Comparison of perfect and imperfect competition

ECONOMICS I :FINAL DRAFT

TOPIC : COMPARISION OF PERFECT AND IMPERFECT COMPETITION.

TABLE OF CONTENTS

1. INTRODUCTION………………………………………………….4
2. WHAT IS A MARKET?………………………………………………………….4
3. PERFECT COMPETITION………………………………………5
4. IMPERFECT COMPETITION……………………………………8
5. COMPARISION OF VARIOUS MARKETS……………………..9
6. COMPARISION ON BASIS OF DEMAND……………………..11
7. COMPARISION ON BASIS OF SUPPLY……………………….12
8. REAL WORLD SCENARIO……………………………………..13
9. CRITICISMS OF PERFECT COMPETITION……………………14
10. CONCLUSION……………………………………………………15
11. BIBLIOGRAPHY…………………………………………………16s

INTRODUCTION

The Father of Economics Adam Smith in his book “ The Theory of Moral Sentiments”, wrote about the main characteristics of human beings. According to him a human being is very selfish or possesses self-love as well as there exists an invisible hand. The concept of self- love in human being is one of the most important factor in “ the value theory” as well as in the development of market.

Generally a human being carries out economic activities till a point where he thinks that what I am paying is equal to what I am receiving, Human being willingly trade or carry out exchange till he feels that what I am giving is less and what I am receiving is more, once he realises that what I am giving is equal to what I am receiving, he will stop further trade.

This is one of the most important philosophy of consumers and producers. Both the concept is based on selfish motives of maximising returns in terms of their efforts that is money. Since an economy consists of various economic agents with diverse interests, allocating resources optimally becomes an intricate task. Economic planners have two mutually opposing means to solve this allocation problem: planning versus competition. Which avenue will be adopted by the planners depends crucially on their value judgments.

WHAT IS A MARKET?

“Originally” says Jevons, : a market was a public place in a town where provisions and other objects were exposed for sale; but the world has been generalised so as to mean any body of persons who are in intimate business relations and carry on extensive transactions in any commodity.

In the words of Cournot, a French economist, “Economics understand by the term market not any particular market placec in which things are bought and sold but the whole of any region in which buyers and sellers are in such free intercourse with one another that the price of the same goods tends to equality easily and quickly.”

Thus, the essentials of market are:

1. A commodity which is dealt with.
2. The existence of buyers and sellers
3. A place, be it certain region, country or entire world.
4. Such intercourse between buyers and sellers that only one price should prevail for the same commodity at the same time.

PERFECT COMPETITION

Perfect competition is a theoretical market structure. Perfect competition is the world of price-takers. A perfectly competitive firm sells a homogenous product. It is so small relative to its market that it cannot affect the market price; it simply takes the price as give.

Under perfect competition, there are many buyers and sellers, and prices reflect supply and demand. Also, consumers have many substitutes if the good or service they wish to buy becomes too expensive or its quality begins to fall short. New firms can easily enter the market, generating additional competition. Companies earn just enough profit to stay in business and no more, because if they were to earn excess profits, other companies would enter the market and drive profits back down to the bare minimum.

Real-world competition differs from the textbook model of perfect competition in many ways. Real companies try to make their products different from those of their competitors. They advertise to try to gain market share. They cut prices to try to take customers away from other firms. They raise prices in the hope of increasing profits. And some firms are large enough to affect market prices. But the perfect competition model is not an ideal that we should try to achieve in the real world.

Features of Perfect Competition

1. There are many small firms, each producing an identical product .
2. Each too small to effect the market price.
3. The perfect competitior faces a completely horizontal demand curve.
4. The extra revenue gained from each extra unit sold is therefore the market price.
5. Freedom of Entry and Exit; this will require low sunk costs.

Diagram for Perfect Competition

These factors are unrealistic in the real world. However Perfect Competition is as important economic model to compare other models. It is often argued that competitive markets have many benefits which stem from this theoretical model.

• In the Industry price is determined by the interaction of Supply and Demand.
• The firm will maximise output where MR = MC at Q1
• In the Long Run Firms will make Normal profits.

If Supernormal profits are made new firms will be attracted into the industry causing prices to fall. If firms are making a loss then firms will leave the industry causing price to rise.

Assumptions behind a Perfectly Competitive Market

1. Many suppliers each with an insignificant share of the market – this means that each firm is too small relative to the overall market to affect price via a change in its own supply – each individual firm is assumed to be a price taker

2. An identical output produced by each firm – in other words, the market supplies homogeneous or standardised products that are perfect substitutes for each other. Consumers perceive the products to be identical

3. Consumers have perfect information about the prices all sellers in the market charge – so if some firms decide to charge a price higher than the ruling market price, there will be a large substitution effect away from this firm

4. All firms (industry participants and new entrants) are assumed to have equal access to resources (technology, other factor inputs) and improvements in production technologies achieved by one firm can spill-over to all the other suppliers in the market.

IMPERFECT COMPETITION

Imperfect competition is a competitive market situation where there are many sellers, but they are selling heterogeneous (dissimilar) goods as opposed to the perfect competitive market scenario. As the name suggests, competitive markets that are imperfect in nature.

Imperfect competition is the real world competition. Today some of the industries and sellers follow it to earn surplus profits. In this market scenario, the seller enjoys the luxury of influencing the price in order to earn more profits. It prevails in an industry whenever individual sellers have some measure of control over the price of their output. Take the example of Coco-cola and perpsi together have the majpr share of the market, and imperfect competition clearly prevails.

If a seller is selling a non-identical good in the market, then he can raise the prices and earn profits. High profits attract other sellers to enter the market and sellers, who are incurring losses, can very easily exit the market. The major types of imperfect competition are : monopoly, oligopoly and monopolistic competition.

Monopolistic Competition: This market structure is characterized by a large number of relatively small competitors, each with a modest degree of market controlon the supply side. A key feature of monopolistic competition is product differentiation. The output of each producer is a close but not identical substitute to that of every other firm, which helps satisfy diverse consumer wants and needs.

Oligopoly: This market structure is characterized by a small number of relatively large competitors, each with substantial market control. Oligopoly sellers exhibit interdependent decision making which can lead to intense competition among the few and the motivation to cooperate through mergers and collisions.

Monopoly: Monopolies are thus characterized by a lack of economicto produce theorand a lack of viablesubstitute goods. Monopoly is an enterprise that is the only seller of a good or service. In the absence of government intervention, a monopoly is free to set any price it chooses and will usually set the price that yields the largest possible profit. Just being a monopoly need not make an enterprise more profitable than other enterprises that face competition, the market may be so small that it barely supports one enterprise.

But if the monopoly is in fact more profitable than competitive enterprises, economists expect that other entrepreneurs will enter the business to capture some of the higher returns. If enough rivals enter, their competition will drive prices down and eliminate monopoly power.

COMPARISION OF VARIOUS MARKETS

A distinction has been made between perfect and imperfect competition. “ A market is said to be perfect when all the potential sellers and buyers are promptly aware of the prices at which transactions take place and all the offers made by other sellers and buyers, and when any buyer can purchase from any seller. Same price same commodity same times is essential characteristic of perfect market.

On the other hand, a market is imperfect when some buyers or sellers or both are not aware of the prices made by others. Different prices come to prevail for the same commodity at the same time in an imperfect market.

COMPARISION ON BASIS OF DEMAND

In economics, basicallydemandis theutilityfor a good or service of an economic agent, relative to his income.Demand is a buyer’s willingness and ability to pay a price for a specific quantity of a good or service.

Demand refers to how much (quantity) of a product or service is desired by buyers at various prices. The quantity demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and quantity demanded is known as the demand.

The term demand signifies the ability or the willingness to buy a particular commodity at a given point of time.

In the above diagram, PART A reflects that the perfect competitor faces a horizontal demand curve, indicating that it can sell all it wants at the going market price. The price elasticity is perfectly elastic. When there is pure competition, since the number of firms is large, no individual has power to influence the market price. Also, since the products are identical from the consumer’s point of view, the price paid by them can’t be different. OX and OY are two axes. Along OX is the output and the OY is the price/revenue. At OP price a seller can sell as much as he likes. He cannot charge more and not charge less because then he’ll lose all his customers.

PART B says that an imperfect competition, in contrast, faces a downward sloping demand curve. Meaning that if an imperfect competitive firm increases its sales, it will definitely depress the market price of its output as it moves down its dd curve. The price elasticity is finite elastic.

COMPARISON ON BASIS OF SUPPLY

Competitive firm has direct implications for the market supply curve and the law of supply. The primary conclusion is that a perfectly competitive firm’s short-run supply curve is that segment of its marginal cost curve that lies above the average variable costcurve.

A perfectly competitive firm produces the quantity of output that equates marginal revenue, which is equal to price, and marginal cost, as long as price exceeds average variable cost. The profit-maximizing choices of output at alternative prices generate the perfectly competitive firm’s short-run supply curve.

Consider three key points:

1. A profit-maximizing firm produces the quantity of output that equates marginal revenue and marginal cost (MR = MC).
2. A perfectly competitive firm is characterized by the equality between price and marginal revenue (P = MR).
3. The law of diminishing marginal returns gives the marginal cost curve a positive slope.

Combining all three points means that a profit-maximizing perfectly competitive firm produces the quantity of output that equates price and marginal cost (P = MC).

• An increase in the price, moves the profit-maximizing quantity to a higher point on the positively-sloped marginal cost curve, and a larger production quantity.
• A decrease in the price, moves the profit-maximizing quantity to a lower point on the positively-sloped marginal cost curve, and a smaller production quantity.

REAL WORLD SCENARIO

In the post independence era, India adopted highly restrictive industrial policy. India’s industrial licensing policy created entry barriers for private enterprises in sectors earmarked for them and hence didn’t promote ‘perfect competition’. Indian planners who believed in the doctrine of ‘infant industry argument’ provided necessary protection to domestic manufactures from foreign competition by way of tariff barriers.

During this regulated regime, however, India’s industrial growth rate was not promising. In India, under Structural Adjustment Programme (SAP), industrial licensing policy was abolished and tariff and quantity restrictions on imports were also dispensed with. Thus the New Economic Policy made an effort to promote a competitive market system in India. As a result India’s industrial sector started showing some signs of improvement in terms of growth.

In the real world, situations like perfect market exists for markets for most of unbranded staple goods such as food grain and vegetables. However it should be noted that there is a trend of branding more and more of such goods also, and in this ways making their markets become more and more like oligopolistic markets.

In a monopoly like in Saudi Arabia the government has sole control over the oil industry. A monopoly may also form when a company has a copyright or patent that prevents others from entering the market. Pfizer, for instance, had a patent on Viagra.
In an oligopoly, assume, for example, that an economy needs only 100 widgets. Company X produces 50 widgets and its competitor, Company Y, produces the other 50. The prices of the two brands will be interdependent and, therefore, similar. So, if Company X starts selling the widgets at a lower price, it will get a greater market share, thereby forcing Company Y to lower its prices as well.
There are two extreme forms of market structure: monopoly and, its opposite, perfect competition. Perfect competition is characterized by many buyers and sellers, many products that are similar in nature and, as a result, many substitutes. Perfect competition means there are few, if any, barriers to entry for new companies, and prices are determined by supply and demand. Thus, producers in a perfectly competitive market are subject to the prices determined by the market and do not have any leverage. For example, in a perfectly competitive market, should a single firm decide to increase its selling price of a good, the consumers can just turn to the nearest competitor for a better price, causing any firm that increases its prices to lose market share and profits.

CRITICISMS OF PERFECT COMPETITION

The use of the assumption of perfect competition as the foundation ofprice theoryfor product markets is often criticized as representing all agents as passive, thus removing the active attempts to increase one’s welfare or profits by price undercutting, product design, advertising, innovation, activities that – the critics argue – characterize most industries and markets. These criticisms point to the frequent lack of realism of the assumptions ofproduct homogenity and impossibility to differentiate it, but apart from this the accusation of passivity appears correct only for short-period or very-short-period analyses, in long-period analyses the inability of price to diverge from the natural or long-period price is due to active reactions of entry or exit.

Some economists have a different kind of criticism concerning perfect competition model. They are not criticizing theprice taker assumption because it makes economic agents too “passive”, but because it then raises the question of who sets the prices. Indeed, if everyone is price taker, there is the need for a benevolent planner who gives and sets the prices, in other word, there is a need for a “price maker”. Therefore, it makes the perfect competition model appropriate not to describe a decentralize “market” economy but a centralized one. This in turn means that such kind of model has more to do with communism than capitalism.

Another frequent criticism is that it is often not true that in the short run differences between supply and demand cause changes in price; especially in manufacturing, the more common behaviour is alteration of production without nearly any alteration of price.

CONCLUSION

In this industrial and competitive world not everyone has a chance to excel. Sometimes there is boom period in the economy when the firm’s income flourishes while at other times there can be a depression which will create losses for the firm. It is thus a firm’s ability to manage its resources carefully and feasibly.

Why do consumers spend their income on new brands? A classical reference may be in order: “The love of novelty manifests itself equally in those who are well off and in those who are not. For . . . men get tired of prosperity, just as they are afflicted by the reverse. . . . This love of change . . . opens the way to everyone who takes the lead in any innovation in any country.”

Thus, in an economy there will be different types of market and each market will have its own pros and cons it just depends on the various innovations they undertake to attract more consumers. Both perfect and imperfect competitions excel in their fields.

BIBLIOGRAPHY

BOOKS:

1. Nordhaus, Samuelson. (2008) Economics. Tata Mc-Graw-Hill Publishing Company Limited.
2. Dewett, K.K., Nevalur, M.H., Modern Economic Theory, S. Chand, New Delhi, 2010.

WEBSITES :

1

Dewett, K.K., Nevalur, M.H., Modern Economic Theory, S. Chand, New Delhi, 2010.

Dewett, K.K., Nevalur, M.H., Modern Economic Theory, S. Chand, New Delhi, 2010.

Nordhaus, Samuelson. (2008) Economics. Tata Mc-Graw-Hill Publishing Company Limited.

The Index of Industrial Production (IIP) was 6.2 percent for April-Dec, 1999.