REVISION NOTES

BY
SUMIT ARORA

Chapter-9- Market Forms

Perfect Competition

Features of Perfect Competition

1. Homogeneous Product: The products offered by firms for sale under perfect competition
are homogeneous. It means that the goods are identical in every respect such as size, shape,
colour, quality, etc. As the goods are identical, these can be easily substituted for each other,
which results in zero specific preference of the buyer from any particular seller.

As the products are homogeneous, the buyers are willing to pay the same price only for the
products of every firm of the industry.

2. Very large number of Buyers and Sellers: The number of buyers and sellers in a perfect
competition market is very large. It means that the number of buyers in a perfect
competition market is so large that the total share of one single buyer is insignificant to the
total purchase; therefore, a single buyer cannot influence the price of a product in the
market. Similarly, the number of sellers is so large that the share of one single seller is
insignificant to the total supply of the economy; therefore, a single seller cannot influence
the price of a product in the market.

Because of the large number of buyers and sellers, the firms under perfect competition are
just price-takers. It means that the firms do not have any option over the price of a product
and have to just sell the products at the price determined by the industry. In the same way,
the buyers are also just price-takers and cannot influence the price of a product in the
market by changing their demand.

3. Freedom of Entry and Exit: The sellers under the perfect competition market have the
freedom of entry and exit in/from the industry. It means that there are no artificial
restrictions or barriers to the entry of a new firm or exit of an existing firm.

Freedom of Entry of the new firms under a perfect competition market indicates that there
are no barriers for the new firms to enter the industry. When the existing firms in the
industry are making abnormal profits from their business, it attracts new firms to enter for
profit, which in result increases the market supply of goods, ultimately resulting in the
reduction in market price and profits. Hence, the entry of new firms into the industry only
happens until every firm in the industry is earning normal profits only.

Freedom of Exit of the existing firms under a perfect competition market indicates that there
are no barriers for the existing firms to leave the industry. Firms generally exit the industry
when they are facing losses, and their exit decreases the market supply of goods resulting in
an increase in the market price of those goods. However, their exit also reduces the losses,
and hence the firms exit the industry until all the losses are wiped out from the industry and
each of the existing firms earns normal profits.

[Author Name] 1
REVISION NOTES
BY
SUMIT ARORA

4. Perfect Mobility of Factors of Production: The factors of production such as land, labor,
capital, and entrepreneurship under a perfect competition market are perfectly mobile.
There is no occupational and geographical restriction on the movement of factors of
production, i.e., they are free to move to the industry with the best price.

5. Perfect Knowledge among Buyers and Sellers: Under a perfect competition market, the
buyers and sellers have complete knowledge about the market price of the products. It
means that no firm/seller can charge a different price from the customers and no buyer will
pay a higher price than the price in the market. In other words, it results in uniformity in the
market price of a product. Besides, the sellers of the product have perfect knowledge
regarding the input markets. It means that each firm has equal access to the inputs and
technology used for the production of goods, resulting in a uniform cost structure. Also, as
the price and cost of a product is uniform, the profits earned by the firms are also uniform.

6. Absence of Selling Costs: Selling cost is the cost of the advertisement of a product. As the
goods under perfect competition are homogeneous, they do not include selling costs. The
perfect knowledge of the buyers and sellers regarding the product, makes it easy for the
firms to sell the goods without selling cost.

7. Absence of Transportation Costs: To ensure uniformity in the price of goods, it is assumed

that there is no transportation cost under perfect competition. In other words, it is assumed
that a manufacturer can sell the product at any place, and the buyers can purchase the
product from any place of their choice.

8. Firm as a Price-Taker: As there are a very large number of buyers and sellers under perfect
competition, every firm is a price-taker. It means that no single firm has the ability to
influence the price of a product in the market, and has to therefore sell the product at the
price determined by the industry. It is so because the share of firms under perfect
competition in the total market supply is negligible.

A firm is different from an industry. A firm is a single unit producing or providing the market
with goods and services. However, an industry is the total of all the firms manufacturing the
same goods in the market. For example, Cadbury is a chocolate manufacturing firm, which
comes under the chocolate industry with other firms producing chocolates.

Hence, it can be concluded that a firm does not play any role in the price determination of a
product, as it can neither affect the supply of a product nor it can affect its demand in the
market. Therefore, a firm is a Price-Taker and an industry is a Price-Maker. The price of a
product is determined by the industry at the point where the market demand curve and
supply curve of the product meets, and every firm has to sell their product at this price only.
This concept can be understood with the help of a graphical representation.

In the above graph, the market

demand for a product is shown by
the DD curve and its supply is
shown by the SS curve. The DD
curve and SS curve intersect with

[Author Name] 2
REVISION NOTES
BY
SUMIT ARORA

each other at point E, which means that the price determined by the industry through
demand and supply of the product is OP. This price is adopted by the price taker firms, and
they are free to sell any unit of quantity OQ, OQ1, etc., at this price. It means that the AR
curve of the product becomes perfectly elastic and parallel to the X-axis. Besides, when AR
remains constant, it becomes equal to MR (AR = MR).

9. Demand Curve under Perfect Competition: As the firms under perfect competition sell
homogeneous products at a uniform price fixed by the market and have a large number of
buyers and sellers, each firm in this market is a price-taker and has a perfectly elastic
demand curve.

In the given graph, the X-axis represents the

Output of a product, and the Y-axis represents
Price and Revenue. The horizontal straight line
parallel to the X-axis is the demand curve of a firm
under perfect competition. As the price of goods is
determined by the market with the help of
demand and supply of the good in the market,
every firm has to sell the goods at this price. In this
case, the price is determined by OP. At price OP, a
seller can sell different quantities like OQ1, OQ2,
etc. However, a firm cannot change the price of the
good.

As each firm (being a price-taker) has to sell the goods at the price determined by the forces
of supply and demand, uniform price prevails in the market. It means that the revenue
generated by the firm from every extra unit, also known as MR, is equal to the price of the
product, also known as AR.

Therefore, under perfect competition, AR = MR.

1. Price Ceiling
When the equilibrium price established by the free play of demand and supply is too high for the
poor, the government plays a significant role in regulating the prices of essential commodities
(wheat, sugar, kerosene, etc.). Price Ceiling refers to fixing the maximum price of a commodity at a
level lower than the equilibrium price. Simply put, price ceilings are higher limits set by the
government on the price of a product.
Need for Price Ceiling
It is often enforced on essential items and is set below
the equilibrium or market-determined price. The
equilibrium price is too high for the average person to
afford, which is why there is a price ceiling.
Demand curve DD and supply curve SS intersect at
point E in the above diagram, and as a result,
equilibrium price OP is established.

[Author Name] 3
REVISION NOTES
BY
SUMIT ARORA

 Assume that the equilibrium price of OP is high and that many low-income individuals
cannot afford the product at this price.
 As a result, the government intervenes and sets the maximum price (also referred to as the
Price Ceiling) at OP1, which is lower than the equilibrium price OP.
 Producers are only willing to supply P 1A (or OQ1) at this controlled price (OP 1), but consumers
want P1B (or OQ2).
 The ceiling has the effect of creating a shortage equal to AB(Q 1Q2), which could further
encourage black marketing.
Consequences of Price Ceiling:
i) Black Marketing:
A market in which commodities are sold at a price higher than the maximum price fixed by the
government is known as Black Market.
 Black Marketing refers to a situation when a good covered by the government’s control
policy is being sold illegally at a price greater than the one set by the government. This
condition is referred to as a direct consequence or implication of price ceilings.
 It may occur, especially as a consequence of the presence of customers who are willing to
spend a higher price for the commodity rather than go without it.
To increase profits from black marketing, producers of the product will sometimes purposefully
reduce the availability of the product in the legal market.
ii) Rationing System:
Rationing is a technique adopted by the government to sell a minimum quota of essential
commodities at a higher price less than the equilibrium price to supply goods to the poor community
at a cheaper price.
 The government may also impose the “Rationing System” to fulfil the excessive demand.
 Consumers are given ration cards/coupons to use in ration shops to purchase commodities at
a cheaper price.
 Consumers must stand in huge lines to purchase products from ration shops. The ration
shops occasionally run out of certain items or their quality is poor.
2. Price Floor or Minimum Support Price (MSP)
Through the Price Floor, the government also intervenes in the price determination process. Price
Floor refers to the minimum price (above the equilibrium price), fixed by the government, which the
producers must be paid for their produce.
The establishment of a lower limit on the price that may be charged for a specific commodity or
service is referred to as setting a price floor or minimum price ceiling. Government sets a price
(known as the Price Floor) that is higher than the equilibrium price when it believes that the price
determined by supply and demand is not fair from the perspective of the producers.
Need for Price Floor
When the government determines that the equilibrium price is
too low for the producers, a price floor is required.
 The most well-known examples of imposing price floors
are minimum wage legislation and agricultural price
support schemes.
 For various agricultural products like wheat, sugarcane,
and others, the Indian government maintains several

[Author Name] 4
REVISION NOTES
BY
SUMIT ARORA

minimum support price programs, and the floor is often set at a level higher than the price
determined by the market for these goods.
As seen in the diagram, demand curve DD and supply curve SS intersect at point E, as a result,
equilibrium price OP is established.
 Assume that the government sets OP1 as the minimum price (also known as the price floor),
which is higher than the equilibrium price OP, to protect the interests of the producers and
encourage increased production.
 Producers are only willing to supply P 1B (or OQ2) at this ‘Support price’ (OP1), but consumers
want P1A (or OQ1). This forms a situation of market surplus, which is equal to AB as sown in
the diagram.
The term “Floor Price” also refers to the “Support Price,” which is typically set above the equilibrium
price to safeguard the interests of producers like farmers. The government purchases all of the
agricultural products that farmers are unable to sell on the free market at this support price.
 The government may decide to buy the excess supply for exports or to build up its buffer
stocks.
Implications of Price Ceiling or Minimum Price Ceiling
Typically, the price floor is established at a level above the equilibrium price. As a result, there is an
excess supply. As the producers are unable to sell what they want to sell, they turn to illegal sales
of goods and services at the price below the minimum price.
Buffer Stock acts as a Tool for Price Floor
Governments can use buffer stock as a powerful instrument to maintain a price floor. When the
market price is lower than what the government believes should be paid to the farmers and
producers, it buys the commodity from them at a higher price to save a stock of it for possible
release in the event of future shortages.

[Author Name] 5