imperfect competition always results in a worse outcome for consumers than perfect competition

8/12/2019 Imperfect competition always results in a worse outcome for consumers than perfect competition

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Imperfect competition always results in a worse outcome for consumers than perfect

competition. Examine the reasoning behind and validity of this statement.

A market is any place where the sellers of a particular good or service can meet with the buyers

of that goods and service where there is a potential for a transaction to take place. The buyers

must have something they can offer in exchange for there to be a potential transaction.

-Mike Moffat

Various economic and political factors contribute towards creation of an environment in which

firms operate. Factors such as economies of scale, information dissemination, number of buyers

and sellers, etc. blend together to create a market structure and are reflected in the level of

competition that prevails in the market.

The competitive structure of market holds an important place in managerial decision making

process as it helps in deciding whether the decision variable will be price or output or both.

"Competition" entered economics from common discourse, and for long it connoted only the

independent rivalry of two or more persons. When Adam Smith wished to explain why a reduced

supply led to a higher price, he referred to the "competition [which] will immediately begin"

among buyers; when the supply is excessive, the price will sink more, the greater "the

competition of the sellers, or according as it happens to be more or less important to them to get

immediately rid of the commodity." (Stigler,1997) .Therefore it is clear that the price of

commodities in any market depends largely on number of sellers and buyers.

On the basis of nature of competition or the buyer-seller interaction markets can be broadly

divided into two categories:


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Perfect Competition

Imperfect Competition

William S. Jevons' (1871) concept of competition was a part of his concept of a market, and a

perfect market was characterized by two conditions:

[1.] A market, then, is theoretically perfect only when all traders have perfect knowledge of the

conditions of supply and demand, and the consequent ratio of exchange; ...

[2.] .There must be perfectly free competition, so that anyone will exchange with any one else

upon the slightest advantage appearing. There must be no conspiracies for absorbing and holding

supplies to produce unnatural ratios of exchange.

In a competitive market a firm is not price controller, it takes the price prevalent in the market

although it also contributes in the process of deciding the market price (Varian,1992).

Specific characteristics may include:

Unlimited numbers of buyers and sellers in the market

No entry-exit barriers


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Perfect knowledge of market among sellers as well as buyers

Zero transportation cost

Maximisation of profit of firms

The products being offered are homogenous

Imperfect Competition: In real life we dont have perfect competition scenario. Imperfect

competition scenarios arise because in real world there are finite number of buyers and sellers

and also due to existence of product differentiation. On the basis of degree of imperfection, it can

be of different types:

Monopoly: It means that there is a single seller in the market with aproduct having no close

substitutes. It refers to a situation where a single firm has the exclusive control over the market

forces. He is able to decide the increase or decrease in price of the product by increasing or

lowering the output. In monopoly there is strong barrier to entry and exit of firms in the industry.

Perfect competition and monopoly are two extremes. In case of perfe ct competition a firm cant

increase the price and is a price taker but in monopoly the firm is price maker.

Similarly the market can be oligopolistic i.e. having few firms with homogenous products each

exercising some control over the price and there can be monopolistic competition having large

number of firms selling differentiated products but they can be each other .

Perfect Competition results in a scenario where consumer is the king in real sense, he has a

freedom to choose from a variety of products offered at best possible prices. In reality, perfect

competition does not actually exists but markets like vegetable market or fruit market may be

considered to be perfectly competitive to certain extent as there are lots of sellers selling almost

similar articles and there are many consumers as well. There are no entry or exit barriers as such.


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However, recent literature on the industrial organization of agricultural markets has indicated

that many markets exhibit structural characteristics at odds with the axioms of perfect

competition(Alston et.al.,1997).On the other hand we come across many examples of imperfect

competition especially oligopoly. For example petroleum sector market can be said to be

oligopolistic in nature and also the telecom market. Monopoly can be said to exist in case of

defense services and water supply.

Under Perfect competition Firms are price-taker, no control and no influence over price. Goal is

to choose the optimal output level to maximize the profit. Firms can sell as much as it wishes at

the given price level. Therefore, Demand curve is perfectly elastic (horizontal). However

Industry demand curve is downward sloping . The aim of the firm is to maximize its total profits.

Mathematically Total Profit = Total Revenue Cost. In words, firm choose quantity say q* so

as to maximize profits given the price of output (and input prices). So for any firm, the profit-

maximizing quantity is that at which marginal revenue equals marginal cost; MR = MC which

can be obtained from first order conditions. A firm will then uses the demand curve to find the

price that will induce consumers to buy the profit-maximizing quantity .On solving we will get

Price = Marginal cost = Marginal revenue i.e. P = MR = MC under perfect competition.

Firms in a perfectly competitive market do not have any market power at all. Substitution goods

are available. If a firm raises its price in a perfectly competitive market, all its customers will

switch to another firm which is selling the same product at the market price.

Under imperfect competition Firms are price maker. They have market power: a firms ability to

raise the price of a good without losing all its sales. As there is only one firm as in monopoly or


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few firms as in oligopoly , so they can raise price without losing all of their consumers. Demand

curve is downward-sloping .So prices are always set higher than marginal cost. i.e. P > MC . As

firms maximizes their profits, so MC = MR. So, price under imperfect competition is always

greater than in perfect competition thus reducing the welfare of the consumers as they have to

pay higher price for the same utility they derive from consuming the same unit of good.

Demand Curves Under Perfect Competition andImperfect Competition

Quantity of Output

Demand

(a) Under Perfect Competition

(b ) Under Imperfect Competition

0

Price

Quantity of Output0

Price

Demand

Consumer Welfare : Consumer welfare is generally defined as the maximisation of consumer

surplus, which is the part of total surplus given to consumers. This is realised through, direct

and explicit economic benefits received by the consumers of a particular product as measured by

its price and quality (Brodley, 1987). Clssically, consumer surplus has been used as measure of

consumer welfare. The decrease in consumers welfare can also be shown using the concept of

consumer surplus. As we know that the demand curve reflects a consumers marginal willingness


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to pay which is defined as the maximum amount a consumer will spend for an extra unit. An

individuals consumer surplus is the area under the demand curve and above the market price up

to the quantity the consumer buys.

Under imperfect competition as the price become greater than marginal cost, the area of triangle

representing consumer surplus decreases. This can be seen through the following graph below:


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Consumer Surplus Under Perfect competition andimperfect competition

Quantity0

Costs andRevenue

DemandMarginalrevenue

Quantity underimperfect

competition

P m

Marginalcost

Competitivequantity

P > MC ;imperfectcompetition

P = MC ; perfectcompetition

P p.c

A

B

C

D

Area of the triangle AP mB is consumer surplus (CS) under imperfect competition and area of the

triangle AP pcC is CS in case of perfect competition. Clearly there is decrement in CS which is

equal to the area of the triangle BDC.

We can show the above discussion mathematically by assuming a linear market demand function

and linear cost function.

Let market demand function be given by P = a- y and cost function of the firm be C(y) = c*y

Under perfect competition P = MC = c (here)

Problem of firm : Max = P.y- C(y) with respect to y

For perfect competition = 0 as P= c.

Consumer surplus = area of triangle AP pcC = * y*(a-P) = *(a-c) 2


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For imperfect competition the problem of firm reduces to Maximize (a-y)y c.y.

Solving for y we get y m = (a-c)/2 , P m = a- (a-c)/2 = (a+c)/2

Therefore consumer surplus = area of triangle AP mB = *(a-P m). y m = (a-c) 2/8

CS under imperfect competition < CS under Perfect competition.

In imperfect competition, when market price rises above the competitive level, consumers

who continue to purchase the sellers' product at the new, higher price suffer a loss exactly

offset by the additional revenue that the sellers obtain at the higher price. Those who stop

buying the product suffer a loss not offset by any gain to the sellers. (Tullock, 1967). The

reason that perfect competition maximizes welfare is that in this case price equals marginal cost

at the competitive equilibrium, however in case of imperfect competition, its above the marginal

cost reducing the consumer surplus.

The consumer is better off in case of Perfect Competition as it maximizes consumer welfare and

allows them to take part in decisions such as What to produce ,how to produce and for whom to

produce by way of market forces of demand and supply leading to increased production of

desired products. No single buyer or seller can influence the prices for their own benefits.

Perfect competition is also beneficial for society at large as it directs the producers to use the

scarce resources of society in the best possible manner otherwise they will be out .This results in

minimum average cost of production and marginal cost pricing thus providing goods at lowest

possible price.

Even though perfect competition is a desired scenario but it is unrealistic as some amount of

restriction are essential in cases such as defense and other infrastructure related goods and


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services. Also, in real world we come across scenarios where startup cost or transportation cost is

pretty high.

But it can not be ignored that in most of the cases imperfect competition scenarios need to be

controlled especially in case of monopoly and oligopoly. Government shall take strong steps to

protect consumers in these cases it can use antitrust laws and act against the company, it can

break the company in parts or it can pass orders against the colluding companies.

References


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Alston,Julian M., Sexton, Richard J., and Zhang,M. (1997), The Effects of Imperfect

Competition on the Size and Distribution of Research Benefits , Amer. J. Agr. Econ., 79,

1252-1265

Tullock, Gordon. (1967),"The Welfare Costs of Tariffs, Monopolies, and Theft." Western

Econ . J.,224-32.

Stigler, George J. (1997), Perfect competition. Historically Contemplated , JPE , 65, 1-17

Jevons, William S.(1871), Theory of Political Economy , 1st ed.; London.111

Varian, Hal R. (1992), Microeconomic Analysis

Brodley, JF(1987), The economic goals of antitrust: efficiency, consumer welfare, and

technological progress, 62 NY Univ LR

imperfect competition always results in a worse outcome for consumers than perfect competition

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