These characteristics along with different market structures are
summarized in the following table:
At one end of the spectrum, we have a competitive ideal which
represents a standard by which we evaluate all other types of
competitive behavior. At the other end, monopoly represents an
absolute lack of competition such that the single firm in the
industry has a high degree of price-making ability.
Perfect Competition defines one end of the competitive spectrum with
each firm behaving as a price taker in their respective industry.
What this means is that, with a large number of firms, a high degree of
product similarity (homogeneous products), and perfect market information
available, each individual firms has absolutely no influence on market price.
In a perfectly competitive industry, prices are strictly established by the interaction
of market supply (a summation of individual business firm supply choices) and
market demand (the summation of all individual consumer demand choices).
Each firm then responds to this market price by making output choices that
maximize the profits of that firm.
In a competitive market, profit maximization choices are based the notion
of a producer optimum. This condition with respect
to labor input is defined as:
MPL = w/P
or with simple algebraic manipulation,
P = w/MPL
and taking note that:
Marginal Costs (MC) are defined as (DTotal Costs/DX)
MC = DVariable
MC = D(wL)/DX
MC = w(DL/DX) =
Thus profit maximization implies that:
P = MC
Since the perfectly competitive firm is a price-taker, the price of
the good being sold is set by the interaction of competitive supply and
demand forces in the industry in which the firm competes. If the profit
maximizing level of output for the representative firm (one with an industry
average cost structure) results in abnormal profits (i.e., P > ATC), then
new firms will be induced to enter the industry. This is possible since there
are no barriers to entry.
(Note: Abnormal profits act as signal for the
market entry of new firms resulting in an allocation of factor inputs towards
the production of the product being produced and sold).
This market entry
will lead to an outward shift in supply, creating a surplus of product and pushing
prices downward. The process will continue until the abnormal profits have been
eliminated. The ultimate equilibrium for the representative firm will be
a level of output where:
P = MC = min[ATC]
If the profit maximizing level of output for the representative firm
results in losses
(i.e., P < ATC), then some existing firms (those operating below their shut-down
point) will leave the industry and restrict their losses to the Fixed Costs.
(Note: Losses act as signal for the
market departure of existing firms resulting in an allocation of factor inputs away
from the production of the product being produced and sold).
This market departure
will lead to an inward shift in supply, creating a shortage of product and pushing
prices upward. The process will continue until the losses for the remaining firms have been
Concepts for Review:
- Abnormal Profits
- Barriers to Entry
- Heterogeneous Goods
- Homogeneous Goods
- [An] Industry
- Market Entry
- Market Exit
- Monopolistic Competition
- Normal Profits
- Perfect Competition
- [A] Price-maker
- [A] Price-taker
- [A] Producer Optimum
- Profit Maximization
- [A] Representative Firm