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Relationship between price and revenue of a perfect competitive firm

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Published: Mon, 5 Dec 2016

Introduction

A market refers to a mechanism or arrangement y which buyers and sellers of a commodity are able to contact each other for having economic exchange and are able to strike a deal about the price and the quantity to be bought and sold. Essentially, there are 4 types of market structures:

Perfect Competition

Monopolistic Market

Monopoly

Oligopoly

All of these firms have one thing in common – a definite relationship between price and revenue. In this essay, we shall look at the relationship between price and revenue in a perfectly competitive market structure.

Perfectly Competitive Market

Before we look at the relationship between price and revenue, we must understand what a perfectly competitive market is.

Perfect competition is a market structure in which there are a large number of producers (firms) producing a homogeneous product so that no individual firm can influence the price of the commodity. In this type of market, the price is determined by the industry. A perfectly competitive firm is such a small part of the total industry in which it operates that it cannot affect the price of the product. This means that the firm under perfect competition is assumed to be a price – maker rather than a price – taker.

Features of Perfect Competition

A market to be perfectly competitive must have the following features:

Large number of buyers and sellers – this means that under perfect competition, a firm produces such a small part of the total market output that a change in its output will have no noticeable effect on market supply and, hence, the price of the commodity.

Homogeneous product – All firms under perfect competition produce homogeneous or perfectly standardised products. Since there is no room for product differentiation, there is no room for price differentiation. The implication of this characteristic is that a uniform price will rule throughout the market.

Freedom of entry and exit – this means that new firms are free to enter the industry and existing firms are free to leave the industry if they desire so. This implies that firms under perfect competition are only capable of earning normal profits in the long run.

Perfect mobility of resources – this characteristic implies that resources or factors of production can enter or quit a firm or industry at will. It also implies that resources are able to switch over from one use to another without any restriction.

Perfect knowledge – consumers, firms and resource owners under perfect competition have perfect knowledge about the market. This characteristic would ensure that price differences are quickly eliminated and a single price for the commodity would ultimately prevail throughout the market.

Absence if transport costs – this feature implies that there is no cost of transport. This is to maintain uniform price throughout the market.

Price and Revenue in Perfect Competition

Perfect competition implies a market structure where all firms are exactly the same – and this includes to process of production. Here, there is no room for one individual firm to grow exponentially. The price of the commodity is exactly the same in all firms under perfect competition. In the same way, revenue also does not change as there is neither product differentiation nor price differentiation. In theory, the income of all the firms will be the same. Here, we shall focus on Average Revenue (AR) and Marginal Revenue (MR).

Relationship Between AR, MR and Price (P)

Average Revenue is defined as the revenue earned per unit of the product sold. Marginal revenue is defined as the addition to total revenue which results from the sale of one additional unit of output. There is a clear relationship between AR, MR, and Price. Let us see how they behave in a Perfectly Competitive market structure.

Units of Output Q

Price P

Total Revenue TR

Average Revenue TR

Marginal Revenue MR

(1)

(2)

(3)

(4)

(5)

1

15

15

15

15

2

15

30

15

15

3

15

45

15

15

4

15

60

15

15

5

15

75

15

15

Let us take the example in table and in the graph above.

Since a firm under perfect competition is not required to reduce the price selling more units of output, AR is constant at all levels of output. This is because AR is the same as price and price under perfect competition is constant. It is clear from the table above that AR is the same at all levels of output. Graphically, AR curve is a horizontal straight line at the level of ruling price OP in the graph below.

Since every additional unit can be sold at the same price, it follows that the firm’s MR resulting from an increase in sale by one unit is constant and equal to the price of the product. In other words, if the price or AR remains the same when more units of a product are sold, MR will be equal to AR and it will be constant. From the table above, it is clear that MR is Rs. 15 at all levels of output and is equal to AR and/ or price. Thus, in the graph below, MR and AR curves are shown to coincide at the level of price OP, showing that AR = MR at all levels of output.

Examples of Perfect Competition

Although there is no ‘real life’ example of Perfect Competition, there are some that come close. Take agricultural products for instance. There are agricultural products like Ponni Rice and Samba Wheat for which the market is near perfect. There is very little differentiation between these products grown in one place and grown in another. Price and revenue will be more or less the same all around. But, there are factors which ensure that a situation like perfect competition will never occur. One major factor is that there will be a transport cost. This factor is enough to ensure that the market is imperfect. Another factor is that the quality of the product grown may vary from place to place. Hence, a situation of perfect competition can never exist. We can only achieve a near perfectly competitive market structure.

Conclusion

As mentioned above, in perfect competition, price and average revenue and marginal revenue are equal. But there are no examples that we can identify as perfectly competitive in real life. Perfect competition is a theory of market structure that is useful to understand other concepts of economics. What we normally experience is that as the number of units of output is increased, price decrease causing average revenue and marginal revenue to decrease as well.


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