Session Objectives:

The session introduces the concept of market structures. The focus is on perfectly
competitive market structure. The behavior of demand and supply in the perfectly
competitive market structure should also be studied. The way a firm operating in
perfectly competitive market attains equilibrium in both short run and long run is
also explained.

The session continues its discussion on perfect competition. The discussion is on

how a firm in perfectly competitive market structure attains long run competitive
equilibrium and allocative efficiency. The focus should also be on the effect of
different types of taxes like lump-sum tax, specific tax on price and output.

Characteristics of Perfectly Competitive

Market

Though, in reality, there is no existence of perfectly competitive market, but it

helps managers to analyze the role played by demand and supply in determining
the price.
Characteristics of perfectly competitive market

Large number of buyers and sellers

The number of buyers and sellers in the market would be so large that no single
buyer or seller can influence the price. The significance of an individual player is
negligible.
Free entry and exit of firms
Firms have no barriers for entry or exit, they can move in and out of the market
any time.

Perfect mobility

Resources in the market are assumed to be mobile, hence they can move in and
out of the market at convenience.

Absence of transportation cost

In perfectly competitive market, there are no transportation costs.

Horizontal demand curve

The demand curve for the firm in perfectly competitive market is horizontal, as P
= AR = MR.

Supply and Demand in Perfect

Competition
In the given figure, the difference between the demand curve of an industry and a
firm can be determined. The number of firms in the perfectly competitive industry
is very high, the demand curve for a single firm is a tiny segment of the industry’s
curve. Demand curve of a single firm is so small that it looks completely
horizontal (infinitely elastic).
As the market share of an individual firm in the perfectly competitive market is
very low, no firm can influence the market. Firms can maximize the profit by
adjusting the output accordingly. Equilibrium price will be P = MR = MC. In perfect
competition, MR= P, therefore the slope is equal to zero.
The basic questions of what to produce, how to produce and for whom to produce
are answered, analyzing the demand and supply conditions.

To analyze the demand and supply conditions of a firm in the short run, aggregate
supply of the industry needs to be looked at. In the short run, factors of
production cannot be altered, hence there is no scope of new firm entering the
market. But, in the long run, all the factors are variable, hence the firms can
freely enter the industry and
move out as well. In the short run, many firms are attracted towards the market
as a result of the high profits, but in the long run, as many firms join the industry,
profits come down to zero.

In the industry, the demand curve slopes downwards to the right indicating that
demand increases as price falls. Supply curve slopes upward to the right
indicating that as price increases, supply increases automatically. Price is
determined at the point where the demand and supply curve intersect each other
at a point 'A'. Shows the inelastic demand of the competitive equilibrium at A. the
firm in the perfectly competitive market has an insignificant share, making the
demand curve completely horizontal
 Short run Equilibrium of the Competitive
Firm

Factors determining the short run equilibrium in perfectly competitive

environment are:

• Total revenue

• Total cost

• Marginal Revenue

• Marginal cost

As all the firms in the perfect competition are price takers, they maximize their
profits by adjusting their outputs, so that marginal cost is equal to marginal
revenue.
In the short run, a firm varies its production by changing its variable inputs,
however, it cannot make any changes in the fixed inputs. As a result, the demand
curve shifts to D1D1 from DD. With rise in prices, the firms would like to increase
their output. In short run, it cannot increase or install any additional facilities.
Thus, it makes alteration in the variable inputs and increases the output to a
certain extent. As a result of the increased output, equilibrium point also shifts to
E1 from E.

Long run Equilibrium of Competitive

Firm

A firm may continue its operations even if it makes losses in the short run. But
long run equilibrium plays crucial role in the existence of the firm. In the long run,
firms have enough time to cover its losses and firm can earn normal profits. This
happens because all the inputs are variable in the long run, and the firm gets
enough time to cover the losses and make the normal profits. In the long run,
resources are used in the most efficient manner to produce goods and services in
the most efficient manner.

In the long run, the higher prices attract new firms to the industry. As a result,
the supply curve shifts to SLSL and the long run equilibrium shifts to E1. The
intersection of the long-run supply curve with the new demand curve yields the
long-run equilibrium attained when all economic conditions have adjusted to the
new level of demand.

Long Run Competitive Equilibrium and Allocative

Efficiency

Allocative efficiency can be defined as a situation in which no reorganization or

trade could raise the utility or satisfaction of one individual without lowering the
utility or satisfaction of another individual. Under certain limited conditions,
perfect competition leads to allocative efficiency.

The factors that make perfectly competitive markets more conducive for allocative
efficiency are as follows:

There exists equilibrium of production, which results in the efficient allocation of

resources among firms.
 In perfect competition the distribution of goods produced takes place in an
efficient manner.

Products are combined in an efficient manner, resulting in simultaneous

equilibrium of production and consumption.
If the market conditions are satisfying the conditions of allocative efficiency, a
person’s satisfaction or

utility increases only when someone else’s utility comes down.

Efficient output of a good

In order to show that the competitive market has the potential to achieve
allocative efficiency, let us take the example of a single competitive industry
producing meat. In the given figure, the point at which the output can be said as
efficient is at point E. At this point, the marginal benefit of meat is equal to the
marginal cost.
It can be seen that the marginal benefit declines with the consumption of meat,
while the marginal cost increases. As long as the marginal benefit exceeds the
marginal cost, firm can make profits by providing
more meat. If the firm provides 100 kg of meat per day, marginal benefit is Rs 30
and marginal cost is Rs 10. If the meat is made available at Rs 10, producers
would be able to just cover the opportunity cost and would not be worse off.
Mutual gains are possible, if the firm provides 100 kg of meat per day and is made
available in the price range of Rs 10 and Rs 30, but it is not the efficient output.
The marginal cost equals marginal benefit when the firm provides 150 kg of meat.
At this point, the marginal cost of providing quantity above 150 kg would be more
than the marginal benefit. Therefore, the efficient output of the meat is 150 kg
 per day.
If meat is traded in competitive market the equilibrium would occur at point E. At
this point the marginal benefit and marginal cost curves intersect each other. The
market equilibrium point would be Rs 20 per Kg. The quantity of meat demanded
at that price would be equal to the quantity supplied, which would be 150 Kgs per
day- this happens to be efficient output as well.

Efficiency in Competitive
Markets

In the markets operating under the perfectly competitive environment, price of

the product is equal to the marginal cost of the product, while in the long run
price equate minimum possible average cost. When the marginal benefit of buyers
is more then the market price of the good, buyers gain. Therefore, buyers
continue buying the product as long as the marginal benefit equals the market
price.
In the long run, for a firm in the perfect competition, price is equal to the
minimum possible average cost which is equal to the marginal cost. If it is
assumed that perfect competition exists for each and every product, the price of
each product would reflect its minimum possible average cost.

Types of
Taxes

There are three types of taxes that a government usually imposes on the business
firms.
• Lump-sum tax

Lump Sum tax is imposed on a firm irrespective of the profits and goods
produced. It is like a fixed cost to the firm.
 • Profit tax

Profit tax forms a percentage of net profit of the firm.

• Specific tax

This tax is imposed as a given amount of money per unit of output produced.

Effect of lump-sum
Tax

Lump-sum tax is like a fixed cost to the firm. As a result of the lump sum tax, the
costs of the firm increases. As it is like a fixed cost, the effect of lump-sum tax is
felt on both fixed cost and total cost. The rise in the average fixed cost and
average total cost results in the upward shift in the respective curves.

Since the tax is fixed, the impact of the tax is not felt on the variable cost, hence
marginal cost and the average variable cost remains unaffected, and so the
respective curves.

The effect of the lump-sum tax is felt in the long run. As a result of the tax, the
firm’s cost increases. This results in the decline of profits to the firm. The declining
profits discourages the other firms to enter the market, and even the existing
firms in the industry also exits the market as it becomes unviable for the firms to
operate in such a market. As a result, the number of firms in the market
declines.

Imposition of Profit
Tax

The effect of specific tax is also the same that is felt with the incidence of lump-
sum tax. Specific tax too reduces the profit of the firm. As there will not be any
affect on the marginal cost of the firm, the equilibrium of the firm remains
unaffected. Firms earning normal profits exit the market. In the long run, as a
result of the increase in the prices, there will be an upward shift in the supply
curve resulting in the change in the equilibrium of the firm.

Imposition of Specific Sales

Tax

This tax is imposed as a given amount of money, like per unit of output produced.
This tax influences the MC of the firm. MC curve which is the supply curve of the
firm shifts upwards to the left.
Specific tax also leads to increase in the prices. But the extent of the price rise
depends upon the bearing of the tax. The important question is who is bearing the
tax, the customer, the firm or both.
Price elasticity of supply determines who is going to pay the tax. The greater the
elasticity of supply, the lesser the tax burden on the firm. If the price elasticity of
supply is less elastic, the burden would be more on the firm.

Summary
 • Characteristics of Perfectly Competitive Market

• Supply and Demand in Perfect Competition

• Short Run and Long Run Equilibrium of the Competitive Firm

• Long run Competitive Equilibrium and Allocative Efficiency

• Efficiency in Competitive Markets

• Effect of Taxes on Price and Outputs

In this session, perfect competition and characteristics of perfectly competitive

market was discussed. In perfect competition, there is large number of buyers
and sellers, products are homogeneous, there are no barriers to enter and exit,
buyers and sellers have perfect knowledge about the market conditions and there
is perfect mobility of resources and the absence of transportation cost.
Supply and demand forces determine the price of a commodity. Short run
equilibrium of a firm is based on the total revenue and total cost, and marginal
revenue and marginal cost. Firms in an industry try to maximize their profits by
adjusting the output to a level where MC=MR.
In this session, the long-run competitive equilibrium and allocative efficiency was
explained. Long run equilibrium plays a crucial role in deciding the existence of
the firm. Profits earned by the firms would attract others to enter the industry and
with the entry of new firms there will be a shift in the short-run industry supply
curve to the right until it intersects with the market demand curve at the price at
which all firms make zero economic profits. It is then that the industry will be in
equilibrium.
To fulfill the marginal conditions of allocative efficiency, three properties are
observed in a freely competitive market mechanism: efficient allocation of
resources among firms; efficient distribution of goods produced between
consumers; and efficient combination of products. In competitive markets, prices
equal the marginal benefits and marginal cost of goods.
Taxes such as a lump sum tax, a profit tax, or a specific tax, will have an effect on
price and output. Imposition of a lump sum tax will not affect the firm and
industry in the short run. However, it will effect the firm and industry in the long
run. The lesser the proportion of specific tag the firm bears, the more will be the
burden of the consumer.