markets. Example: the stock market, the exchange market.

• Standardized product Pure competitive firms produce a standardized product. Since price is the same demanders won’t care which product to buy. All goods are substitutes of each other.  They make no attempt to differentiate their products and there is not any non-price competition, because their goods are homogeneous.
• Price-Takers In pure competitive markets firms don’t try to control the price, because each firm is producing only a small amount of the total product, so increasing or decreasing their output won’t affect the price. We may say that firms and pure-competitive markets are price-takers: they can’t change the market price, they only adjust to it. Selling their goods on a higher price will results in loss of revenue, because 1000 sellers will offer their goods for a smaller price so the consumers, since the goods are identical, will buy less costly one, because in this way they get more marginal benefit. There isn’t any reason to decrease the price, because sellers want to get higher revenues if it is possible. By decreasing price they may lose higher profits. So the price of the sellers will be the same, since their goods are identical.
• Free entry and free exit  New firms can freely enter and the existing ones may exit the pure competitive industry. No legal, financial, technological or other obstacles prohibit suppliers to sell their goods in any pure-competitive market.

Even if pure competition is relatively rare in our real world, it is meaningful starting point for any discussion about price and output determination. It provides a standard for evaluating the efficiency of real world economy. Even if this kind of market system is extremely rare some industry may be a close approximation of it: market for agricultural goods, foreign exchange, and stock share market. So by means of them we can learn more about this model of market system.

Four Market Systems (summary)

  

  There are four models of market system: pure competition, pure monopoly, oligopoly, monopolistic competition.

Let’s describe them briefly:

• Pure competition– is a market structure that is composed of a very big number of firms that produce a standardized product. Entry and exit from this type of market is very easy.
• Pure monopoly- is a market structure in which one firm (or a very few ones) is single seller of a product or service. Entry to this kind of market system is blocked, so one firm can rule the entire industry. Monopolists produce unique product and there is not any reason to difference it, since there are not competitors.
• Monopolistic Competition-is characterized by relatively large number of suppliers who produce differentiated products. There is nonprice competition (each firm is trying to distinguish its product or service by some characteristics like quality, price). Entry to monopolistically competitive industry is relatively easy.
• Oligopoly- is made up of sellers with identical or similar products so that the change in price of one may affect future decisions of other firms.

Pure monopoly, oligopoly and monopolistic competition are considered as imperfect competition.