The Economics Book

128

The assumptions of Marshall’s

model create certain consequences

for firms in perfectly competitive

industries. One of the most

important of these is that firms

have no power over the price that

they can charge. This is because

there are so many firms selling an

identical product that if any one firm

attempts to sell at a price higher

than its competitors, it will sell

nothing. This is virtually guaranteed

because the consumer has perfect

knowledge about the prices being

asked by all firms. In this way the

market price is determined by the

collective interaction of all the firms

and consumers, and each firm has

to accept that one particular price is

the price at which they can sell the

product. They have to “take” the

price, not make it.

Competitive selling

The standard representation of

Marshall’s perfectly competitive

industry (see below) demonstrates

this idea. For instance, at any

moment in time there will be a

world price of wheat—such as $350

per ton—which is determined by

the industry. At this industry price

(shown as a dotted line in the

graph), each farm can sell as much

as it likes, but it will sell nothing at

any price higher than this (because

buyers can go elsewhere). Farms

can choose to sell at a lower price

than other farms if they desire, but

this would be of no advantage to

them—a lower price will not attract

extra demand, because in perfect

competition each farm is a tiny part

of the total world supply (in wheat,

this is around 700 million tons).

By lowering the price, the farm

would merely lower its profits. The

farm has only to decide what output

it needs to produce to maximize

profits. In the case demonstrated by

the graph, it is 3,000 tons, which

the farmer knows can be sold for

$350 per ton.

In this example, the farm is

selling wheat for much more than

the cost of producing it. By selling

3,000 tons at $350 per ton, the

farm’s revenue is $1.05 million; its

costs, however, are $450,000 ($150

× 3,000 tons). The farm’s profit is

THE COMPETITIVE MARKET

In the perfectly competitive industry price

remains the same regardless of any individual firm’s

level of output. A firm will expand production until it

reaches a level beyond which any further production

would cost more than the goods’ selling price.

revenue minus cost—in this case,

$600,000. This is an example of

what classical economists such as

David Ricardo (p.84) describe as

“the market price moving away from

the natural price.” However, in a

perfectly competitive market these

high profits cannot be sustained in

the long term.

Short-term profits

Classical economists such as Smith

and Ricardo were well aware of the

consequences—in competitive

markets—of a price being well

above that required to cover costs.

The high level of profits would act

as an incentive for new firms to

enter the industry. The lack of

barriers to entry in a perfect market

allows any firm to enter the market

easily. In our example it is easy to

imagine farmers switching out of

barley production and into wheat

production if wheat is more

profitable to produce. The impact

of the new entrants would be to

increase total supply, and through

competitive pressure drive the

price downward, so that in a short

time firms would only be able to

make a “normal” level of profit.

This would be when the price just

Average cost

per ton for

firm to supply

product

Price is

determined in

the industry

PROFIT

Cost of

production

Laborers will seek those

employments, and capitalists

those modes of investing their

capital, in which... wages and

profits are highest.

John Elliott Cairnes

Irish economist (1824 –75)

Point at which

increased production

Cost per ton initially would decrease profits

decreases with

economies of scale

0

150

350

0 1,500 3,000

PRICE ($)

OUTPUT OF FIRM (TONS)

COMPANIES

ARE PRICE

TAKERS NOT

PRICE MAKERS

THE COMPETITIVE MARKET