What Are the Distinctive Features of the Perfectly Competitive Model of the Market for Goods and Services? What Are the Implications for a Business Strategy Aimed at Enhancing Profitability?

What are the distinctive features of the perfectly competitive model of the market for goods and services? What are the implications for a business strategy aimed at enhancing profitability?

Perfect competition is an idealised market structure theory used in economics to show the market under a high degree of competition given certain conditions. This essay aims to outline the assumptions and distinctive features that form the perfectly competitive model and how this model can be used to explain short term and long term behaviour of a perfectly competitive firm aiming to maximise profits and the implications of enhancing these profits further.

In a perfectly competitive market each firm is a “Price Taker” , i.e. the prices and wages are determined by the market and the firm is so small relative to the size of the market that they can have no influence over the market price. For a market to be perfectly competitive there are certain conditions that have to be met.

The first set of conditions for perfect competition applies to the market structure. There are many small buyers and firms (suppliers), where none have an influence over the market price as they are small relative to the market as a whole. This means that each of the suppliers in the industry is a price taker. One firm’s change in output will not affect the total market supply. Products supplied in this market structure are homogenous, meaning that they are perfect substitutes for each other. This is another condition that makes each of the firms a price taker, as any rise in their price would lead to the buyer going to the next perfect substitute. For this condition to apply it further assumes that in the market there is perfect information for buyers so that they are aware of each firm’s price in the industry.

These market structure conditions allow the assumptions for perfect competition to be met. The first assumption is that firms are price takers, as explained by the first condition above. The fact that each firm is a price taker is acknowledged across the industry, so that there is no strategic behaviour because an individual firm cannot influence the market supply and demand. This is also linked into the behaviour of the buyers in the market. Buyers are also price takers because they can purchase as much as they wish without influencing the market price. The final assumption is important when considering the long term equilibrium price of a firm in perfect competition. This assumption is that entry into the market is free and that there are no barriers to entry. Any costs incurred are incurred by all of the suppliers; an entrant will pay no additional cost for entering the firm.

In the short run the perfect competition equilibrium can be found by graphing the marginal cost (MC), average total cost (ATC) and marginal revenue (MR) curves. In perfect competition the price is equal to the average revenue, which is equal to the marginal revenue and these are all constant, giving an infinitely elastic demand curve for the firm. The demand curve is “perfectly price elastic” due to the homogeneity of the products supplied, where each supplier, as a price taker, must focus on a single price. Given this, the only choice a supplier has in the short run is how much to produce. For profit maximisation to occur marginal costs (supply curve) must equal marginal revenue (demand curve). Profit maximisation is assumed to mean the maximisation of normal economic profit (i.e. revenue that covers the total costs of production by the firm including a return to capital) and not accounting profit, which just deducts explicit costs from total revenue. Supposing a firm sets its output so that ATC are below the profit maximisation point as shown in figure 1.

Figure 1.

Normal profit is produced where MC=MR=ATC. This is due to that fact that profit maximisation occurs where MC=MR and optimal output occurs at the lowest point of the ATC curve. In this case the difference between the AR and ATC curves denote the supernormal profit per unit. In figure 1 the shaded area represents the total supernormal profit. In a perfectly competitive market structure the earning of supernormal profit is a short run phenomenon.

This supernormal profit acts as an incentive for new suppliers to enter the market. This increases the total market supply. As there is no change in the market demand excess supply is present, so price levels will fall pack to a level of P to encourage demand, a point at which AR=ATC, so only normal profit is achieved. Figure 2 shows the long term equilibrium in a perfectly competitive market.

Figure 2.