Following are some of the conditions that determine which markets are oh so perfect and which fall below the standard. A number of factors are required for a given market to be in perfect competition:
Each firm is small relative to the market and has no influence on price.
Firms and products are substitutable.
Each consumer is small relative to the market and has no influence on price.
Perfect information about prices and quantities is available.
There is easy entry into and exit from the market.
If you fail to find any of these conditions holding in a given market, the market is not perfectly competitive.
Each firm is small relative to the market
In a perfectly competitive market, no firm is individually able to influence the price or quantity sold of a given good. For this to be the case, each firm has to be a small producer relative to the quantity demanded. Typically, this means there are many firms to supply the market, none of which has a significant share of the market. This is obviously not always the case in many markets, because many markets are dominated by one firm or a small group of firms.
The small firm condition leads to economists describing firms in the market as price takers (the opposite being price makers or price setters). None of them can influence market price or demand, and so firms have no option but to take whatever price is determined by the market as a whole.
Firms and products are substitutable
Products in a perfectly competitive market are said to be homogenous, that is, indistinguishable from one another. If, for example, you're shopping at a fruit and veg market with many sellers (so that none can influence the price paid for apples), the apples that each sells must be the same: no better or worse apples and no stalls that are the only ones selling Macintosh or the only ones selling Granny Smith. Instead, all must be selling the same, indistinguishable product.
Similarly, the firms must have the same production technology. If they don't, long-run differences between firms are possible, which leads to differences between the firms in the market. This would open up the possibility of one firm being different enough from the other firms to be considered as being in a different market altogether and to be able to influence that market.
Again, these conditions may not reflect real-world conditions. Although some goods are entirely homogenous, they aren't necessarily always produced by firms with the same production technologies. Take commodities, which are defined by their homogeneity: Gold is either gold or something else. An atom of the metal is either a gold atom or an atom of a different metal, not a different kind of gold atom. But this isn't to say that firms mining gold produce it to the same level of efficiency everywhere in the world.
Each consumer is small relative to the market
A similar issue is the degree to which consumers are small relative to the market. This means that there is not a consumer whose purchasing behavior is able to influence the price. For many markets, this is a pretty plausible condition. A regular at Starbucks does not influence the price of a latte. However, a large pharmacy chain such as CVS is likely to be able to influence the price it pays for the prescribed medications it sells to consumers.
Perfect information about products and prices
A perfectly competitive market contains no hidden surprises. Consumers are perfectly informed about what products are available, the qualities of the products, where they are sold, and at what prices. Thus they're immediately able to assess whether they want to purchase from one firm or another.
This information does not come at a cost. If consumers have to work to find out prices, the competition may not be perfect.
Easy entry and exit
Easy entry into and exit from the market is an extremely important condition. If an entrepreneur sees profits being made in a perfectly competitive market, he's able to enter that market immediately and begin competing profits away from the firms in the market. Similarly, if he's in a market and not making profits, he's able to pack up and leave without his leaving incurring any costs that can't be recovered.
This condition doesn't mean that starting up involves no costs — just that it doesn't involve any costs above and beyond those of producing whatever he's producing in that market: no fees for entering and no costs of closing.
Learning Objectives
By the end of this section, you will be able to:
- Explain the characteristics of a perfectly competitive market
- Discuss how perfectly competitive firms react in the short run and in the long run
Firms are said to be in perfect competition when the following conditions occur: (1) many firms produce identical products; (2) many buyers are available to buy the product, and many sellers are available to sell the product; (3) sellers and buyers have all relevant information to make rational decisions about the product being bought and sold; and (4) firms can enter and leave the market without any restrictions—in other words, there is free entry and exit into and out of the market.
A perfectly competitive firm is known as a price taker, because the pressure of competing firms forces them to accept the prevailing equilibrium price in the market. If a firm in a perfectly competitive market raises the price of its product by so much as a penny, it will lose all of its sales to competitors. When a wheat grower, as discussed in the Bring it Home feature, wants to know what the going price of wheat is, he or she has to go to the computer or listen to the radio to check. The market price is determined solely by supply and demand in the entire market and not the individual farmer. Also, a perfectly competitive firm must be a very small player in the overall market, so that it can increase or decrease output without noticeably affecting the overall quantity supplied and price in the market.
A perfectly competitive market is a hypothetical extreme; however, producers in a number of industries do face many competitor firms selling highly similar goods, in which case they must often act as price takers. Agricultural markets are often used as an example. The same crops grown by different farmers are largely interchangeable. According to the United States Department of Agriculture monthly reports, in 2015, U.S. corn farmers received an average price of $6.00 per bushel and wheat farmers received an average price of $6.00 per bushel. A corn farmer who attempted to sell at $7.00 per bushel, or a wheat grower who attempted to sell for $8.00 per bushel, would not have found any buyers. A perfectly competitive firm will not sell below the equilibrium price either. Why should they when they can sell all they want at the higher price? Other examples of agricultural markets that operate in close to perfectly competitive markets are small roadside produce markets and small organic farmers.
Visit this website that reveals the current value of various commodities.
This chapter examines how profit-seeking firms decide how much to produce in perfectly competitive markets. Such firms will analyze their costs as discussed in the chapter on Cost and Industry Structure. In the short run, the perfectly competitive firm will seek the quantity of output where profits are highest or, if profits are not possible, where losses are lowest. In this example, the “short run” refers to a situation in which firms are producing with one fixed input and incur fixed costs of production. (In the real world, firms can have many fixed inputs.)
In the long run, perfectly competitive firms will react to profits by increasing production. They will respond to losses by reducing production or exiting the market. Ultimately, a long-run equilibrium will be attained when no new firms want to enter the market and existing firms do not want to leave the market, as economic profits have been driven down to zero.
Key Concepts and Summary
A perfectly competitive firm is a price taker, which means that it must accept the equilibrium price at which it sells goods. If a perfectly competitive firm attempts to charge even a tiny amount more than the market price, it will be unable to make any sales. In a perfectly competitive market there are thousands of sellers, easy entry, and identical products. A short-run production period is when firms are producing with some fixed inputs. Long-run equilibrium in a perfectly competitive industry occurs after all firms have entered and exited the industry and seller profits are driven to zero.
Perfect competition means that there are many sellers, there is easy entry and exiting of firms, products are identical from one seller to another, and sellers are price takers.
Self-Check Questions
- Firms in a perfectly competitive market are said to be “price takers”—that is, once the market determines an equilibrium price for the product, firms must accept this price. If you sell a product in a perfectly competitive market, but you are not happy with its price, would you raise the price, even by a cent?
- Would independent trucking fit the characteristics of a perfectly competitive industry?
Review Questions
- A single firm in a perfectly competitive market is relatively small compared to the rest of the market. What does this mean? How “small” is “small”?
- What are the four basic assumptions of perfect competition? Explain in words what they imply for a perfectly competitive firm.
- What is a “price taker” firm?
Critical Thinking Questions
- Finding a life partner is a complicated process that may take many years. It is hard to think of this process as being part of a very complex market, with a demand and a supply for partners. Think about how this market works and some of its characteristics, such as search costs. Would you consider it a perfectly competitive market?
- Can you name five examples of perfectly competitive markets? Why or why not?
Glossary
market structurethe conditions in an industry, such as number of sellers, how easy or difficult it is for a new firm to enter, and the type of products that are soldperfect competitioneach firm faces many competitors that sell identical productsprice takera firm in a perfectly competitive market that must take the prevailing market price as givenSolutions
Answers to Self-Check Questions
- No, you would not raise the price. Your product is exactly the same as the product of the many other firms in the market. If your price is greater than that of your competitors, then your customers would switch to them and stop buying from you. You would lose all your sales.
- Possibly. Independent truckers are by definition small and numerous. All that is required to get into the business is a truck (not an inexpensive asset, though) and a commercial driver’s license. To exit, one need only sell the truck. All trucks are essentially the same, providing transportation from point A to point B. (We’re assuming we not talking about specialized trucks.) Independent truckers must take the going rate for their service, so independent trucking does seem to have most of the characteristics of perfect competition.