- Figures 1 and 2 prove that no economic profit is possible for firms in a perfectly competitive market; any gain in profits a firm makes by alterations in the equilibrium price or quantity by a single firm will be offset by a loss in efficiency, price or quantity produced. The equilibrium in the long run will always remain at the point where MR = MC.
In choosing the best production mix, we are assuming that the firm’s management is rational in making the decisions they make and that consumers are also rational and will choose the product that best suits them at the best suitable prices.
Profit maximization occurs at the output level which corresponds with the equality point between marginal costs and marginal revenue given that a profit-maximizing firm operates at a point where total revenue less total cost is highest. In the Long run, the firm will have to explore different options.
- Output Q1 with Average cost 1
- Output Q2 with AC3
- Output Q3 with AC3
- Output Q4 with AC2
All the production combinations above the LRAC are attainable but unrealistic, while all the combinations below it are unrealistic for a firm focused on profit maximisation.
At Q1 the firm is producing but at a level below potential, given the resource mix present. As the firm takes advantage of economies of scale and becomes more efficient, it will start enjoying increasing returns to scale. As firms expand, the economies of scale will come from factors such as more availability of cheap credit, more specialization of its labour, more discounts and bargaining power among others. Point Q2 is referred to as the minimum efficient point, which is the point at which a firm has exhausted its economies of scale.
Over a certain range of output (Q2 – Q3), the Average cost could be constant, but after some time, the benefits brought about by the economies of scale will start getting eroded. The erosion will arise from factors such as rising administrative costs, and increased investments in capital goods such as space and equipment. The management will also start meeting challenges, which will cause the average cost to rise from here. The returns to scale will also start to decrease, resulting in scale diseconomies.
Question 3: The Perfect Market
A perfect market or perfect competition is hypothetically a market where competition is at its best. The neo-classical theory proffered that this is the market form that would yield the outcomes that would best suit all stakeholders; society, consumers and producers. The competitive market theory operates under certain assumptions.
Assumptions behind perfect competition (Miller 2001)
In the world today, very few markets can be said to be perfectly competitive. Although the model can be termed as unrealistic, it is applicable in some instances, for example, in most of the primary markets and commodity markets especially coffee and tea, the assumptions are not very farfetched. This is especially when you consider the number of producers involved and their lack of power to influence prices. Even though this type of competition has been challenged in the manufacturing and other industries, it still remains important as a yardstick for evaluating the competition levels in real markets.
Top of Form
Baumol, W & Blackman, S 2001, Perfect markets and easy virtue: business ethics and the invisible hand, Cambridge, Mass., USA, B. Blackwell.
Cassidy, J 2009, How markets fail: the logic of economic calamities, New York, Farrar, Straus and Giroux.
Black, J 2002, Perfect Markets and Economics today,Top of Form Cambridge, MA, MIT Press.
Miller, R 2001, Paving Wall Street: experimental economics and the quest for the perfect market, New York, Wiley.