Lesson 7: Markets and competition - the differentiation of goods

1. Perfect Competition

Perfect Competition

In the perfect competition market none of the economic agents, buyer or seller, is able to individually influence prices. That is, price formation happens exclusively as a result of the action of supply and demand forces in the market. The conditions for the market to work in perfect competition can be listed as follows:
  1. There are many buyers and sellers, each small enough not to exert influence on market prices;
  2. Firms in the market of perfect competition seal a homogeneous product;
  3. Economic agents, buyers and sellers, have perfect information about products and prices in the market;
  4. There is free entry and exit of firms in the market.
The existence of a large number of buyers and sellers in the perfect competition market, distributed in an atomized way, ensures that not one of them can individually exercise market power. As the product is homogeneous, sellers will not have the incentive to raise prices, otherwise they will lose customers to competitors who sell a similar product. There is also no incentive to lower prices, since firms always expect to sell everything at the current price. The market information is the same for all economic agents, which ensures that no firm can sell above the competitive price. The barriers in this market are practically nonexistent. Thus a firm enters or leaves easily on the market. This market condition encourages firms to enter when there is economic gain and otherwise allow them to easily exit the market when there is loss. Profit, therefore, can occur in the short run, but is always zero in the long run.

Figure 01 shows the firm and market demand in perfect competition. The right panel shows the demand curve of the individual firm. Considering that sellers are price takers, each of the units of the product are sold at the same price Pe (equilibrium price), which makes the demand curve horizontal. The Marginal Revenue (RMg), which by definition is the increase in the firm's income as a consequence of the sale of one more unit of the product, will also be equal to the demand curve and the price of the product. This is because, as the price of the product does not change, the contribution of the sale of each unit sold to the company's revenue is the same. If, for example, a bottle of mineral water is sold for $ 1.00 in a perfect competition market, all other bottles will also be sold for $ 1.00. The marginal revenue of the company will always be the same and equal to the price of the product. The left panel of Figure 01 shows the balance between supply and demand, which represents the behavior of the market as a whole in relation to price formation. When, for example, there is an increase in supply, able to shift the curve to the right along the demand curve, a new market equilibrium will define lower prices. On the other hand, if there is a shift in demand to the right along the supply curve, a new equilibrium will set prices higher for the market. In either case, buyers and sellers adapt to the price defined by the interaction between supply of demand.

Figure 01 - Demand of Firm and Market in Perfect Competition

BOX 01 - Production Cost
The company's Total Cost of Production (CT) is equal to Fixed Costs (CF) plus Variable Costs (CV). Fixed costs are those that do not change when the volume of production increases or decreases. CF example is the rent that a company pays for the space where it works. Even if the production is zero, you will have to pay the rent because. The variable cost is one that depends on the quantity produced. The cost of a restaurant with food and other ingredients used to prepare meals varies. If you do not produce any meals you will not have to buy the inputs. The average cost (CTMe) is the CT divided by the number of units produced, the average variable cost (CVMe) is the variable cost divided by the quantity produced and the average fixed cost (CFMe) is the fixed cost divided by the number of units produced. Marginal Cost (CMg) is the cost to produce an additional unit of product.

In the short term, the entrepreneur can have economic profit (P> CTMe) or loss (Pe <CTMe). In the long term, the existence of profit attracts new firms to the market, while the injury stimulates the exit of some. Thus, the perfect long-term competitive price is always equal to CTMe. The perfect in-competition company experiencing prices below CTMe, but above CVMe, keeps in business. When Pe, however, is below CVMe, the company decides to close. That is, the company stays in the market when it manages to pay variable production costs, even if it does not fully pay the fixed costs. When you can no longer pay variable costs, you decide to leave the business.
Perfect Competition in the Short Run- Microeconomics [Courtesy of ACDCLeadership]