162 Reading: Perfect Competition: A Model

Perfect Competition: A Model

Virtually all firms in a market economy face competition from other firms. In this module, we will be working with a model of a highly idealized form of competition called “perfect” by economists.

Perfect competition is a model of the market based on the assumption that a large number of firms produce identical goods consumed by a large number of buyers. The model of perfect competition also assumes that it is easy for new firms to enter the market and for existing ones to leave. And finally, it assumes that buyers and sellers have complete information about market conditions.

As we examine these assumptions in greater detail, we will see that they allow us to work with the model more easily. No market fully meets the conditions set out in these assumptions. As is always the case with models, our purpose is to understand the way things work, not to describe them. And the model of perfect competition will prove enormously useful in understanding the world of markets.

Assumptions of the Model

The assumptions of the model of perfect competition, taken together, imply that individual buyers and sellers in a perfectly competitive market accept the market price as given. No one buyer or seller has any influence over that price. Individuals or firms who must take the market price as given are called price takers. A consumer or firm that takes the market price as given has no ability to influence that price. A price-taking firm or consumer is like an individual who is buying or selling stocks. He or she looks up the market price and buys or sells at that price. The price is determined by demand and supply in the market—not by individual buyers or sellers. In a perfectly competitive market, each firm and each consumer is a price taker. A price-taking consumer assumes that he or she can purchase any quantity at the market price—without affecting that price. Similarly, a price-taking firm assumes it can sell whatever quantity it wishes at the market price without affecting the price.

You are a price taker when you go into a store. You observe the prices listed and make a choice to buy or not. Your choice will not affect that price. Should you sell a textbook back to your campus bookstore at the end of a course, you are a price-taking seller. You are confronted by a market price and you decide whether to sell or not. Your decision will not affect that price.

To see how the assumptions of the model of perfect competition imply price-taking behavior, let us examine each of them in turn.

Identical Goods

In a perfectly competitive market for a good or service, one unit of the good or service cannot be differentiated from any other on any basis. A bushel of, say, hard winter wheat is an example. A bushel produced by one farmer is identical to that produced by another. There are no brand preferences or consumer loyalties.

The assumption that goods are identical is necessary if firms are to be price takers. If one farmer’s wheat were perceived as having special properties that distinguished it from other wheat, then that farmer would have some power over its price. By assuming that all goods and services produced by firms in a perfectly competitive market are identical, we establish a necessary condition for price-taking behavior. Economists sometimes say that the goods or services in a perfectly competitive market are homogeneous, meaning that they are all alike. There are no brand differences in a perfectly competitive market.

A Large Number of Buyers and Sellers

How many buyers and sellers are in our market? The answer rests on our presumption of price-taking behavior. There are so many buyers and sellers that none of them has any influence on the market price regardless of how much any of them purchases or sells. A firm in a perfectly competitive market can react to prices, but cannot affect the prices it pays for the factors of production or the prices it receives for its output.

Ease of Entry and Exit

The assumption that it is easy for other firms to enter a perfectly competitive market implies an even greater degree of competition. Firms in a market must deal not only with the large number of competing firms but also with the possibility that still more firms might enter the market.

Later in this module, we will see how ease of entry is related to the sustainability of economic profits. If entry is easy, then the promise of high economic profits will quickly attract new firms. If entry is difficult, it won’t.

The model of perfect competition assumes easy exit as well as easy entry. The assumption of easy exit strengthens the assumption of easy entry. Suppose a firm is considering entering a particular market. Entry may be easy, but suppose that getting out is difficult. For example, suppliers of factors of production to firms in the industry might be happy to accommodate new firms but might require that they sign long-term contracts. Such contracts could make leaving the market difficult and costly. If that were the case, a firm might be hesitant to enter in the first place. Easy exit helps make entry easier.

Complete Information

We assume that all sellers have complete information about prices, technology, and all other knowledge relevant to the operation of the market. No one seller has any information about production methods that is not available to all other sellers. If one seller had an advantage over other sellers, perhaps special information about a lower-cost production method, then that seller could exert some control over market price—the seller would no longer be a price taker.

We assume also that buyers know the prices offered by every seller. If buyers did not know about prices offered by different firms in the market, then a firm might be able to sell a good or service for a price other than the market price and thus could avoid being a price taker.

The availability of information that is assumed in the model of perfect competition implies that information can be obtained at low cost. If consumers and firms can obtain information at low cost, they are likely to do so. Information about the marketplace may come over the internet, over the airways in a television commercial, or over a cup of coffee with a friend. Whatever its source, we assume that its low cost ensures that consumers and firms have enough of it so that everyone buys or sells goods and services at market prices determined by the intersection of demand and supply curves.

The assumptions of the perfectly competitive model ensure that each buyer or seller is a price taker. The market, not individual consumers or firms, determines price in the model of perfect competition. No individual has enough power in a perfectly competitive market to have any impact on that price.

Perfect Competition and the Real World

The assumptions of identical products, a large number of buyers, easy entry and exit, and perfect information are strong assumptions. The notion that firms must sit back and let the market determine price seems to fly in the face of what we know about most real firms, which is that firms customarily do set prices. Yet this is the basis for the model of demand and supply, the power of which you have already seen.

When we use the model of demand and supply, we assume that market forces determine prices. In this model, buyers and sellers respond to the market price. They are price takers. The assumptions of the model of perfect competition underlie the assumption of price-taking behavior. Thus we are using the model of perfect competition whenever we apply the model of demand and supply.

We can understand most markets by applying the model of demand and supply. Even though those markets do not fulfill all the assumptions of the model of perfect competition, the model allows us to understand some key features of these markets.

Changes within your lifetime have made many markets more competitive. Falling costs of transportation, together with dramatic advances in telecommunications, have opened the possibility of entering markets to firms all over the world. A company in South Korea can compete in the market for steel in the United States. A furniture maker in New Mexico can compete in the market for furniture in Japan. A firm can enter the world market simply by creating a web page to advertise its products and to take orders.

In the remaining sections of this module, we will learn more about the response of firms to market prices. We will see how firms respond, in the short run and in the long run, to changes in demand and to changes in production costs. In short, we will be examining the forces that constitute the supply side of the model of demand and supply.

We will also see how competitive markets work to serve consumer interests and how competition acts to push economic profits down, sometimes eliminating them entirely. When we have finished we will have a better understanding of the market conditions facing farmers and of the conditions that prevail in any competitive industry.

Watch this video to learn more about the characteristics of perfect competition: