Perfect Competition: Short Run and Long Run Profits Trends

This paper is written to critically discuss the following statement: “If a firm is in perfect competition, it is unable to make supernormal profits in the long run. Therefore, they should strategize to move from a price taker in a perfect competition situation towards a price maker monopoly situation as part of their corporate strategy.”

This report firstly provides an analysis of the overview of perfect competition, including its short-run and long-run profits trends. This is followed by an analysis of monopoly. Specific information is given out here. And then Strategies for maintaining monopoly position is given for references but they may not always helpful. Finally, it reaches the overall conclusion of this paper.

Table of Contents

1. Introduction

2. Perfect competition

2.1 The short run and the long run

2.2 Normal and supernormal profits in a context of perfect competition

3. Monopoly

4. Strategies for maintaining monopoly position

5. Conclusions

List of References

1. Introduction

This paper is written to critically discuss the following statement: “If a firm is in perfect competition, it is unable to make supernormal profits in the long run. Therefore, they should strategize to move from a price taker in a perfect competition situation towards a price maker monopoly situation as part of their corporate strategy.” The scope of this paper focuses on the two extremes-perfect competition and monopoly. The writer’s insufficient experience in the microeconomic area appears to be main limitation of this report.

2. Perfect competition

Industries are traditionally divided into four categories according to the degree of competition that exists between the firms within the industry (Sloman 2005): At one extreme is perfect competition where there are very many firms competing. Each firm is so small relative to the whole industry that is has no power to influence price. It is a price taker. At the other extreme is monopoly, where there is just one firm in the industry, and hence no competition from within the industry. In the middle come monopolistic competition, which involves quite a lot of firms competing and where there is freedom for new firms to enter the industry, and oligopoly, which involves only a few firms and where entry of new firms is restricted.

Perfect competition is a theoretical market structure that will give the optimum allocation of resources (Sloman 2005). There are four conditions that have to be fulfilled for perfect competition to exist in an industry:

1. There must be many buyers and sellers and none of them can be large enough to have any influence over the market price

2. There must be perfect knowledge of the market (this means no advertising is necessary)

3. There must be no barriers to entry – firms must have complete freedom of entry and exit

4. The goods being sold must be homogenous in nature

If these conditions are met, then the industry is in perfect competition (Sloman 2005).

Perfect competition was well developed to illustrate that in some sense it is optimal and in fact represents the end-state. Consequently, it meant that competition between buyers and sellers was completed, and neither party can increase utility or profits (Steven and Heijdra 2004). Transformation occurs only if independent variables change, but the situation becomes how fast and under what circumstances the new equilibrium will be accomplished. Competition might not actually direct to a peaceful state because market forces distinguish profit and utility maximizing behavior with an equilibrium situation that can be, from a social viewpoint, sub-optimal (Steven and Heijdra 2004).

2.1 The short run and the long run

In the short run, the number of firms is fixed. Depending on its costs and revenue, a firm might be making large profits, small profits, no profits or a loss; and in the short run, it may continue to do so.

In the long run, however, the level of profits affects entry and exit form the industry. if profits are high, new firms will be attracted into the industry, whereas if losses are being made, firms will leave.

2.2 Normal and supernormal profits in a context of perfect competition

Normal profit is the level of profit that is just enough to persuade firms to stay in the industry in the long run, but not high enough to attract new firms. If less than normal profits are made, firms will leave the industry in the long run.

Although the talking is about the level of normal profit, in practice it is usually the rate of profit that determines whether a firm stays in the industry or leaves. The rate of profit (r) is the level of profit (Tп) as a proportion of the level of capital (K) employed (Sloman 2005). Larger firms will require making a larger total profit to persuade them to stay in an industry. Total normal profit is thus larger for them than for a small firm. The rate of normal profit will probably be similar.

Supernormal profit is any profit above normal profit. If supernormal profits are made, new firms will be attracted into the industry in the long run. Thus whether the industry expands or contracts in the long run will depend on the rate of profit. Naturally, since the time a firm takes to set up in business varies from industry to industry, the length of time before the long run is reached also varies from industry to industry.

Thereby, in the short-run, it may be possible for an individual firm to make supernormal profit. This situation is shown in the diagram below, as the price (average revenue) is above the average cost (AC). As fewer firms had happened to enter in the period of high profits, the actual price of a given output would be higher.

Not all firms make supernormal profits in the short run. Their profits depend on the position of their short run cost curves. Some firms may be experiencing sub-normal profits because their average total costs exceed the current market price. Other firms may be making normal profits where total revenue equals total cost (i.e. they are at the break-even output). In the diagram below, the firm shown has high short run costs such that the ruling market price is below the average total cost curve. At the profit maximizing level of output, the firm is making an economic loss (or sub-normal profits)

However, this supernormal profit that some firms made will not last as it will attract new firms into the industry (Sloman 2005). The arrival of new firms shifts the supply curve to the right, as shown in the diagram below, and pushes the price down.

The lower price shifts the average revenue curve downwards until all the supernormal profit has been competed away and the firms are making just normal profits. This long-run equilibrium is shown in the diagram below.

Another force that shifts the supply curve happens when discontinuous changes in the number of fresh entrepreneurs (each in front of imperfect knowledge of the others’ action) come into the trade. Through this new competition, actual profits are heavily reduced to a level below the one that attracts new comers, but they are not sufficiently low to run out any existing firms. The industry will continue at this inflated size, and it will be in equilibrium in the sense that no new enterprise tends to enter or old enterprise to leave (Robinson 1934).

In a word, in contrast to a monopoly or oligopoly, it is impossible for a firm in perfect competition to earn supernormal profit in the long run, which is to say that a firm cannot make any more money than is necessary to cover its economic costs. If a firm is earning supernormal profit in the short term, this will act as a trigger for other firms to enter the market. They will compete with the first firm, driving the market price down until all firms are earning normal profit, it could be said that supernormal profit is ‘competed away’. On the other hand, if firms are making a loss, then some firms will leave the industry, reduce the supply and increase the price. Therefore, all firms can only make normal profit in the long run.

3. Monopoly

A monopoly is a market structure in which there is only one producer/seller for a product. In other words, the single business is the industry. Entry into such a market is restricted due to high costs or other impediments, which may be economic, social or political. For instance, a government can create a monopoly over an industry that it wants to control, such as electricity. Another reason for the barriers against entry into a monopolistic industry is that oftentimes, one entity has the exclusive rights to a natural resource. For example, in Saudi Arabia the government has sole control over the oil industry. A monopoly may also form when a company has a copyright or patent that prevents others from entering the market. Pfizer, for instance, had a patent on Viagra. Firms with a monopoly position is a price maker because a single firm controls the total supply in a pure monopoly, it is able to exert a significant degree of control over the price by changing the quantity supplied.

The conventional concept of monopoly was the main part of the field of production outside that of perfect competition, so it was recognized that the monopolist’s position was never absolute and the elasticity of the demand for his product was always greater than zero. Harrod (1934) reveals that if products are absolutely homogeneous and marketed by organized exchange is likely to perfect competition to reign. If differences of design and detail are possible, each producer may be defined as a monopolist of his own goods, but subject to the reaction of his rivals. The degree of monopoly may be measured by the similarities of commodities.

Figure: The traditional analysis of monopoly

Source: Adapted from Harrod (1934)

The notation in the figure 2 is given as such: MC is the marginal cost, D is the demand, MR is the marginal revenue, Q is quantity, and P is the price. Harrod (1934) stated that the volume of output (figure 2) is determined by the intersection between the marginal revenue curve, derived from the demand curve, and the marginal cost, but the price M P is defined by the demand curve.

According to Robinson (1933), the demand curve imposes upon the seller a price problem for his product comparatively to the horizontal one from the perfect competition. However, the monopolist decision about the price and the output depends upon the elasticity of the curve and upon its position relative to the cost curve for his product. In that circumstance, profits may be bigger, perhaps by increasing the price and selling less, perhaps by reducing it and selling more. The position and elasticity of the demand curve for the product of any one seller depend in large part upon the availability of competing products and prices that are asked for them.

Since there are barriers to the entry of new firms, the supernormal profits derived from the monopoly will not be competed away in the long run. The only difference, therefore, between short-run and long-run equilibrium is that in the long run the firm will produce where MR = long-run MC.

However, if the barriers to the entry of new firms are not total, and if the monopolist is making very large supernormal profits, there may be a danger in the long run of potential rivals breaking into the industry. In such cases, the monopolist may keep its price down and thereby deliberately limit the size of its profits so as not to attract new entrants (Sloman 2005). This practice is known as limit pricing (Sloman 2005).

In the following Figure, two AC curves are drawn: one for the monopolist and one for a potential entrant. The monopolist, being established, has a lower AC curve. The new entrant, if it is to compete successfully with the monopolist, must charge the same price or a lower one. Thus provided the monopolist does not raise price above P1, the other firm, unable to make supernormal profit, will not be attracted into the industry.

AC for new entrant

AC for monopolist

P1

Quantity

Price

P1 may well be below the monopolist’s short-run profit-maximizing price, but the monopolist may prefer to limit its price to P1 to protect its long-run profits from damage by competition. Fear of government intervention to curb the monopolist’s practices may have a similar restraining effect on the price that the monopolist charges.

Consumers are willing to buy more goods if the price level is lower than the one determined under monopoly, but the conditions of imperfect competition imposes restrictions over the market mechanism to bring in more firms to compete and to reduce the price level. Firms invest in product differentiation to avoid the competition of new entrants, so the volume of sales is based upon the method in which his product differs from competitors’ product. Differently, under perfect competition, a producer may shift from one sector to another, but the volume of sales never depends, as under imperfect competition, upon product differentiation. The producer, in perfect competition, is always a part of the market in which many others are producing the identical good. The sales may vary over a wide range without changing the price, so they may be as large or as small as he pleases without the necessity of altering his product (Robinson, 1933).

The differentiation is an important aspect but its variation may refer to the quality of the product – technical changes, new designs, or better materials; it may mean a new package or container; it may mean more prompt or courteous service, a different location (Robinson, 1933).

If economies of scale is totally absent when the demand rises the inflow of new producers will continue, leading to a continuous reduction in the output of existing producers and a continuous increase in the elasticities of their demand until the latter becomes infinite and prices will equal average cost. There the movement will stop. However, each firm will have reduced his output to such an extent that he has completely lost his hold over the market (Kaldor, 1935).

The role of the economies of scope is demonstrated by Kaldor (1935) as a mechanism that reinforces imperfect competition. Thus, if there is not a sufficiently great demand to produce one product on an optimal scale, the producer may still utilize his plant fully by producing two or more products, rather than building a smaller, sub-optimal plant or leaving his existing plant under-employed. According to Kahn (1935), the size of a firm depends on two sets of factors: a) the technical conditions of production, as expressed by its cost curve; and b) the degree of imperfection of competition, as expressed by the demand curve for its product.

The question about market integration can be analyzed using the explanation of Harrod (1931), so the firms, in order to maintain their market power, may require a license from some controlling authority, or the existing firms may be so strong that they are able to repel new competition employing a price war. They may even resort to violence to prevent fresh rivals from appearing on the industry. In such cases, no level of high profits will be sufficiently enough to tempt new firms into the trade, and the supply of enterprise to that trade is perfectly inelastic at the existing amount. For such industry, any level of profits is normal and the term ceases to have a valid application.

In a world in which all entrepreneurs are alike there would be a uniform rate of profit in all industries in the long period. In the real world entrepreneurship is no more homogenous than land in the real world. It is socially desirable to reroute entrepreneurs from industries in which the firms are naturally larger than the average for industry as a whole, and to attract them into industries where firm are naturally below the average in size. Where the firms are already naturally large under conditions of laissez-faire it is in the interests of society that they should be yet larger; where they are already naturally small it is interest of society that should be yet smaller. Consequently, trades which require unusual personal ability or special qualifications, such as the power to command a large amount of capital for the initial investment, will tend to have a high level of profits; trades which are easy to enter will have a lower level (Robinson 1934 and Kahn 1935).

4. Strategies for maintaining monopoly position

As stated in the previous sections, it is impossible for a firm in perfect competition to earn supernormal profit in the long run, but possible in a monopoly situation. For a firm to strive for or maintain its monopoly position, there must be barriers to entry of new firms (Sloman 2005). Barriers also exist under oligopoly, but in the case of monopoly they must be high enough to block the entry of new firms. Barriers can be of various forms.

Economies of Scale. If a monopoly experiences substantial economies of scale, the industry may not be able to support more than one producer (Sloman 2005). In Figure below, D1 represents the industry demand curve, and hence the demand curve for the firm under monopoly. The monopolist can gain supernormal profit at any output between points a and b. if there were two firms, each charging the same price and supplying half the industry output, they would both face the demand curve D2. There is no price that would allow them to cover costs.

LRAC

D1

D2

Quantity

Price

a

b

It is particularly likely if the market is small. Even if a market could support more than one firm a new entrant is unlikely to be able o start up on a very large scale. Thus a monopolist already experiencing economies of scale can charge a price below the cost of the new entrant and drive it out of business. If, however, the new entrant is a firm already established in another industry, it may be able to survive this competition.

Product differentiation and brand loyalty. If a firm produces a clearly differentiated product, where the consumer associates the product with the brand, it will be very difficult for a new firm to break into that market (Sloman 2005). This barrier can occur even though the market is potentially big enough for two firms each gaining all the available economies of scale. In other words, the problem for the new firm is not in being able to produce at low enough costs, but in being able to produce a product sufficiently attractive to consumers who are loyal to the familiar brand.

Lower costs for an established firm. An established monopoly is likely to have developed specialized production and marketing skill (Sloman 2005). It is more likely to be aware of the most efficient techniques and the most reliable and/or cheapest suppliers. It is likely to have access to cheaper finance. It is thus operating on a lower cost curve. New firms would therefore find it hard to compete and would be likely to lose any price war.

Ownership of, or control over, key inputs. If a firm governs the supply of vital inputs, it can deny access to these inputs to potential rivals (Sloman 2005). On a world scale, the de Beers company has a monopoly in fine diamonds because all diamond producers market their diamonds through de Beers.

Ownership of, or control over, wholesale or retail outlets. Similarly, if a firm controls the outlets through which the product must be sold, it can prevent potential rivals from gaining access to consumers (Sloman 2005). For example, Birds Eye Wall’s used to supply freezers free to shops on the condition that they stocked only Wall’s ice cream in them.

Legal protection. The firm’s monopoly position may be protected by patents on essential processes, by copyright, by various forms of licensing and by tariffs and other trade restrictions to keep out foreign competitors (Sloman 2005). Examples of monopolies protected by patents include most new medicines developed by pharmaceutical companies, Microsoft’s Windows operating systems and agro-chemical companies, such as Monsanto, with various genetically modified plant varieties and pesticides.

Mergers and takeovers. The monopolist can put in a takeover bid for new entrant. The sheer threat of takeover may discourage new entrants (Sloman 2005).

Aggressive tactics. An established monopolist can probably sustain losses for longer than a new entrant. Thus it can start a price war, mount massive advertising campaigns, offer an attractive after-sales service, introduce new brands to compete with new entrants, and so on.

Intimidation. The monopolist may resort to various forms of harassment, legal or illegal, to drive a new entrant out of business.

However, to gain or maintain monopoly position is actually a very difficult process. In real world, in fact, in many sectors of the economy markets are best described by the term oligopoly-where a few producers dominate the majority of the market and the industry is highly concentrated (tutor2u.net (n.d.)). In a duopoly two firms dominate the market although there may be many smaller players in the industry (tutor2u.net (n.d.)).

5. Conclusions

Perfect competition and monopoly are actually two extremes when dividing the industries according to the degree of competition that exists between the firms within the industry. It is impossible for a firm in perfect competition to earn supernormal profit in the long run, which is to say that a firm cannot make any more money than is necessary to cover its economic costs. If a firm is earning supernormal profit in the short term, this will act as a trigger for other firms to enter the market. They will compete with the first firm, driving the market price down until all firms are earning normal profit, it could be said that supernormal profit is ‘competed away’. On the other hand, if firms are making a loss, then some firms will leave the industry, reduce the supply and increase the price. Therefore, all firms can only make normal profit in the long run.

Due to the high barriers to the entry of new firms, the supernormal profits derived from the monopoly will not be competed away in the long run. However, if the barriers to the entry of new firms are not total, and if the monopolist is making very large supernormal profits, there may be a danger in the long run of potential rivals breaking into the industry. In real world, in many sectors of the economy markets are best described by the term oligopoly-where a few producers dominate the majority of the market and the industry is highly concentrated. Hence many of the firms’ striving for monopoly position could only lead to the oligopoly position rather than monopoly position, because after all, it is a free market.