Features of markets and profit maximization in perfect competition

Firms do not operate in a vacuum, they interact with their customers and with other firms. These interactions take place in markets and economics has developed models of markets that predict how firms will behave in certain situations. The three major markets are 1. Perfect competition, 2. Perfect monopoly, and 3. Monopolistic competition.

Perfect competition is the most intense form of market interaction and though it may be intense, it is not as rare as many would have us believe. Perfect competition is characterized by the following:

1.         There are many firms selling a homogenous product.
2.         There are many buyers.
3.         There are no barriers to entering or exiting the industry.
4.         Firms in the industry have no advantage over new entrants.
5.         There are no transaction costs.
6.         There are no externalities.
7.         Firms and buyers in the industry have complete information.

Given the assumptions of perfect competition, it is unlikely that a firm can unilaterally influence the market price of a good will be. Hence, firms are called price takers. This is because there is nothing that the firm can do unilaterally to raise or lower the price of the goods it produces.

Perfection competition, satisfying all five requirements, does not happen that often, but many industries can satisfy three or four of the assumptions, and the industry approaches perfect competition. Hence the model’s results are still valid and can lend insight into what happens in reality.

What is an example of a price taker? Major applications of this occur in agriculture. If you grow soybeans and you grow 50 acres of beans, your beans are no better than the thousands of other acres of soybeans and there is nothing you can do to command a higher price for your beans. You are a price taker.
From the fact that a firm is a price taker, we can look at the individual firm’s demand curve,
The firm faces a perfectly elastic demand curve (Recall that perfect elasticity implies that a percentage change in price will lead to an infinite percentage change in quantity demanded). If the firm harvests 60 acres of soybeans instead of 50 acres, it can sell the extra 10 acres at the same price, and it can do this forever at the prevailing market price. (Reality may not support this proposition, but recall that economic models are not supposed to exactly represent reality, but should approximate reality. Therefore this assumption of the model may not directly apply to reality).

The firm is a price taker and has to compare with other firms by mimicking what they do and trying to get ahead at the same time. Therefore, the competitive firm has to make some decisions if it continues to stay in the industry. A perfectly competitive firm has to make the following decisions:

1.         Whether to stay in the industry or leave it.
2.         Whether to produce or to temporarily shut down.
3.         How much to produce.

Assume that the firm wishes to stay in the industry and it is going to produce. We know that the firm wants to maximize profits, but how is it going to do that?
We know that for the firm:


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