Perfect competition is a microeconomic model, to the most common traits of which belong the following: – a large amount of small producers (sellers) of a homogenous product; – a large amount of consumers; – both consumers and producers can not influence the price on their own; – mobility of all resources; – operational costs are zero; – equilibrium price (determined by the intersection of supply and demand curves); – lack of barriers to enter or exit from the market.
Under conditions of perfect competition the price is equal to marginal revenue and, in its turn, marginal revenue is equal to marginal costs.
When a company loses money, then it is time to decide whether to continue operating on the market or to shut down. In order to make a right decision it is necessary to analyze total revenue and total costs (fixed and variable). As far as the fixed costs are equal whether the company operates or shut down, variable costs are equal to variable. So if the price per product unit is less than the costs per product unit it means that total revenue (quantity of product multiplied by price) is less than total costs (fixed plus variable) and the company should shut down. Of course, if total revenue is larger than total costs the company should continue operating. When total costs are equal to total revenue – it is called the shut down price and it does not matter for company whether to shut down or operate further.
In the long-run companies receive zero economic profit and thus other companies are not interested in entering the market (it means that market participants completely satisfy the demand). But if the demand suddenly increases – the prices would increase too and thus new participants would enter the market until the price won’t become equilibrium.
In practice, perfect competition does not exist as others. This model is abstracts and describes the market in general terms. As the most common example there is used local agriculture sector: there are many producers and consumers, the price is close to equilibrium, there are not enter or exit barriers; but operating costs can not be zero because it takes time, efforts and some costs to sell the product; resources are not absolutely mobile.
I would like to introduce my own example and explain why do I think it is quite suitable one: e-trading. Trading through the Internet is very popular now – there are many sellers and consumers, there is no any serious obstacles or barriers to enter or leave the market, if to take more precise example – books e-trading – than the product becomes quite homogenous, the price level is quite close to equilibrium and producers can not seriously influence it nor can customers, resources are quite mobile (especially information – there are plenty of resources in the Internet), transaction cost are quite low (but not zero of course).
If the average price of the product, book in our case, is larger than average variable cost, costs on selling and delivering book in our case, then the company receives profit and it can be said that it operates successfully (in the long run there will occur incentives to enter the market); inside out some companies, most probably, would leave the market and may be try to sell something else.
Finally, I would like to conclude that perfect competition is quite abstract microeconomic model, which describes market under the certain conditions (which can not be absolutely met in practice, but can be met close enough). But this model gives good economic basis for firms to think in advance about their operational activities or business decisions.
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