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The Stock Market as a Perfectly Competitive Market

Discuss about the Perfect Competition In Markets With Adverse.

The stock market can be referred as perfectly competitive market because of the large number of groups. This market consists with four groups, viz., public corporations, buyers, sellers and market makers. In this market, sellers refer as shareholders, who exchange their stock for cash. Some shareholders of BP (British Petroleum) are Barrow Hanley Mewhinney and Strauss, Status Street Corporation, Dimensional Fund Advisors, Franklin Advisers Inc. and Wellington management Company and so on (Chaplinsky, Lynch and Doherty 2017). One of the chief assumptions of a perfectly competitive market is the homogeneity of products that means, each seller sells same products (Özdemir, Munoz, Ho and Hobbs 2016). This is also true for stock market. Another assumption of perfectly competitive market is that no seller or buyer can influence the market price of this similar product and consequently those persons become the price taker. This is also true for the stock market, where shareholders cannot change price for shares of BP. Moreover, shareholders of BP can freely enter or exit from the market and this is another assumption of perfect competition. This implies that shareholders do not sell any unwanted things in market and for this shareholders of BP can freely enter or exit from this market.

            The market demand curve for egg is P= 1000 – 2Q

            The market supply curve for egg is P = 100+ Q

            These two equations are required to equate with each other for getting equilibrium quantity and price in the market (Kolmar and Hoffmann 2018).

Hence, equilibrium quantity in the market is

            1000 – 2Q = 100+ Q

  • 2Q + Q = 1000 – 100
  • 3Q = 900
  • Q = 300

Hence, equilibrium quantity of egg in market is 300.

To obtain equilibrium price of egg, it is essential to substitute this value in demand equation. Therefore:

      P= 1000 – 2Q

  • P = 1000 – 2 * 300
  • P = 1000 – 600
  • P = 400

Hence, equilibrium price of egg in market is 400.

Based on part a, the equilibrium price of egg in market is $400. Moreover, under perfect competition, a firm maximises its profit when its marginal cost (MC) equates with its marginal revenue (MR), that means, MR = MC (Brecher and Gross 2018). In this market, equilibrium market price and marginal revenue of a firm is equal, that is, $400. Hence, putting this value of price in given equation of MC of a firm, its profit maximising level of output can be obtained. Hence,

Equilibrium Quantity and Price in the Egg Market

MC = 2q + 1

  • 400 = 2q +1
  • 2q = 399
  • q= 199.5

Hence, for this firm, the profit maximising level of output is 199.5 units at price $ 400.

Therefore, total revenue (TR) of the firm is  quantity (q) times the price (P), that is:

TR=  q*P

  • TR = 199.5* 400
  • TR = 79800

Hence, total revenue of the firm is $ 79800.

To find total cost, unit of output needs to substitute in the total cost (TC) function of the firm. The given total cost function is:

TC = 100 + q2 + q

  • TC = 40099.75

Profit of the firm can be obtained by differentiating total revenue and total cost of it. Hence,

Profit = TR – TC

  • Profit = 79800 – 40099.75
  • Profit = 39700.25

Hence, profit of the firm is $ 39700.25.

In perfect competition, the amount of long-run profit of a firm is zero (Aghion et al. 2015). However, in part (b), the given profit is not zero. Hence, this is short-run profit.

As the firm has obtained positive profit in short-run, other firms can also enter into the market. This in turn can increase the supply of egg in market and reduce the price level in the long run. As a result, each firm under this market can obtain zero economic profit in the long run.

In long-run, the egg firm can obtain its equilibrium price when its can earn zero economic profit. Hence, this implies that marginal cost curve and average total cost (ATC) curve of the firm in long-run is equal (Hirsch 2018). Here, the given ATC is (100 + q2 + q)/q, where q = 10. Hence, substituting the value of q, ATC can be measured.


ATC = (100 + 102 + 10) / 10 = 210/10 = 21

Hence, at break-even point, price of this firm can equate with marginal revenue, minimum point of ATC and marginal cost, which is, $ 21 (Azevedo and Gottlieb 2017). Hence, computing of total revenue is required at q= 10. TR = 10 * $ 21 = $ 210.

Thus, in the long run, TC=TR of this firm and consequently it is earning zero economic profit. Hence, long-run price is $ 21.

To obtain the number of egg boxes produced in this market, it is required substitute the value of price $ 21 into the market demand function. Hence,

            21= 1000 – 2Q

  • 2Q = 979
  • Q = 489.5

 Each box contains 12 eggs. Hence, total number of egg boxes is 489.5/12= 40.7, that is, almost 41.

The chief factor that drives profit to zero in the long-run for a perfectly competitive market is the free entry or exit of firms through selling identical products. After observing short-run conditions of various firms including its own, an existing firm can take decision that whether it is going to operate in long-run or not (Shaffer and Spierdijk 2017). Moreover, new firms can also take decisions to enter within market if it observes that existing firms are making profits above its normal level. Hence, in long-run, this characteristic helps the market to earn only normal profits.

Factors that Drive the Market's Profit to Zero in the Long-run

In short-run, firms can earn excess profits and consequently new firms can get incentives to enter into the market for taking excess profits like others. However, due to excess number of firms, market price in the long-run can decrease and this in turn can lead the opportunity to make excess profits low. On the other side, firms can take incentives to leave the market in long-run after incurring huge losses. This further can reduce the number of firms in market and consequently market price can increase. This further can help other existing firms to earn normal profits. Hence, excess profit and excess loss are two incentives that drive the perfectly competitive market to a long-run equilibrium.

In the short run, a firm can choose to operate at a loss if it can cover its all variable costs and some portions of fixed costs by production during this short period. Each firm incurs some costs during production and this is called total cost (TC), which can be divided into two parts that are total fixed costs (TFC) and total variable costs (TVC) (Matsumura and Yamagishi 2017). If the firm divide its TC, TFC and TVC with total amount it has produced then the firm can get per unit cost for producing one unit of output and those costs are called average total cost (ATC), average fixed costs (AFC) and average variable cost (AVC). If the firm shutdowns its production, then it needs to bear the entire costs from its personal savings (Honja 2015). However, if the firm can cover its variable costs, then excess revenue can cover fixed costs and this is comparatively better for this concerned entity. However, in long run a firm leaves the market after making losses for long period.

In the above figure, a firm can produce output above the minimum point of AVC because up to this portion the firm can bear its entire variable costs and a small portion of fixed costs as well.


In the short run, a firm can decide to shut down production if it cannot bear variable costs. In this situation, production of more outputs can generate more losses for this firm because for producing more outputs, the firm needs to bear variable costs (Kastl, Pagnozzi and Piccolo 2018) Hence, it can be beneficial for this business entity to shut down production and bear only fixed costs. In figure 1, this point has arrived at minimum point of AVC.

Profit Maximization Strategies for Firms

Under a perfectly competitive market, the short-run supply curve is referred as the marginal cost (MC) curve. However, entire portion of this curve does not represent this supply curve for the firm (Impullitti and Licandro 2018). The portion of MC above the shutdown point represents this supply curve          

In above diagram, AB portion of the MC curve has represented supply curve of a firm. This is because a firm wants to produce goods only if the marginal revenue can cover its variable costs.  At this moment, the firm needs to bear some portion of fixed cost from its personal savings. However, at shutdown point and below, the firm cannot bear its variable costs also and consequently it is economically beneficial for the firm to stop further production.

The given equation of total cost of the firm is TC = 100 + Q2 + Q

Hence, the equation of marginal cost is MC = 2Q + 1

The equation of market demand is P = 1000 – 2Q

  1. i) In monopoly, demand curve and average revenue curve is same, which means,

P = AR = 1000- 2Q

Total revenue of the firm is price time quantity it produces: that means

TR = P * Q

TR = (1000-2Q) * Q

TR = 1000 Q – 2Q2

Differentiating total revenue, marginal revenue can be obtained:

MR = 1000 – 4Q

Hence, the equation of marginal revenue of this firm is 1000 – 4Q.

Figure 3: Marginal revenue curve

Source: (created by author)

  1. ii) The profit maximising quantity and price can be obtained by equating marginal revenue and marginal cost of this monopoly firm (Mahoney and Weyl 2017). Hence,

MR = MC

  • 1000 – 4Q = 2Q + 1
  • 6Q = 999
  • Q = 999/6
  • Q = 166.5

Hence, profit maximising price is P = 1000 – 2 * 166.5

P = 1000 – 333

P = 667

Thus, profit maximising output is 166.5 and profit maximising price is $ 667.

Hence, substituting the value of profit maximising output, total revenue of the firm can be obtained:

TR = P* Q

  • TR = 667 * 166.5
  • TR = 111055.5

Hence, total revenue of the firm is $111055.5

Total cost of the firm is:

TC = 100 + Q2 + Q

  • TC = 100 + (166.5)2 + 166.5
  • TC = 27988.75

Hence, profit of the firm is the difference of total revenue with its total cost. This is:

Profit = TR – TC

  • Profit = 111055.5-27988.75
  • Profit= 83066.75

In monopoly, a firm can obtain excess profit in both short run and long run. Hence, it is difficult to say that whether it is a short run or long run equilibrium.

In the long run, monopolist organisation tries to adjust the size of its plant and consequently, long-run average cost curve and corresponding marginal cost curve represent the alternative plants, which means, various plant sizes from where the concerned firm can choose any particular one for operation in the long-run (Arthur 2018). In the short-run, the firm adjusts its output level for a given existing plant. Hence, by equating marginal cost with its marginal cost, the firm can obtain its short run profit-maximising output. However, in the long run, the firm can increase its profit further by adjusting plant size. Hence, in this situation, marginal revenue curve equates with its long-run marginal cost curve. Moreover, marginal revenue also equates with short run marginal cost of the firm. Thus, the chief difference between perfectly competitive market and monopoly market is that a monopolist can earn excess profit in long run as well.

Like perfectly competitive market, number of buyers and sellers is large in a monopolistically competitive market. Moreover, barriers regarding entry or exit of new existing firms and new firms are absent in both markets. Hence, those are the similarities between a perfectly competitive market and a monopolistically competitive market. However, those markets have some contrasts as well (Derakhshan and Hosseini Kondelaji 2018). In a monopolistically competitive market, each seller sells products, which are close substitute of each other but not perfect one. Hence, product differentiation can be seen within a monopolistically competitive market for which each firm bears advertisement cost. Thus, the demand curve for a firm in a perfectly competitive market has a vertical straight line while for monopolistically competitive market, this demand curve has negative slope.


In a monopolistically competitive market, if a new firm enters, the demand curve for each existing firms shifts downwards and consequently reduces the price and quantity sold of products for incumbent firms (Impullitti and Licandro 2018). Therefore, introducing new product by a firm can reduce the quantity sold and price received of existing products as well.

The steepness or flatness of a firm’s demand curve depends on the demand elasticity for the product of the firm. The elasticity for the demand curve of a firm under monopolistically competitive market is greater compare to the elasticity of the market demand curve. This is because it is easier for a consumer to shift his or her demand for other firm’s highly substitutable product rather than shifting the demand for completely new products (Pan and Hanazono 2018). Hence, by increasing price, a firm can reduce its quantity demanded for its product by large amount while for a market the demand curve does not shift by same amount after increasing of market price for the product.

Due to many brands of breakfast cereal, the product gets excess supply in market. The profit maximisation output of firm becomes lower compare to the output related with minimum average cost. This situation implies inefficiency within the monopolistically competitive market (Murphy 2017). On the other side, consumers get the freedom to select among wide range of varieties of same product.

Specific characteristics of the oligopoly market:

  1. The chief characteristic of an oligopoly market is that various firms interdependent with each other regarding decision-making.
  2. In this market, firms select various effective and defensive market tools for capturing large share of market (Amir, Gama and Werner 2017). For this, they bear advertisement costs and also spend on some promotional tools.
  3. In oligopoly market, number of firms is very low. The chief reason behind this is that, the market prevents other firms to enter into the market as new firm requires more capital investment, patent and fine raw materials to survive within the market.
  4. Group behaviour is other characteristic of this market, where firms act like a single firm though they are independent entities. In this situation, firms set their price and output level through a group discussion.
  5. In this market, firms can motivate or control prices. However, they always intend to avoid this circumstance, as they know that they have ability to lead a price war. Consequently, they always want the price rigidity policy, where under this policy changes in demand and supply cannot influence the product price and can remain constant.

The kinked demand curve represents an oligopolistic market, where each firm sells products, which are different with each other. According to this concept, each firm experiences two types of market demand curves, for instance, at high prices, a firm experiences relatively an elastic demand curve while at low prices, the firm gets relatively an inelastic market demand curve (Kolmar 2017). Hence, this concept represents higher degree of interdependency that exists among firms within the market. However, this theory has some limitations as well. Firstly, the theory does not state how firms under this market see the kinked point within its market demand curve. Secondly, this theory does not support the concept that possibility of price increase one firm can match with other firms. Lastly, this concept does support the concept of collusion for setting price and output.

The OPEC oil cartel has succeeded in increasing prices substantially but the CIPEC copper cartel has remained unsuccessful. The chief reason behind success of oil cartel is the inelastic demand and supply of oil ((Vatter 2017). However, for copper cartel, this demand is elastic due to other substitute products of copper. Moreover, supply of copper of rivals is also highly elastic.

To obtain successful cartelisation, a producer can analyse simple static computation for a specified market of the potential monopoly profit. The chief condition is controlling of supply. Keeping price low can discourage consumers to look for substitute goods and consequently it negatively influences new suppliers as well.

Cartels can increase prices and profits of firms. In this context, centralised cartels are more affective as these can increase prices by 10% to 400% more than the unit cost of production and distribution.

References:

Aghion, P., Cai, J., Dewatripont, M., Du, L., Harrison, A. and Legros, P., 2015. Industrial policy and competition. American Economic Journal: Macroeconomics, 7(4), pp.1-32.

Amir, R., Gama, A. and Werner, K., 2017. On environmental regulation of oligopoly markets: Emission versus performance standards. Environmental and Resource Economics, pp.1-21.

Arthur, W.B., 2018. Self-reinforcing mechanisms in economics. In The economy as an evolving complex system (pp. 9-31). CRC Press.

Azevedo, E.M. and Gottlieb, D., 2017. Perfect competition in markets with adverse selection. Econometrica, 85(1), pp.67-105.

Brecher, R.A. and Gross, T., 2018. Employment gains from minimum?wage hikes under perfect competition: A simple general?equilibrium analysis. Review of International Economics, 26(1), pp.165-170.

Chaplinsky, S., Lynch, L.J. and Doherty, P., 2017. British Petroleum, Ltd. Darden Business Publishing Cases, pp.1-28.

Derakhshan, M. and Hosseini Kondelaji, M., 2018. Modelling and Experimental Testing of Asymmetric Information Problems in Lease and Hire Contracts (Based on Contract Theory). Iranian Journal of Economic Studies, 6(1), pp.65-86.

Hirsch, S., 2018. Successful in the Long Run: A Meta?Regression Analysis of Persistent Firm Profits. Journal of Economic Surveys, 32(1), pp.23-49.

Honja, T., 2015. Managerial Decision Tools for the Efficiency of Perfect Competition: An Approach for Ensuring Economies of Scale in Perfectly Competitive Markets. analysis, 7(1).

Impullitti, G. and Licandro, O., 2018. Trade, firm selection and innovation: The competition channel. The Economic Journal, 128(608), pp.189-229.

Impullitti, G. and Licandro, O., 2018. Trade, firm selection and innovation: The competition channel. The Economic Journal, 128(608), pp.189-229.

Kastl, J., Pagnozzi, M. and Piccolo, S., 2018. Selling information to competitive firms. The RAND Journal of Economics, 49(1), pp.254-282.

Kolmar, M. and Hoffmann, M., 2018. A Second Look at Firm Behavior Under Perfect Competition. In Workbook for Principles of Microeconomics (pp. 105-132). Springer, Cham.

Kolmar, M., 2017. Firm Behavior in Oligopolistic Markets. In Principles of Microeconomics (pp. 281-300). Springer, Cham.

Mahoney, N. and Weyl, E.G., 2017. Imperfect competition in selection markets. Review of Economics and Statistics, 99(4), pp.637-651.

Matsumura, T. and Yamagishi, A., 2017. Long-run welfare effect of energy conservation regulation. Economics Letters, 154, pp.64-68.

Murphy, D., 2017. Excess capacity in a fixed-cost economy. European Economic Review, 91, pp.245-260.

Özdemir, Ö., Munoz, F.D., Ho, J.L. and Hobbs, B.F., 2016. Economic analysis of transmission expansion planning with price-responsive demand and quadratic losses by successive LP. IEEE Transactions on Power Systems, 31(2), pp.1096-1107.

Pan, L. and Hanazono, M., 2018. Is a Big Entrant a Threat to Incumbents? The Role of Demand Substitutability in Competition among the Big and the Small. The Journal of Industrial Economics, 66(1), pp.30-65.

Shaffer, S. and Spierdijk, L., 2017. 1 Market power: competition among measures. Handbook of Competition in Banking and Finance, p.11.

Vatter, M.H., 2017. OPEC's kinked demand curve. Energy Economics, 63, pp.272-287.

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