SummaryEven though perfect competition is hard to come by, it’s a good starting point to understand market structures. A deep understanding of how competitive markets work and are formed is the cornerstone to understand why it’s so hard to reach them. In this first Learning Path on perfect competition, we start by analysing firms’ cost structure, before analysing their interaction in the market.
- Period analysis
- Short run cost analysis
- Long run cost analysis
Industry and market:
Period analysis show the inter-temporal dimension of production theory. It was developed by Alfred Marshall in his “Principles of Economics”, 1890, and has remained practically unaltered since. It tries to explain how equilibrium is achieved and explains the adjustment processes to reach it, going from the short-run equilibrium to the long-run equilibrium. His method is able to classify forces with references to the length of time needed for the production process; and then confine in ceteris paribus those forces that are of less importance with regards to the specific time we are considering. Four periods can be distinguished: very short-run, short-run, long-run and very long-run.
The very short-run period is normally not studied as it is considered irrelevant. It is a period characterized by having all its production factors or inputs, fixed; thus implying there can be no change in their quantities. Costs are therefore considered to be fixed and logically there is inexistence of technological progress in this period.
The short-run period is a period in which some factors remain fixed while others may vary in their quantity. Capital elements, such as equipment, are considered fixed factors while labour is considered to be a variable factor. During this period, cost analysis has a large dependence on marginal cost and average total costs. But, since not all factors can be increased, this will result in diminishing returns, which will imply that marginal costs will increase. A firm should stop production until marginal costs reach average total costs in order to maximize profits. In this period technological progress is still non-existing.
The long-run period is formed by the succession of several short-run periods and it is considered to be like an envelope of many of these. As inputs can be increased, economies of scale can be achieved, so the cost of producing an extra unit of output will decrease, and thus reduce the average costs. Inputs and outputs should be increased until the point where the optimum size of the firm is achieved and from whereon an increase in size will only mean diseconomies of scale. All inputs may be varied but the basic technology of production still cannot be changed.
Finally, it is in the very long-run period when new production processes and new products come as a result of the existence of technological changes within this period, which allow for new ways of producing and different input requirements.