Perfect Competition In a Market
By Saad Bin Abbas
We used a simple supply-demand analysis to elucidate how changing market conditions affect the market value of such products as wheat and gasoline. We saw that the equilibrium price and quantity of every product decided by the intersection of the market demand and market supply curves. Underlying this analysis is that the model of a wonderfully competitive market. The model of perfect competition is extremely useful for studying a spread of markets, including agriculture, fuels, and other commodities, housing, services, and financial markets. Because this model is so important, we’ll spend a while laying out the essential assumptions that underlie it. The exemplary of perfect competition respites on three basic conventions:
(1)Price taking
(2)Product homogeneity, and
(3)Free entry and exit.
You have encountered these assumptions earlier within the book; here we summarize and elaborate on them.
PRICE TAKING:
Because many firms compete within the market, each firm faces a big number of direct competitors for its products. Because each individual firm sells a sufficiently small proportion of total market output, its decisions haven’t any impact on market value. Thus, each firm takes the market value as given. In short, firms in perfectly competitive markets are price takers. Suppose, for instance, that you simply are the owner of a little Electronics distribution business. You purchase your Electronics from the manufacturer and resell them at wholesale to small businesses and shops. Unfortunately, you’re just one of the many competing distributors. As a result, you discover that there’s little room to barter together with your customers. If you are doing not offer a competitive price-one that’s determined within the marketplace-your customers will take their business elsewhere. Additionally, you recognize that the number of electronics that you simply sell will have little or no effect on the wholesale price of electronics. You’re a price taker. The idea of price taking applies to consumers also as firms. During a perfectly competitive market, each consumer buys such a little proportion of total industry output that he or she has no impact on the market value, and thus takes the worth as given. Differently of stating the price-taking assumption is that there are many independent firms and independent consumers within the market, all of whom believe-correctly-that their decisions won’t affect prices.
PRODUCT HOMOGENEITY:
Price-taking conduct usually happens in marketplaces where firms produce indistinguishable, or nearly identical, products. When the products of all of the firms during a market are perfectly substitutable with one another-that is, once they are homogeneous-no firm can raise the worth of its product above the worth of other firms without losing most or all of its business. Most agricultural products are homogeneous: Because product quality is comparatively similar among farms during a given region, for instance, buyers of corn don’t ask which individual farm grew the merchandise. Economists ask for such homogeneous products as commodities. In contrast, when products are heterogeneous, each firm has the chance to boost its price above that of its competitors without losing all of its sales. Premium ice creams like Haagen-Dazs, for instance, are often sold at higher prices because Haagen-Dazs has different ingredients and is perceived by many consumers to be a higher-quality product. The idea of product homogeneity is vital because it ensures that there’s one market value, according to supply-demand analysis.
FREE ENTRY AND EXIT:
This third assumption, free entry (or exit), means there are not any special costs that make it difficult for a replacement firm either to enter an industry and produce, or to leave if it cannot create earnings. As a result, buyers can easily switch from one supplier to a different one, and suppliers can easily enter or exit a market. The special costs that would restrict entry are costs that an entrant to a market would need to bear, but which a firm that’s already producing wouldn’t. The pharmaceutical industry, for instance, isn’t perfectly competitive because Merck, Pfizer, and other firms hold patents that give them unique rights to supply drugs. Any new entrant would either need to invest in research and development to get its own competing drugs or pay substantial license fees to at least one or more firms already within the market. Likewise, the aircraft industry isn’t perfectly competitive because entry requires an immense investment in plant and equipment that has little or no resale value. The idea of free entry and exit is vital for a competition to be effective. It means consumers can easily switch to a rival firm if a current supplier raises its price. For industries, it means a firm can easily arrive at an industry if it sees a profit opportunity and exit if it’s losing money. Thus a firm can hire labor and buy capital and raw materials as required, and it can release or move these factors of production if it wants to pack up or relocate. If these three assumptions of perfect competition hold, market demand and provide curves are often wont to analyze the behavior of market prices. In most markets, of course, these assumptions are unlikely to carry exactly. This doesn’t mean, however, that the model of perfect competition isn’t useful. Some markets do indeed compared to satisfying our assumptions. But even when one or more of those three assumptions fails to carry, in order that a market isn’t perfectly competitive, much is often learned by making comparisons with the superbly competitive ideal.
Apart from agriculture, few real-world markets are perfectly competitive within the sense that every firm faces a wonderfully horizontal demand curve for a homogeneous product in an industry that it can freely enter or exit. Nevertheless, many markets are highly competitive in the sense that firms face highly elastic demand curves and comparatively easy entry and exit. An easy rule of thumb to explain whether a market is on the brink of being perfectly competitive would be appealing. Unfortunately, we’ve no such rule, and it’s important to know why. Consider the foremost obvious candidate: an industry with many firms (say, a minimum of 10 to 20). Because firms can covertly or unambiguously collude in setting prices, the presence of the many firms isn’t sufficient for industry to approximate perfect competition. Conversely, the presence of only a couple of firms during a market doesn’t rule out competitive behavior. Suppose that only three firms are within the market but that market demand for the merchandise is extremely elastic. During this case, the demand curve facing each firm is probably going to be nearly horizontal and therefore the firms will behave as if they were operating in a perfectly competitive market. Albeit market demand isn’t very elastic, these three firms might compete very aggressively. The important point to recollect is that although firms may behave competitively in many situations, there’s no simple indicator to inform us when a market is very competitive. Often it’s necessary to research both the firms themselves and their strategic interactions.
Originally published at https://www.studentsofeconomics.com.
