In Chapter 2, we used supply–demand analysis to explain how chang- ing market conditions affect the market price of such products as wheat and gasoline. We saw that the equilibrium price and quantity of each product was determined by the intersection of the market demand and market supply curves. Underlying this analysis is the model of a perfectly competitive market. The model of perfect competition is very useful for studying a variety of markets, including agriculture, fuels and other commodities, housing, services, and financial markets. Because this model is so important, we will spend some time laying out the basic assumptions that underlie it.
The model of perfect competition rests on three basic assumptions: (1) price taking, (2) product homogeneity, and (3) free entry and exit. You have encoun- tered these assumptions earlier in the book; here we summarize and elaborate on them.
PRICE TAKING Because many firms compete in the market, each firm faces a significant number of direct competitors for its products. Because each individual firm sells a sufficiently small proportion of total market output, its decisions have no impact on market price. Thus, each firm takes the market price as given. In short, firms in perfectly competitive markets are price takers.
Suppose, for example, that you are the owner of a small electric lightbulb dis- tribution business. You buy your lightbulbs from the manufacturer and resell them at wholesale to small businesses and retail outlets. Unfortunately, you are only one of many competing distributors. As a result, you find that there is little room to negotiate with your customers. If you do not offer a competitive price—one that is determined in the marketplace—your customers will take their business elsewhere. In addition, you know that the number of lightbulbs that you sell will have little or no effect on the wholesale price of bulbs. You are a price taker.
The assumption of price taking applies to consumers as well as firms. In a per- fectly competitive market, each consumer buys such a small proportion of total industry output that he or she has no impact on the market price, and therefore takes the price as given.
Another way of stating the price-taking assumption is that there are many independent firms and independent consumers in the market, all of whom believe—correctly—that their decisions will not affect prices.
PRODUCT HOMOGENEITY Price-taking behavior typically occurs in markets where firms produce identical, or nearly identical, products. When the products of all of the firms in a market are perfectly substitutable with one another—that is, when they are homogeneous—no firm can raise the price of its product above the price of other firms without losing most or all of its business. Most agricultural products are homogeneous: Because product quality is relatively similar among farms in a given region, for example, buyers of corn do not ask which individual farm grew the product. Oil, gasoline, and raw materials such as copper, iron, lumber, cotton, and sheet steel are also fairly homogeneous. Economists refer to such homogeneous products as commodities.
In contrast, when products are heterogeneous, each firm has the opportu- nity to raise its price above that of its competitors without losing all of its sales. Premium ice creams such as Häagen-Dazs, for example, can be sold at higher prices because Häagen-Dazs has different ingredients and is perceived by many consumers to be a higher-quality product.
The assumption of product homogeneity is important because it ensures that there is a single market price, consistent with supply–demand analysis.
FREE ENTRY AND EXIT This third assumption, free entry (or exit), means that there are no special costs that make it difficult for a new firm either to enter an industry and produce, or to exit if it cannot make a profit. As a result, buyers can easily switch from one supplier to another, and suppliers can easily enter or exit a market.
The special costs that could restrict entry are costs which an entrant to a mar- ket would have to bear, but which a firm that is already producing would not. The pharmaceutical industry, for example, is not perfectly competitive because Merck, Pfizer, and other firms hold patents that give them unique rights to pro- duce drugs. Any new entrant would either have to invest in research and devel- opment to obtain its own competing drugs or pay substantial license fees to one or more firms already in the market. R&D expenditures or license fees could limit a firm’s ability to enter the market. Likewise, the aircraft industry is not perfectly competitive because entry requires an immense investment in plant and equipment that has little or no resale value.
The assumption of free entry and exit is important for competition to be effective. It means that consumers can easily switch to a rival firm if a current supplier raises its price. For businesses, it means that a firm can freely enter an industry if it sees a profit opportunity and exit if it is losing money. Thus a firm can hire labor and purchase capital and raw materials as needed, and it can release or move these factors of production if it wants to shut down or relocate.
If these three assumptions of perfect competition hold, market demand and supply curves can be used to analyze the behavior of market prices. In most markets, of course, these assumptions are unlikely to hold exactly. This does not mean, however, that the model of perfect competition is not useful. Some mar- kets do indeed come close to satisfying our assumptions. But even when one or more of these three assumptions fails to hold, so that a market is not perfectly competitive, much can be learned by making comparisons with the perfectly competitive ideal.
When Is a Market Highly Competitive?
Apart from agriculture, few real-world markets are perfectly competitive in the sense that each firm faces a perfectly horizontal demand curve for a homoge- neous 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 relatively easy entry and exit.
A simple rule of thumb to describe whether a market is close to being per- fectly competitive would be appealing. Unfortunately, we have no such rule, and it is important to understand why. Consider the most obvious candidate: an industry with many firms (say, at least 10 to 20). Because firms can implic- itly or explicitly collude in setting prices, the presence of many firms is not sufficient for an industry to approximate perfect competition. Conversely, the presence of only a few firms in a market does not rule out competitive behav- ior. Suppose that only three firms are in the market but that market demand for the product is very elastic. In this case, the demand curve facing each firm is likely to be nearly horizontal and the firms will behave as if they were oper- ating in a perfectly competitive market. Even if market demand is not very elastic, these three firms might compete very aggressively (as we will see in Chapter 13). The important point to remember is that although firms may behave competitively in many situations, there is no simple indicator to tell us when a market is highly competitive. Often it is necessary to analyze both the firms themselves and their strategic interactions, as we do in Chapters 12 and 13.
Source: Pindyck Robert, Rubinfeld Daniel (2012), Microeconomics, Pearson, 8th edition.