Wednesday, 21 September 2016

FEATURES OF PERFECT COMPETITION

Introduction 

Perfect competition is a state of a market. Anything which facilitates contact between buyers and sellers constitutes a market. It may be a face to face meeting at some place or simply verbal negotiations through telephone, internet, etc.

Conventionally, in microeconmoics the markets are classified into these states: perfect competiton, monopoly, monopolistic competition and oligopoly. There are many criteria of classification, the number of sellers, similarity of products, availability of information, mobility of firms and the inputs engaged in the firm, etc. Whatever the criteria the end result is reflected in one thing : how much influence an individual seller, on his own, is able to exercise on the market. Lower the influence more the competitive nature of the market it indicates. If the influence of an individual seller is zero, or virtually zero, the market is said to be perfectly competitive.

Meaning 

Perfect competition can be defined either in terms of its characteristic features, or in terms of the unique end result of these characteristics. Unique in the sense that it is specific to a perfectly competitive market. In terms of its features, a perfectly competitive is a market where there are large number of buyers and sellers, the firms produce homogeneous products, the buyers and sellers have perfect knowledge and the firm are free to entry or make an exit in and out of industry. In terms of the end result of these features which is unique to this market, a perfectly competitive market is one in which an individual firm cannot influence the prevailing market price of the product on its own.


Features and their implications

A perfectly competitive market has the following features:

1. Large number of sellers and buyers 

Note that 'large number' is not a specifically defined number. However, it has a specific implication. Let us talk about the large number of sellers first. The words 'large number' imply that the number of sellers is large enough to render a single seller's share in total market supply of the product insignificant. It has a further implication. Insignificant share means that if only one individual firm reduces or raises its own supply, the prevailing market price remains unaffected. The prevailing market price is the one which was set through the interaction of market demand and market supply forces, for which all the sellers and all the buyers together are responsible. One single seller has no option but to sell what it produces at this market determined price. This position of an individual firm in the total market is referred to as price taker. This is a unique feature of a perfectly competitive market. 
Similarly, the 'large number' of buyers also has the same implication. A single buyer's share in total market demand is so insignificant that the buyer cannot influence the market price on his own by changing his demand. This makes a single buyer also a price taker.
To sum up, the feature 'large number' indicates ineffectiveness of a single seller or a single buyer in influencing the prevailing market price on its own, rendering him simply a price taker

2. The products of all the firms in the industry are homogenous 

It means that the buyers treat the products of all the firms in the industry as homogenous. The products produced by the firms are identical, or treated as identical, or perfectly standardized. The buyers do not distinguish the output of one firm from that of the other. 

The implication of this feature is that since the buyers treat the products as identical they are not ready to pay a different price for the product of any one firm. They will pay the same price for the products of all the firms in the industry. On the other hand, any attempt by a firm to sell its product at a higher price will fail. 

To sum up, the 'homogenous products' feature ensures a uniform price for the products of all the firms in the industry.


3. Perfect knowledge about markets for outputs and inputs. 

The firms have all the knowledge about the product market and the input markets. Buyers also have perfect knowledge about the product market. 

Let us take the product market first. The implication of perfect knowledge about the product market is that any attempt by any firm to charge a price higher than the prevailing uniform price will fail. The buyers will not pay because they have perfect knowledge. There is no ignorance factor operating in the market. The sellers do not charge a lower price due to ignorance. The buyers do not pay a higher price due to ignorance. A uniform price prevails in the market. 

As regards the knowledge about the input markets, the implicit assumption is that each firm has an equal access to the technology and the inputs used in the technology. No firm has any cost advantage. Cost structure of each firm is the same. All the firms have a uniform cost structure. 

Since there is uniform price and uniform cost in case of all firms, and since profits equals cost less price, all the firms earn uniform profits.


4. Freedom to firms to enter or to leave the industry in the long run 

Freedom of entry means that there are no artificial barriers and natural barriers in the way of a new firm wishing to enter into industry. The artificial barriers may take the form of patent rights, legal restrictions, etc. The natural barrier may take the form of huge capital expenditure required to start a new firm, which the firm wishing to enter is not able to arrange. 

Freedom of exit means no barriers in the way of a firm deciding to leave the industry. Government rules, labour laws, loss of huge fixed capital etc. do not come in the way. 

The freedom of entry and exit of firms has an important implication. This ensures that no firm can earn above normal profits in the long run. Each firm earns just the normal profits, i.e. minimum necessary to carry on business. In Microeconomics, normal profits is treated as an opportunity cost, and therefore, counted in calculation of total cost. Since profit equals total revenue minus total cost, normal profit means zero economic profit. Why? Let us explain. 

Suppose the existing firms are earning above normal profits, i.e. positive economic profits. Attracted by the positive profits, the new firms enter the industry. The industry's output, i.e. market supply, goes up. The price comes down. New firms continue to enter and the price continues to fall till economic profits are reduced to zero. 

Now suppose the existing firms are incurring losses. The firms start leaving. The industry's output starts falling, price starts going up, and all this continues till losses are wiped out. The remaining firms in the industry then once again earn just the normal profits. 
Only zero economic profit in the long run is the basic outcome of a perfectly competitive market.

Returns to Scale

Introduction 

This topic is a part of study of production function. A production function is an expression of quantitative relation between change in inputs and the resulting change in output. It is expressed as;
Q = f (i1 , i2 ......in )

Where Q is output of a specified good and i1 , i2 ….in are the inputs usable in producing this good. To simplify let us assume that there are only two inputs, labour (L) and capital (K), required to produce a good. The production function then takes the form :
Q = f (K,L)

In microeconomics, conventionally, we study two aspects of relation between inputs and output. One aspect is : in what manner the change takes place in output of a good, if only one of the inputs required in producing that good is increased, i.e. other inputs kept unchanged? The manner of change in output is summed up in the law of variable proportions which you have already studied. The second aspect is : in what manner the output of a good changes, if all the inputs required in producing that good are increased simultaneously and in the same proportion. This aspect is technically termed as returns to scale, and is the subject matter of this study. The word 'return' refers to the change in physical output. The word 'scale' refers to the scale of operation expressed in terms of quantum of inputs employed.

Meaning

Returns to scale means the manner of change in physical output caused by the increase in all the inputs required simultaneously and in the same proportion. Elaborating, suppose one unit of capital and one unit of labour (1K + 1L), produce 100 units of output. Further suppose that both the inputs are doubled, i.e. 2K + 2L. The point of interest is : will output increase by just 100%; by more than 100%, or by less than 100%. There is no unique answer. All the three states are possible. The three states are respectively called Constant Returns to Scale (CRS), Increasing Returns to Scale (IRS) and Decreasing Returns to Scale (DRS). Let us first illustrate the three states and then explain reasons.

Constant Returns to Scale (CRS)

Suppose 1K+1L produce 100 units of output, and 2K+2L produce 200 units of output. It is 100 percent increase in inputs leading to just 100 percent increase in output. This manner of change in output is called CRS.

Increasing Returns to Scale (IRS)

Suppose 1K+1L produce 100 units of output and 2K+2L produce 250 units of output. It is 100 percent increase in inputs in leading to 125 percent increase in output. This manner of change in output is called IRS.

Decreasing Returns to Scale (DRS) 

Suppose 1K+1L produce 100 units of output, and 2K+2L produce 180 units of output. It is 100 percent increase in inputs leading to only 80% increase in output. This manner of change in output is called DRS. 
Which of the above states actually results depends to a great extent on the type of technology used. There are technologies which result in IRS from the beginning and continue upto a large output level. Similarly, there are technologies leading to CRS almost throughout. There can also be technologies leading to DRS from the very beginning.


Why do IRS arise?

There are two possible reasons:

1. More division of labour 

Division of labour means subdividing a task into many small sequential operations, with each worker (or a group of workers) assigned each operation. A single worker, instead of doing all the operations, concentrates on only one operation and specializes. This raises efficiency of the worker. 
Returns to scale means increasing the number of workers along with other inputs. More workers mean more division of labour. If one task can be divided into 20 small operations, with each worker assigned only one operation, the worker becomes an expert in the operation he is assigned. Efficiency increases and so the production. In business circles, the division of labour type production is called assembly line production.

2. Use of specialized machines

More capital means more capital goods and bigger capital goods. Fully automatic machines can replace the semi-automatic or the hand operated machines. Bigger machines can be used in place of small machines. Bigger capital goods can be used in place of smaller capital goods. It is a common knowledge that a double size capital input may produce more than double the output. Let us take an interesting example. Suppose a firm needs a wooden box to store goods. 
Suppose initially the firm goes in for 1'x1'x1' (LxBxH) size box. Let us see the input requirement and the resulting output. Let the wood be the only input required. A box has 6 sides. Each side requires 1 sq. ft. of wood (=1'x1'). Then
the input requirement = 1'x1'x6 = 6 sq.ft. 
The storing capacity of the box is measured by its volume. Then : 
Output of the box : 1'x1'x1' = 1 cubic ft. 
Let us now see what happens when the size of the box is increased to 2'x2'x2'. 
Input requirement = 2'x2'x6 = 24 sq.ft.
Output = 2'x2'x2' = 8 c.ft.

Now compare. Input of the box rises from 6 sq.ft. to 24 sq.ft. i.e. by 300%. Output of the box rises from 1c.ft. to 8 c.ft., i.e. by 700%. Increasing returns to scale arise. 

Remember that it may not go on for ever, i.e. we go on increasing the size and continue to get IRS. A stage may reach when IRS may give way to CRS or DRS.


Why do DRS arise?

Economists do not find any specific reason. DRS is a puzzle. Why output rises in a smaller proportion when all inputs are increased? The probable explanation is that the firm finds it difficult to manage and coordinate the activities arising out of larger scale. The difficulties may lead to wastage, inefficiency etc. and cause DRS.

PRODUCER’S BEHAVIOUR AND SUPPLY

Meaning of supply 

Supply means the quantity of a commodity which a firm or an industry is willing to produce at a particular price, during a given time period.

Law of supply 

This law states that 'other things remaining the same', an increase in the price of a commodity leads to an increase in its quantity supplied. Thus, more of a commodity is supplied at higher prices than at lower prices.

‘Change in supply’ versus ‘change in quantity supplied’

 (‘shift of supply curve’ versus ‘movement along a supply curve’)
 The supply of a commodity depends on its own price and 'other factors' like input prices, technique of production, prices of other goods, goals of the firm, taxes on the commodity etc. Movement along a supply curve The law of supply states the effect of a change in the own price of a commodity on its supply, other things remaining constant. The supply curve also carries the same assumption. Thus when other factors influencing supply do not change, and only the own price of the commodity changes, the 9 change in supply takes place along the curve only. This is what movement along a supply curve means. A movement from one point to another on the same supply curve is also referred to as a change in quantity supplied”.‘Change in supply’ versus ‘change in quantity supplied’ (‘shift of supply curve’ versus ‘movement along a supply curve’) The supply of a commodity depends on its own price and 'other factors' like input prices, technique of production, prices of other goods, goals of the firm, taxes on the commodity etc.

Movement along a supply curve

 The law of supply states the effect of a change in the own price of a commodity on its supply, other things remaining constant. The supply curve also carries the same assumption. Thus when other factors influencing supply do not change, and only the own price of the commodity changes, the 9 change in supply takes place along the curve only. This is what movement along a supply curve means. A movement from one point to another on the same supply curve is also referred to as a change in quantity supplied”.


Shifts of the supply curve

 When supply changes due to changes in factors other than the own price of the commodity, it results in a shift of the supply curve. This is also referred to as a “change in supply”. An ‘increase’ in supply means more of the commodity is supplied at the same price. As a result the supply curve shifts to the right.
An ‘increase’ in supply can take place due to many reasons. For example, if the input prices fall or there is an improvement in technology, it will enable producers to produce and sell more at the same price resulting in a rightward shift of the supply curve.
A decrease in supply means less of the commodity is supplied at the same price, than previously. As a result, the supply curve shifts inwards to the left.

Shifts of the supply curve of a good are caused by a change in any one or more of the 'other factors' affecting supply, own price remaining unchanged. For example, if the input prices fall or there is a decrease in the prices of other related commodities, the producers supply more at the same price resulting in a rightward shift of the supply curve.


PRODUCER'S EQUILIBRIUM 

The primary objective of a producer is to earn maximum profits. Profit is the difference between total revenue and total cost. At that level of output, he is in equilibrium at which he is earning maximum profit, and he has no incentive to increase or decrease his output. If he produces less than this he does not maximize total profits. Similarly, if produces beyond this, total profits decline. Thus the producer is in a 'state of rest' only at the level of output at which the difference between the total revenue and total cost of production is maximum i.e total profits are maximum.



CONSUMER'S EQUILIBRIUM

 Introduction  

 A consumer is one who buys goods and services for satisfaction of wants. The objective of a consumer is to get maximum satisfaction from spending his income on various goods and services, given prices. We start with a simple example. Suppose a consumer wants to buy a commodity. How much of it should he buy? One of the approaches used for getting an answer to this question is 'utility' analysis. Before using this approach, we would like to familiarize ourselves with some basic concepts used in this approach,

 Concepts 

The term utility refers to the want satisfying power of a commodity. Commodity will possess utility only if it satisfies a want. Utility differs from person to person, place to place, and time to time. Marginal Utility is the utility derived from the last unit of a commodity purchased. It can also be defined as the addition to the total utility when one more unit of the commodity is consumed. Total Utility is the sum of the utilities of all the units consumed. As we consume more units of a commodity, each successive unit consumed gives lesser and lesser satisfaction, that is marginal utility diminishes. It is termed as the Law of Diminishing Marginal Utility.  Here we observe that as more units are consumed marginal utility declines. This is termed as the law of diminishing marginal utility. The law states that with each successive unit consumed the utility from it diminishes

Assumptions 

The utility approach to consumer's equilibrium is based on certain assumptions. 
 1. Utility can be cardinally measurable, i.e. can be expressed in exact units.
 2. Utility is measurable in monetary terms
 3. Consumer’s income is given
 4. Prices of commodities are given and remain constant.

 Equilibrium 

(a) One commodity case Suppose the consumer wants to buy a good. Further suppose that price of goods is Rs. 3 per unit. Lel the utility be expressed in utils which are measured in rupees. We are given the marginal utility schedule of the consumer. Quantity Price Marginal Utility When he purchases the first unit, the utility that he gets is 8 utils. He has to pay only Rs. 3/- for it. Will he buy the 1st unit? Obviously, yes, because he gets more than what he gives. Similarly, we compare the utility received from other units with the price paid. We find that he will buy 4 units. At the 4th unit, MU equals price. If he buys the 5th unit, he is a looser because the utility that he gets is 2 utils and what he has to pay is Rs. 3. Therefore, the consumer will maximize his satisfaction by buying 4 units of this commodity. The condition for maximization of satisfaction if only one commodity is purchased then is:
 MU = Price
 (b) Two commodities case Suppose a consumer consumes only two goods. Let these goods be X and Y. Given income and prices (Px and Py), the consumer will get maximum satisfaction by spending his income in such a way that he gets the same utility from the last rupee spent on each good. This is satisfied when 
MUx = MUy = M.U. of a rupee spent on a good.
Px Py 
We can show that in order to maximise satisfaction this condition must be satisfied. If it is not satisfied what difference will it make. Suppose the two ratios are: MUx > MUy Px Py 7 It means that per rupee MUx is higher than per rupee MUy. It further means that by transferring one rupee from Y to X, the consumer gains more utility than he looses. This prompts the consumer to transfer some expenditure from Y to X. Buying more of X reduces MUx, Px remaining unchanged, MUx/Px, i.e. per rupee MUx, is also reduced. Buying less of Y raises MUy. Py remaining unchanged it raises, per rupee MUy. The change continues till per rupee MUx becomes equal to per rupee MUy. In other words : MUx = MUy = per rupee MU Px Py 

CONCEPTS OF DEMAND AND DEMAND SCHEDULE 

Demand for a good is the quantity of that good which a buyer is willing to buy at a particular price, during a period of time. Demand schedule is a tabular presentation showing the different quantities of a good that buyers of that good are willing to buy at different prices during a given period of time. Demand schedule of a commodity Price  This schedule indicates that more is purchased as price falls. This inverse relationship between price and quantity demanded, other thing remaining the same is called the law of demand.

 RELATIONSHIP BETWEEN PRICE ELASTICITY OF DEMAND AND TOTAL EXPENDITURE

At this stage of learning it is sufficient to know the following about this relationship:
1. When demand is elastic, a fall (rise) in the price of a commodity results in increase (decrease) in total expenditure on it. Or, when a fall (rise) in the price of a commodity results in increase (decrease) in total expenditure on it, its demand is elastic.

2. When elasticity is unitary, a fall (rise) in the price of the commodity does not result in any change in total expenditure on it, or when a fall (rise) in price results in no change in total expenditure then its elasticity is unitary. 

3. When demand is inelastic, a fall (rise) in the price of a commodity results in a fall (rise) in total expenditure on it, or when a fall (rise) in the price of a commodity results in decrease (increase) in total expenditure on it, its demand is inelastic.