Perfect Competition

1. Perfect Competition

Perfect competition is a market structure in which there are a large number of buyers and sellers of an identical product. Price and quantity decisions are influenced by the conditions assumed to be true about the market.

A market is said to be perfectly competitive if these four conditions are met:

• There are a large number of sellers and buyers of the product.
• All firms in a market sell identical products.
• Firms can freely enter and exit the market.
• All buyers and sellers have the same information about the products and pricing.

Perfect competition is on the far left of the continuum of market structures graphic below. Notice that in a perfectly competitive market, a firm faces the greatest competition and has no influence over pricing.

term to know

Perfect Competition

A market structure in which there are a large number of buyers and sellers of an identical product.

1a. Number of Buyers and Sellers

In a perfectly competitive market, there are a large number of buyers and sellers in the market. Each buyer and seller represents a tiny fraction of the total market quantity, such that no individual buyer nor firm exercises market power. Market concentration is low, which means that the market, rather than the firm, determines product price.

The firm’s pricing behavior is characterized as price-taking, given its horizontal demand curve. A perfectly competitive firm is known as a price taker, because market supply and demand will determine the market price–both buyers and sellers take the price offered by the market. Graphically, the market equilibrium price occurs where the supply and demand curves intersect. The firm sells more or less output without affecting the equilibrium price, therefore, the firm has a horizontal demand curve. An individual firm has many competitors selling identical products at the market-determined price. Raising prices above this equilibrium price, however, will cause sales revenue for the firm to plunge to zero. Each firm makes its own decisions about output independent of any other firm in the market.

IN CONTEXT
Tropicana Premium Fresh oranges are grown in the United States, Chile, South Africa, Spain, and Uruguay. Tropicana purchases oranges in bulk from orange growers. A single orange grower has no influence over the price even if the grower believes their oranges are sweeter than all other growers’ oranges. Tropicana has contracts with these orange farmers, and if any one farmer says they are not taking the going price, then Tropicana will simply switch its purchases to other growers. There are many orange sellers from which Tropicana can choose.

So, what does this mean? It means there is only one price for these oranges. Demand for oranges by Tropicana is perfectly elastic, which you learned about in Challenge 2.1 on elasticity, and in Challenge 2.5 on firm revenue. There is one horizontal demand curve at the equilibrium price in a perfectly competitive market. Growers are price takers. Selling a higher or lower volume has no effect on the going price.

term to know

Price Taker

The firm takes the market price determined by supply and demand for the entire market.

1b. Nature of Product

In a perfectly competitive market there are a large number of firms in the market selling identical products, which means that buyers do not distinguish between vendors and vendor products. An Idaho potato grown by one farmer is indistinguishable from any other vendor’s Idaho potato.

think about it

Can consumers really tell the difference between Pepsi and Coke? In a 2004 study, volunteers were asked to drink Coke and Pepsi, but did not know which beverage they were drinking. The test results showed that slightly over 50% of volunteers preferred Pepsi over Coke. Researchers then altered the test. The volunteers were told exactly which brand of cola they were going to drink. Suddenly 75% of volunteers preferred Coke over Pepsi. The soda market is certainly not producing identical products. The products are clearly differentiated. They are heterogeneous. While both are cola brands, each has a unique recipe, and their packaging and marketing is very different. The fact that people changed their opinions once they knew the brand they were sampling is evidence that the products are differentiated in the minds of consumers. If there is a way to differentiate products in a market, then the product is not identical.

1c. Entry and Exit

In a perfectly competitive market it is easy to enter and exit the market, because there are no barriers. A barrier is anything that makes it difficult to get in or get out of that industry. Barriers to entry are present in other market types, but not in perfect competition. A barrier to entry might be a legal, technological, or a market force that discourages or blocks potential competitors from entering a market. In any market with barriers, the barriers protect the profits of established firms.

hint

You will learn more about entry and exit in the next tutorial, after you learn about short-run profitability, which is relevant to entering the market, and short-run loss, which is relevant to exiting the market in the long run.

EXAMPLE

Occupational licenses are barriers to entry. Occupational licenses are state-issued credentials that a worker must possess to work in certain jobs as an athletic trainer, commercial fisherman, or barber. These affect about 25% of the U.S. labor force. A 2019 study conducted by CATO, a research institution, concluded that occupational licensing reduces labor supply by an average of between 17% and 27%. Restricting the number of persons entering an occupation helps keep wage rates higher for those already in the field.

term to know

Barrier to Entry

A legal, technological, or market force that discourages or blocks potential competitors from entering a market.

1d. Information

In a perfectly competitive market neither buyers nor sellers have a competitive information advantage. All parties in a transaction are in possession of the same information. This is characterized as symmetric information. Symmetric information is also referred to as perfect information. All buyers and all sellers are assumed to know everything needed to make the best choices, because they have the same information about the product and pricing. Markets with symmetric information allocate resources efficiently.

think about it

Have you gone shopping and made a purchase you regretted? After getting an item home, you probably said to yourself, "If I'd only realized how poorly this item was designed, I wouldn't have bought it!" If yes, then you purchased the item without having perfect information about it.

big idea

A perfectly competitive firm is one without market power, which is the ability of a firm to influence the market price.

term to know

Symmetric Information

All parties in a transaction are in possession of the same information.

2. Characteristics of the Perfect Competition Market Structure

In this lesson you learned about the characteristics of a perfect competition market structure. To recap, a market is said to be perfectly competitive if there are a large number of sellers and buyers of the product, there are no barriers to entry, all firms in a market sell identical products, and all buyers and sellers have perfect or symmetric information about the products and pricing. Firms operating in perfectly competitive markets have no market power and are price takers. The following table summarizes the characteristics of the perfect competition market structure.

summary

In this lesson, you learned in Perfect Competition that a perfectly competitive market is a market structure in which there are a large number of buyers and sellers of an identical product. You also learned that in a perfectly competitive market, price and quantity decisions are influenced by the assumed conditions of the market. In Number of Buyers and Sellers you learned that in a perfectly competitive market, because there are a large number of sellers and buyers of the product, the actions of no single buyer or seller can influence the product price. In Nature of Product you learned that in a perfectly competitive market all firms sell an identical product. In Entry and Exit you learned that firms can freely enter and exit a perfectly competitive market. In Information you learned that in a perfectly competitive market all buyers and sellers have the same information about the products and pricing. In Characteristics of the Perfect Competition Market Structure you reviewed an overview of the basic characteristics of the perfect competition market structure.

REFERENCES

Blair, P. Q., & Chung, B. W. (2019, May 1). How Much of a Barrier to Entry Is Occupational Licensing? Cato.org. Retrieved July 25, 2022, from www.cato.org/research-briefs-economic-policy/how-much-barrier-entry-occupational-licensing