What is Perfect Competition?

Perfect competition is said to exist in a market place when all firms face the highest or most complete degree of competition conceivable and all are price takers, meaning they can sell as much as they wish at the going market price but not any higher. But for this to happen, there are four conditions or assumption that have to be fulfilled to guarantee perfect competition.

1. First, there must be many sellers and none should be big enough to exert any discerning perceptible influence on the market price of its products, for example by increasing its product offering for sale.
2. Second, the goods sold must all be homogenous in nature and not differentiable, for example, in tomato farming, all farmers will have a homogenous product (that is tomatoes) unlike, car manufacturing where BMW offers differentiated products from Ford.
3. Third, there must be perfect information and knowledge of prices and qualities of each firm’s products in the market without any need for advertising. So if one farmer raises price, the well informed customers will simply leave and go elsewhere to buy tomatoes as they are homogenous.
4. Fourth, there must be no barriers to entry such as patents, licensing, as firms have complete freedom of entry and exit with no restrictions (Doyle, 2002; Duffy 1993, p107).

What is a Monopoly?

A monopoly is a market with a single supplier or firm that dominates supply of a certain output. The firm and the industry are one and the same. A good example of a monopoly is Microsoft and its dominance of the PC market with regards to its windows operating system. Even though other operating systems such as Linux exist, its Windows product controls virtually 90% of this market. In essence, a monopoly is the opposite extreme to perfect competition. It exists when there is only one supplier for a particular product and there are no close substitutes for that product (Doyle 2002). The Competition Commission in the UK regards any firm with more than 25% of market share as a monopoly (Competition Commission Website).

Example of a monopoly

In 2011, the UK Competition Commission ruled that the UK market in the Payment Protection Insurance in the credit card processing market was a monopoly or had many of the features of a monopoly.

The response of Perfect competition to abnormal profits

If all the four conditions discussed previously are met, then that market or industry can be referred to as being in perfect competition. In the short-run, a firm may find it possible to make abnormal profits profit. This scenario is shown in the diagram below, where it shows this point where the firm’s price (Average Revenue) exceeds or is above its Average Cost (AC). Marginal Cost should cut the Average cost at its lowest point towards a point where MC=MR. Any point after that, the firm will experience profit maximization (See Fig 1)

FIG 1.

However, this situation of a firm making abnormal profits will not last for long because there is free knowledge of information, perfect factors of production and there are no barriers of entry so this will attract new firms into the market. The arrival of new firms will subsequently shift the supply curve to the right, as shown in Fig.2 below, and this will push prices down hence lowering revenue due to more competition. Its important to note that changes in output by any individual firm will not affect market price, but the entry or exit of multiple firms will do so.

FIG 2.

The lower price will now shift the Average Revenue curve downwards until all the abnormal profits have been crowded out, and the firms will return to making just normal profits. This change in the long-run equilibrium is illustrated in Fig 3 below.

FIG 3.

New firms may still enter the market but because the demand curve facing each firm had lowered, most will have to adjust their output to new profit maximising positions, were MC=MR. The market will now be in long run equilibrium reverting back to normal profit. But for a monopoly, the situation will be entirely different

Many variables can restrict entry to a market. There may be government regulations, patents, import/export restrictions or large investment and startup costs. It is the number of restrictions in place that determines the difference between the two markets. There are no restrictions in entering perfectly competitive markets. Sloman and Norris (1999, pg. 161) explain that there is complete freedom of entry for firms and established firms are unable to stop new firms entering the market. On the other hand, access to a monopoly is completely blocked or restricted. The access to a monopoly may be restricted for various reasons such as government regulations, legislation or initial set-up costs. 

The response of Monopoly to abnormal profits

A monopoly in the short run equilibrium will still able to maximise profit just as in the case of Perfect Competition as expressed in the equation of MC=MR. Because a monopoly is the sole supplier of the market, their demand curve is the same as that of the market. But that doesn’t mean they can set the price as in Perfect Competition. What they can is increase output while selling more units at lower prices up to a point where average revenue is above the average cost, and they will make also make abnormal profits.

FIG 4.

How much profit they make is illustrated in Fig 4 (above) which shows the variation between average cost (AC) and average revenue (AR). The point when AR exceeds AC is the point where a monopolist will make abnormal profits. The distance between AR and AC represents abnormal profits per unit output.

In the long run, a monopoly has the option to maintain this position depending on factors such as barriers to entry which can protect that position and prevent other firms from entering the industry. Barriers to exit can also create the same effect as barriers to entry if its expensive for competitors to start up. A monopoly can also advertise unlike in Perfect Competition which can help them continue maximizing profits. A monopoly can also simply force out any competition that tries to enter the market as a result of abnormal profits by cutting prices which they can do due to economies of scale.

Conclusion

Although a pure Monopoly can offer advantages to consumers such as lower prices due to economies of scale, in reality such a market is not healthy. One can argue that in such a market, a firm will use its resources to invest and innovate but in many cases, this does not happen. What happen is often higher prices and less efficiency due to low competition. Perfect Competition seems to be the best choice for consumers as it gives them the power.

References

Competition Commission (2011) “PAYMENT PROTECTION INSURANCE MARKET INVESTIGATION ORDER 2011” Available online at http://www.competition-commission.org.uk/inquiries/ref2010/ppi_remittal/pdf/Notice_of_making_of_an_Order_(2011).pdf

Duffy, John (1993) “Economics” Cliffs Notes Inc. USA

Doyle, P. (2002) “Marketing management and strategy” 3^rd Ed. Harlow: Financial Times Prentice Hall.

Doyle, Peter and Stern, Phillip (2006) “Marketing management and strategy” 4^th Ed. Prentice Hall, Pearson Education Ltd

Sloman, J & Norris, K (1999) Economics, Prentice Hall, Australia