PERFECT COMPETITION: Alfred Marshall, in 1880s propounded the Theory of Value.

The theory deals with the value of money, i.e, with prices. The value of money is, inverse of prices. Money loses its value as prices rise. Marshall asked two basic questions. Why a price? Why the price? The first question was pertinent and basic to all prices. Goods and services have prices because these are useful and relatively scarce. In economics, usefulness is technically expressed as utility. Utility is defined as capacity of goods and services to satisfy human wants. Utility is a measure of satisfactions. Goods which are not useful will not command a price. A rare fish will be of no use to a vegetarian and he will not pay any price for the same. Mere utility is not enough for influencing the price. Most useful thing to sustain life is air but breathing is free. This is because air is available in abundance. Relative scarcity is an important dimension of the pricing process. To answer his second question, Marshall asserted that the usefulness translated in demand in the market place and scarcity defined the supply. To Marshall, interaction of the forces of demand and supply defined the price. In reality, we do know that there is no the price, a single price for goods and services. There are different prices of different products and different prices for the same product at different places and at different times. Sellers and buyers have a say in deciding prices. Marshall wanted only market demand and supply, decide the price. He wanted to marginalize buyers and sellers. To study a single market price he created perfect market with a set of assumptions. Every assumption of perfect competition, as he called it, took the theory away from reality. His economics is often referred to as one where the participants do not have market power. In his economics the illusive market was all powerful. There were many assumptions for perfect competition. Three most pertinent were Infinite Number of Buyers/Infinite Number of Sellers Infinite number consumers with the willingness and ability to buy the product at a certain price, Infinite number of producers with the willingness and ability to supply the product at a certain price. Homogeneous Products The characteristics of any given market good or service do not vary across suppliers. Perfect Information - Prices and quality of products are assumed to be known to all consumers and producers.

The assumption of infinitely large numbers of buyers and sellers made each individual buyer and seller totally insignificant. Each one was too small to have any influence on the market outcome. In practice, even with reasonably large number (if not infinitely large number), every seller creates identity of his own. The seller creates identity by being different. He is not a non-entity as was required by perfect competition of Marshall. To deprive the seller of his identity, Marshall assumed perfect homogeneity of product. Every unit of every ones product was like that of every one elses. Seller had no identity. Buyers and sellers came together as a matter of chance and not choice. They were paired at random. That A bought B from C or X bought Y from Z was a matter of chance. Buyers were no choosers. A person went to a provision store to buy a tooth paste. He did not choose the seller or a product as there was nothing to choose from. Insignificance from number and non-identity from homogenous product deprived a seller any power in the market. He had to sell at the price decided by the market. And still prices may differ due to absence of perfect information. To rule out the possibility, Marshall assumed perfect knowledge on part of buyers and sellers. With perfect information, the possibility of paying a price different from the market price was also ruled out. It is pertinent to note here that with era of internet, availability of information to the buyers is lot more and stronger than was in earlier times. Internet to that extent has taken the step closer to perfect market. With three assumptions of perfect competition, seller became completely powerless. Price was decided for him by the market forces of demand and supply and he became a price taker and not a price maker. Marshalls frame work of perfect competition also had other assumptions. These were Zero Entry/Exit Barriers It is relatively easy to enter or exit as a business in a perfectly competitive market. Perfect Factor Mobility - In the long run factors of production are perfectly mobile allowing free long term adjustments to changing market conditions. Zero Transaction Costs - Buyers and sellers incur no costs in making an exchange [Perfect mobility]. As indicated earlier, through these assumptions Marshall created an illusion of a never never land. His theory was way away from reality. And still his theory has survived to be studied mainly because it lays down benchmark of a perfect market and also because it was a complete theory, howsoever remote it was from reality.

Equilibrium Price in Perfect Market Demand and supply decided the price in the perfect market. Buyers preferred to buy less when the price was high and buy more when the price was low. Sellers interests were exactly opposite to those of the buyers. They would want to sell more a higher price and less at a lower price. Market demand curve sloped down from left to right and supply curve sloped up from left to right. Intersection of demand and supply decided the equilibrium price. Market price would settle down at the point where downward sloping demand intersected the upward sloping supply curve as shown in diagram

Supply d1 P1 P s1

P2

s2

d2

Demand

Buyers and sellers are literally at cross roads and there is only one point where they meet and that is where their roads cross. In the diagram, PO is the equilibrium price and OM is the equilibrium quantity bought and sold in the market. Any price other than the equilibrium price will not sustain in the perfect market. If the price is higher at P1O, the demand P1d1 would be less than supply P1s1, the excess supply s1d1 in the market would represent a large number of dissatisfied sellers with unsold stock. The surplus in the market would put downward pressure on the price. In perfect competitive market, downward price adjustment is the only option available. In reality, a surplus may result in product improvement or more advertising by dissatisfied sellers. These options are unavailable with assumptions of homogeneity of product and perfect knowledge. With downward movement of price from P1O, the surplus will shrink with demand rising and supply shrinking. Downward pressure on price will continue and the surplus will keep on shrinking till the price comes down to P1O. Now there is no dissatisfied seller to force the price down further.

If the price is lower than the equilibrium price, say at P20, demand at P2d2 will be more than supply at P2s2. The deficit would represent dissatisfied buyers. The deficit will put upward pressure on the price. Price will rise. With rising price, demand will shrink, supply will expand and the deficit will shrink. The upward pressure on the price will continue till the rising price eliminates the deficit. At PO, there is no surplus, no deficit. There are no dissatisfied sellers to force the price down and no dissatisfied buyers to force the price up. PO, the equilibrium price will remain stable. Equilibrium of the Firm under Perfect Competition: In perfect competition, price is decided by the demand and the supply on the market. The seller is a price taker and not a price maker. At the market price, the seller can sell all that is produced, which is an insignificant part of the market supply. Unlike the situation in reality, the seller under perfect competition does not have to be concerned about whether or not he will be able to sell. The market clearing equilibrium price ensures that there are enough buyers for the sellers. As a price taker, seller in perfect competition has to sell at the market price only. He will not be able to charge a higher price. Rational and knowledgeable buyers would not pay more. And since he can sell all that he produces at the going price, he will not sell at any price lower. His AR (average revenue) curve will be a horizontal straight line parallel to the x axis. The relationship between the average and the marginal is arithmetic relationship. When the marginal is greater than the average, the average rises. When the marginal is less than the average, average falls. When the marginal is equal to the average, the average remains constant. In perfect competition, since the seller is a price taker, his AR is constant and so MR = AR. This is shown in the following diagram.

AR = MR

Market

Firm

Condition for Equilibrium: The rational firm would want to maximize profits. To decide how much to produce, the firm will consider additional revenue (MR) vis--vis additional cost (MC). If MR > MC, every additional unit produced gets the firm more than what costs to produce it. The surplus revenue adds to its profit. The firm will produce the additional unit. If MR < MC, every additional unit produced gets the firm less than what costs to produce it. The firm looses out on every additional unit produced. The firm will not produce the additional unit. The firm produces up to the point where MR = MC. This is the point where the last unit pays for it self. The equality of marginal revenue and marginal cost gives maximum profit and this is the condition for equilibrium of the firm. It is pertinent to note that irrespective of market conditions, whether there is perfect competition or not, whether the seller has power to influence the market or not, whether the seller is a price taker or a price maker, so long as the seller is seeking maximum profit, equality of MR and MC would be the condition for equilibrium.

The above diagram shows the equilibrium of a firm under the perfect competition. If MR > MC, the firm expands output, if MR < MC, the firm contracts the output. The output is decided where MR = MC. At the market determined price PM, the firm produces OM output.

Short Run Equilibrium of the Firm: Marshall differentiated between short run and long run. In the short run, productive capacities remained unchanged. Factories could not be built over night. The productive capacity would change only in long run. Supply would thus change only in the long run. Because of rigidity of supply, short run market price was not always ideal. Equilibrium would be reached by firms with MR MC equality. But the average cost (AC) remained below or above the AR in the short run. The following diagram shows equilibrium where AC for the firm is below AR.

The market decided price is PM and OM is the equilibrium output of the firm. The average cost of producing each of the units is QM leaving a surplus of PQ per unit. The total profit would be the area of rectangle PQRN. While discussing cost, classical economists had introduced the concept of opportunity cost. A part of the profit of the firm was fair remuneration to the entrepreneur for his efforts at combining other factors of production, organizing business and for taking risk. Normal profit was a part of the cost of the firm. Any profit above the normal profit was economic profit. According to Marshall, there was a possibility of firms under perfect competition making economic profit in the short run. If the market determined price was lower, AC was above AR, the firm would make economic loss. It would represent failure of the firm to make normal profits. Economic loss, it needs to be noted, does not necessarily mean financial losses. A firm may earn Rs. 600,000 and that is accountants profit. But if the opportunity cost of the entrepreneur is

Rs. 1 million the profit he would earn if he were to do something else, Rs. 400,000 is an economic loss. Marshall contended that economic profit or economic loss is only a temporary phenomenon in perfect competition. Economic profit or economic loss is an abrasion. Forces of competition, over time would eliminate the economic profit or loss as has been shown below. Equilibrium of Firm under Perfect Competition Long Term Adjustment

As indicated before, firms make excess profit represented by the rectangle PQRN. These more than normal profits would atttract inflow of resources. Others realizing the opportunity to make more than normal profits would join the industry. Market supply would increase, prices would fall. With falling market prices, AR=MR would shift downwards. Downward shift of AR=MR would bring new adjustment at lower excess profit represented by the rectangle P1Q1R1N. Production of the firm shrinks from OM to Om1. The process would go on. As long as there is excess profits supply would increase, price fall, AR=MR shift downwards reducing the economic profit and the level of output. Downward pressure on price would continue till downward shifting AR=MR is tangent to AC, at its minimum point. All four variables are now equal. (AR=MR=AC=MC). Firms would now make normal profit. Every one will get what is due, that is covering opportunity cost of entrepreneurship. There is now no incentive to others to joinThe market would reach a stable equilibrium in longer run This is shown in the diagram below.

The price is now equal to minimum cost of production. Perfect competition represents an economic heaven of sorts. It is a win-win situation for all. Consumer gets the lowest price. Producer gets normal profit. The firm is operating at its most efficient level, i.e., at its lowest cost. All factors of production, land, labor, capital and entrepreneur are working at their best. Every firm is an optimum firm. Short Run Supply Curve in Perfect Competition: Based on his analysis of equilibrium, Marshall developed his concept of short run supply curve. Supply was based on costs and Marshall analysed costs to explain supply. Costs of a firm are divided in two broad categories. These are fixed cost and variable cost. Fixed costs are fixed irrespective to the level of output. These are also called sunk cost. They are the costs which need to be incurred whether the firm produces or not. These mainly relate to finance cost, depreciation cost, cost of establishment, rent, fixed remuneration to managerial staff and like. As production increases, same amount of fixed casts are distributed over larger number of units produced. Per unit cost, average fixed cost (AFC) continuously falls. The AFC is a rectangular hyperbole. Area under AFC, representing the total fixed cost is constant.

The variable costs are costs that change with the production. These rise when the production rises and fall when production falls. These are costs on raw material, labor, electricity, large part of transport costs, factory costs and like. The behavior of variable costs is subjected to the Laws of Return. As more factors of production are employed, total output increases more than proportionately initially, just proportionately there after and less than proportionately then. These stages are known as stages of increasing return, constant return and diminishing return. With increasing returns, the variable costs increase but less than proportionately. AVC falls. Later the AVC remains constant for and as diminishing returns set in, variable cost increases more than proportionately raising AVC. AVC thus, falls, reaches a minimum and then rises. AVC is U shaped. ATC is the average total costs, sum of AFC and AVC. Both AFC and AVC are falling initially, so ATC falls. Later AVC starts rising but continuing fall of AFC drags ATC down for a while. Soon the rise in AVC overtakes the fall in AFC and ATC starts rising. ATC is U shaped, largely influenced by AVCs U shape as a result of Laws of Return. The conditions for equilibrium of firm in perfect competition and behavior of costs are put together in the following diagram to explain the short term supply curve of the firm.

If the market price is P1O, S1 would represent the firms equilibrium where MC = MR1. Firm is making economic profit of S1Q1 and will produce and offer P1S1.

If the market price is P2O, S2 would represent the firms equilibrium where MC = MR2. Price P2O = AC and the firm is making just normal profit. It will produce and offer P2S2. If the market price is P3O. S3 would represent the firms equilibrium where MC = MR3. Price P3O is below the AC and the firm is suffering an economic loss of S3Q3 per unit. The firm will, however, continue to produce and offer P3S3 because the price covers AVC, the firm more than meets its day to day expenses. A part of the AFC is not covered but as was observed earlier, AFC represents sunk costs anyway. If the market price is P4O, S4 would represent the firms equilibrium where MC = MR4. Price P4O is well below ATC and the firm is suffering an economic loss of S4Q4 per unit. The price just covers minimum AVC and the firm will just continue to produce and offer P4S4 aware of the fact that AFC is not covered at all. At any price below P4O, say P5O, firm will not offer anything. Its sunk cost per unit is not covered by the price and the price also fails to cover AVC. Every unit produced would drain the firm and it will not produce and offer below the price P4O. P4O is known as Reservation Price. The firm will not sell below this price. Now we have the supply schedule of the firm. At P4O it supplies P4S4 At P3O it supplies P3S3 At P2O it supplies P2S2 At P1O it supplies P1S1 Joining S4, S3, S2 and S1 we have the supply curve of the firm under perfect competition. In diagram above, it is shown as a thick line. Supply curve of the firm in perfect competition is that part of the MC curve which lies above its intersection with AVCs minimum point.