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supplied of even major buyers and sellers are very small with
regard to the scales of the market. Here, in this context, "very
small" means that, other things equal, changes in quantities
demanded and supplied of certain subjects do not influence the
market price of the products within a short period. The market
price is characterized only as the number of all sellers and buy-
ers, which is the total result of the market relations.
It is clear that insignificance of market participants also
involves their plurality, which means an availability of a large
number of small sellers and buyers in the market. Insignifi-
cance and plurality of the market participants suggests none of
the formal and informal agreements (contracts) between them
for the purpose of finding exclusive benefits in the market.
3. Free entry and exit. All sellers and buyers are absolutely
free to enter some industry (market) and or leave it. It means that
enterprises can start, continue or stop their production of certain
goods, if they want to. In the same way, buyers can get commodities in any quantities as well as can start purchasing them in larger
or smaller quantities or even can stop doing it at all. There are no
legal or financial barriers against entering an industry. There are
no patents or licenses providing privileges to produce certain
products. An entry to an industry (and an exit from it) does not
require heavy initial costs. Large-scale enterprises that have already taken roots in the industry are not so great to limit an entry
of beginner-enterprises to the industry.
On the other hand, nobody is obliged to stay in the industry if they don’t want to. There is no state interference into the
organization of the market (different subsidies, tax benefits,
quotas and other forms of managing demand and supply).
Both free entry and free exit also suggest a perfect mobility of sellers and buyers in the market as well as no devotion of
buyers to sellers to the industry.
Both free entry and exit are possible due to the mobility
of the factors of production, their free transition from one in-
31
dustry to another, to the place (point) where their alternative
value is higher. It, in particular, means that workers can freely
migrate from one industry to another as well as can change one
profession for another. Their agreement on their new location
or retraining does not require high costs.
4. Perfect knowledge. Subjects/participants of the market
(buyers, sellers, owners of the factors of production) have perfect
knowledge on all the parameters of the market. The concept of
perfect knowledge implies that the subjects of the market un-
doubtedly have knowledge on the distribution of prices among
sellers and that buyers can choose one supplier or another.
It is clear that these four characteristics are so tight that
the real market would hardly be satisfied with them. For exam-
ple, perfect knowledge does not exist at all as information is
scarce, its receiving, processing and use will require some time,
efforts and money. Actually, perfect competition is quite an
exceptional case and only some of the markets really reach
conditions close to it.
A textbook example of this kind of market is the market
of agricultural products. In agriculture, a great number of certain farmers and small companies, each of which acts, offering
their products (wheat, corn, beef, pork, etc.) in the market, can-
not have any significant impact on market prices of such
goods. Products in this market can quite reasonably be considered similar as one farmer’s corn differs but only a little from
another farmer’s corn. One more example of this type of market is retail trading especially of computer programs and com-
puter component parts. There are hundreds and thousands of
sellers offering these goods practically at identical prices. The
reason for this coordination is obvious: if some seller in this
situation tries to set a higher price, he or she will simply open
the door of the competitors’ shop in front of the buyers.
32
Market demand and product demand
of a certain company
Any of the companies operating in a perfect competition
market has no impact on market prices the rate of which is
shown by the intersection of the curves of the market demand
and the market supply. Under these conditions, the enterprise
has to set a price equal to the market one, or its supply will be
of no interest. In competitive markets, the price is represented
by the intersection of the curves of the market demand and
market supply. As the form and position of these curves is de-
pendent on all buyers and sellers, neither of them can affect
this price. In other words, chances of a certain participant are
so weak in relation to the whole market that they cannot con-
siderably affect the aggregate demand and supply in this market, and, therefore, the market price.
The curves of the market demand and the product
demand of a certain company in a perfect competition market
are shown in Figure 2.1. The all-market curve (where the
equilibrium price P is determined by the intersection of the
curves of the market demand and the market supply) is given
on the left. From the point of view of a certain company, it can
sell any amounts of goods at this price, i.e. the demand curve
for an absolutely competitive company is represented by the
straight line parallel to the horizontal X-Y axis (on the right of
the picture) designated by Df. The fact that the curve of the
demand for the products of a certain company is absolutely
elastic reflects the simple idea that any attempts to set a price in
this market (even if it exceeds the market price only a little)
will make it impossible to sell even one commodity item.
33
P
Df=Pe
Q
Product demand
of separate company
S
D
P
Q
Market demand
Figure 2.1. Market demand and
product demand of a certain company
As the curve of demand for the products of a certain com-
pany in a perfect competition market is absolutely elastic, making
price decisions does not cause any problems: the company has to
act like any other one. Under these conditions, what is extremely
important is the volume of production that has to be somewhat
that will bring maximum profit to the seller.
Price formation and production level. A short-term pe-
riod. The period during which the quantity of some resources is
constant (in other words it is called a short-term period) is lim-
ited. To maximize profits in the short run, the enterprise has to
use its limited resources as well as related costs as they are and
to decide on a proper volume of the output taking into account
the fact that they have an opportunity to change only those re-
sources that are under its control.
Profit maximization. Under the conditions of perfect
competition, the product demand of a separate company is de-
termined by the market price of these products that we will
signify as P. Let Q be the production volume of the producing
company, and the total sales of this amount of goods will be
signified as PQ.
34
There is one method by means of which it is possible to
AVC
P
Profit
ATC (Q
*
)
Df=Pe=MR
ATC
MC
Q * Q
Pe
0
determine the output at which the company gets the maximum
profit. This method is as follows. It is shown in Figure 2.2,
where the curves of standard average costs and marginal costs
are provided.
Figure 2.2. Profit maximization
in a perfect competition market
If the market price is Pe, the line of this price intersects
the curve of marginal costs at the point signifying the output Q,
which is considered to be the best conditions under which the
profit of the company is maximum. If the amounts are smaller
than Q*, the price exceeds the marginal costs. As a result, any
increase in output will make the company be able to sell addi-
tional items of production at a price exceeding marginal costs
on the production of these additional products. Thus, the com-
pany which aims to get maximum profit, will not produce
goods at a rate lower than the Q* level. Similarly to the situation of the amounts exceeding the value of Q*, there is another
situation at which the marginal costs exceed the price. In this
case, any decrease in the production of goods will help to save
35
money, rather than will cause revenue losses from a smaller
)(]
)(
[
**
*
*
*
QTCQP
Q
QTC
PQ
ee
−=−
quantity of implementable products. Besides, the company will
move on, on the other hand, to the level of the output of Q * at
which its profit will be maximum.
The shaded rectangle in Figure 2.2 signifies the maxi-
mum profit that the company can receive in this kind of market. The area of this rectangle is defined by the size of an ap-
propriate output of Q *, increased by the difference [Pe–ATC
(Q*)], where automatic telephone exchange (Q *) = TC (Q *) /
Q *, i.e. average total costs are the total costs divided by the
output. Thus, the area of the considered rectangle is equal
(equivalent)
to the company’s
profit. [Pe–ATC (Q*)] is the profit amount per item of supplied
products. If we multiply this single-item profit by the quantity
of the implemented items, the result obtained will serve as an
indication of the general profit of the company.
Minimization of losses. As it has been shown above, it is
possible to define an appropriate level of the output at which the
profit gained by the company is maximum. In certain cases, however, the company will inevitably suffer some losses. Therefore,
what is needed is a strategy at which such losses become minimum in a short-term period. If these losses are still here, and the
company still suffers them even in the long-term period, it will be
better for the company to leave this market.
Short-term operating losses.
First, consider the situation when some resources are
somewhat fixed. Let's assume that the value of the market price
Re lies below the curve of average total costs, as it is shown in
Figure 2.3.
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Figure 2.3. Minimization of losses
(Q *)
Df=Pe=MC
P
Q
Q *
ATC
AVC
Pe
0
Losses
In this case, if the output of the company is equal to Q *
and thus the price is equal to RE=MS, the extent of the losses
will be equivalent to the the size of the shaded area. However,
if the price exceeds average variable costs, each item of
production that has been sold will bring more profit than it is
required by variable costs for producing this item. Thus, if the
company increases the output through this process in a shortterm period, it will be suffering still heavier and heavier losses.
Decisions on the suspension of production. Now, let’s
assume that the market price is so low that it lies below the
curve of average variable costs as it is shown in Figure 2.4. If
the output of the company is equal to Q * and thus RE=MS in
the case of still increasing marginal costs, it will cause losses
the extent of which will be equivalent to the size of two shaded
rectangles.
Thus, the company will lose ATC (Q*) — Pe from each
commodity item that has been sold. If we multiply these singleitem losses by the output, the total value of the losses will be
equivalent to the size of these two shaded rectangles.
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AVC (Q *)
Losses at production continuation
R Q 0
ATC
AVC
Df=Pe=MR
Constants
Losses at a production
suspension
(Q *)
Pe
MC
costs
Figure 2.4. Production suspension
Now, let us assume that instead of producing items in
amounts of Q, the company decides to suspend production. In
this case, its losses will be equal to fixed costs, i.e. those costs
that should be set irrespective of the results of the enterprise
operation. These costs are graphically presented by the upper
rectangle in Figure 2.4, and the area of this figure is equal to
[ATC (Q *) — AVC (Q *)] Q *, i.e. this rectangle is equivalent
to the amount of total fixed costs. Thus, if the price is lower
than the average variable costs of production, it will be cheaper
for a company to stop their business than to continue producing
goods even at the best possible amount of Q*. Generalizing
everything that has been said, it is possible to formulate the
following principle: so as to get the highest profits in the short-
term period, an absolutely competitive company has to produce
goods in the amount which is signified by the upward-going
side of the curve of the marginal costs, where the criteria
R=MS and P≥AVC are met. If P <AVC, it is more reasonable
for the company to stop the process of production to minimize
its losses.
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Long-term period. One of the assumptions that underlies
P2
P0
P1
S2
Exit
P
S0 D Qm 0
S1
Df=P0=MR0
Df=P2=MR2
Entrance
Exit
P
Qf
Df=P1=MR1
0
perfect competition theory is a possibility for new participants
to enter and leave the market on a free basis. If a company
gains short-term profits, in the long-term it will attract other
companies that may want to enter the market of these products
and receive their profit share. As a result, since there is less
“space” for the companies in the market, the curve of the market supply will be displaced still more and more to the right.
This process is shown in Figure 2.5 as a kind of shift of the
supply of S0 to the supply of S1 at which the equilibrium price
falls from P0 to P1. In its turn, it gets displaced downward to
the curve of the demand for products of a certain company,
which will cause a decrease in its profit.
If companies in a competitive market suffer losses in the
short-term, they will have to leave this market in the long-term
period as they cannot meet alternative expenses under these
conditions. If the participants leave the market, the curve of the
market supply will be displaced from the production level of S0
to the the production level of S2, which enables an increase in
the market price from P0 to P2. In its turn, it displaces the
curve of the demand for a product of a certain company upward, which leads to a profit increase of the participants who
have decided to stay in this market.
Figure 2.5. An entry of the participants to the market
and an exit of the companies operating there from it
39
This balancing process will be used until the market price
R
Long-term
Q Q *
MC
AC
Df=Pe=MR
0
Re
reaches the level at which all the companies operating in the
market will get zero economic profit. This conditions are also
shown in Figure 2.6. At a price of Re, the income of each com-
pany will reach the rate that covers average costs of production
(called the EXPERT in the graph, as in the long-term plan, the
difference between variable and fixed costs does not exist), and
the profit equals zero.
competitive balance
Figure 2.6. Long-term competitive balance
If the profit were positive, the market would attract new
companies, and the market price would get down to the level at
which the curve of the demand for the products of a certain
company would have the same angle as the curve of average
costs called the EXPERT do. On the contrary, if companies
were suffering losses, some participants would leave the
market, which would cause an increase in the market price
until the curve of the demand for the products of a certain
40