Determination of price and output of an individual seller are very much influenced by the structure of the market wherein the firm operates. Perfect competition, one particular form of market structure, is characterized by the presence of a large numbers of sellers and buyers, product homogeneity, profit maximization objective, absence of entry and exit barriers and perfect knowledge of both buyers and sellers.
The concept of perfect competition relies on the following assumptions:
1. Large Number of Sellers and Buyers:
Presence of large number of sellers and buyers is considered to be one of the major characteristics of perfectly competitive market. It signifies the fact that market share of each seller is so small as compared to the total market demand that no individual seller can influence the price by increasing or reducing his own supply in the market.
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Similarly, the demand of each consumer is so negligible with respect to the total demand for a product in the market that individual buyers cannot influence price of the products to any extent.
2. Objective of Profit Maximization:
In a perfectly competitive market, every firm seeks to maximize its profit and it is assumed to be the only objective of these firms.
3. Firms and Consumers Have Perfect Information:
It implies that each firm is aware of the market prices and cost of manufacturing different products as well as the business opportunities available in each industry. The consumers also have perfect information regarding price charged by different firms for the same product.
4. Products are Homogenous:
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In a perfectly competitive market, the products sold by different firms are so identical that one firm’s product cannot be differentiated from the products produced by the other firms. As a result, the consumers do not have any preference for products made by a particular firm.
Homogeneity of products not only refers to identical physical attributes of the products but also implies the same behaviour of the sellers, selling location etc.
5. Free entry and free exit:
Perfectly competitive market does not have any entry or exit barrier. The underlying meaning of this assumption is that the existing firms cannot stop the new firms to enter into the industry. Similarly, if any firm incurs losses, they may also close down the business and leave that industry without any hassle. An extension of this assumption is perfect mobility of the factors of production (raw materials, labour etc.).
If a firm observes that there exists a profitable business opportunity at a particular time and location, it will be able to mobilise all the relevant factors of production instantaneously for exploiting that opportunity.
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Similarly, if the firm finds that the current business cannot offer the required rate of profit, the firm will be able to discharge its factors of production without any difficulty and delay.