Download Unit IV – Perfect Competition Overview

Unit IV – Perfect Competition
Competitive Theory and Market Structures – Perfect Competition, Monopolistic Competition,
Oligopolies, and Monopolies
Mr. Stewart’s AP Microeconomics
Spring Semester 2016
Credit: Nano-economics.com, Buzzle.com, and tutor2u.net
Online Tutorials:
Boundless.com – Chapter 9
Economicsonline.co.uk – Perfect Competition
Videos:
Mjmfoodie – Perfect Competiton
Khan Academy – Perfect Competition
Welkerswikinomics – Perfect Competition
Perfect Competition
Perfect Competition’ (also known as ‘pure competition’) in economics is an ideal form of an
industry where price competition is not only dominant but also the only form of competition
available or possible. The concept and terminology is quite popular and yet, is not completely
universal.
For any industry to have perfect competition, it should have the four characteristics that define the
structure of perfect competition.
1. Many buyers and sellers
2. A homogeneous product
3.
Free entry
4. Sufficient knowledge
Many buyers and sellers
In perfect competition, a number of businesses (goods or service
providers) compete with each other for gaining the attention of customers, but, there is no single
business that dominates the market to such an extent that it sets the standards in terms of pricing
of the concerned good or service. Markets fitting this condition usually have large number of
sellers catering to the needs of a sizable amount of consumer market and compete actively or
rigorously with each other for the business of the consumers.
Say, if I am a seller in such a
market, I am bound to think, ‘if I try to change the price of the product I sell to a price higher than
that of the market, then my customers will turn to my competitors for that product. Since my
share of the market is small and I do not control the market, my customers will buy what they
want from my competition and I will be left with no customers’. Due to this, the sellers and
buyers in the market are discouraged from even trying to control prices in the market and instead
encourages them to compete with each other, which in turn drives the price of the good or service
to the equilibrium of supply and demand.
A homogeneous product
‘Homogeneous product’ applies that all the suppliers sell goods or
services that are perfect substitutes of each other. The customers may be reluctant to switch if a
seller raised the price of the product in the scenario that there are different sellers that sell
different products. The customer will mostly stay with the same supplier even though the prices
are high because they like the good or service of their current firm better than that of another
entity or firm. The homogeneity of products encourages price competition by ruling this out.
Free entry
First and foremost a legal condition, free entry means that in ‘perfectly competitive’
markets there are no restrictions on the entry of a new business to compete with established
businesses. Hence a new company, if its feels that the investment is justified (due to high profits),
can set up is its business without any governmental restrictions.
Sufficient knowledge
A few structures of the ‘perfect competition’ model include an additional
factor known as ‘perfect knowledge’. However, we know that such a thing as ‘perfect knowledge’
does not exist. Hence, we cannot assume that the customer knows everything about the good or
service, whereas, it is important that the producer/seller and the consumer both know of the
options and opportunities available to them.
We discussed earlier about the ‘many sellers and
buyers’ and according to that characteristic a seller will know if some competitor is selling the
good or service cheap. If the consumer on the other hand does not know that there exists a seller
who is selling the good or service cheaper than what he/she is paying for, the current seller might
get away with even increasing the price, without loosing out many customers. This characteristic
assumption complements the others assumptions like the assumption that there are many buyers
and sellers and the assumption of free entry and translates into the buyers and sellers knowing of
the potential buyers and sellers that they can choose from. Sufficient knowledge simply assumes
that they know of those buyers and sellers.
There are however, some drawbacks related to perfect competition. Consumer, especially those
reluctant to try new things or brands, might feel intimidated by the sheer number of options
available to them. In such a case, the potential of doing business with each consumer is
diminished and this can ultimately limit the entry of new firms. Also, there is a lack of a single
company that is big enough to drive the market prices in such a marketplace. This also translates
to the absence of a single big entity to set the standards for other companies in terms of the goods
and services of that market. The other repercussion of this would be that there would be wide
differences in the quality of the product and even it’s pricing. This would mean that good or
services of higher quality will be offered along other products of inferior quality. The industry
watchdogs that focus on quality would find this as unhealthy.
Perfect Competition Examples
Perfect competition is a hypothetical concept of a market structure. This Buzzle article lists a few
examples of perfect competition in order to help you understand the concept better.
Perfect competition is a theoretical concept like the Euclidean line, which has no width and no
depth. Just as we've never seen that line there has never been truly free enterprise.
- Milton Friedman
Perfect competition, also termed pure competition is an ideal market scenario, where all
competitors sell identical products, each having a small share in the market. The market price is
not determined by the sellers, but purely rides on the merit of the product. Safe to say, then, that
perfect competition exists mostly in theory, with the exception of a few, isolated cases.
Understanding Perfect Competition
Perfect competition, as explained above, constitutes a market with infinite sellers and buyers. All
sellers bring homogeneous products to the market. Owing to the large number of sellers, the
prices of commodities remain more or less stable, and no single seller would be able to influence
a price hike. In other words, sellers are compelled to adhere to market rules.
The competition existing between the sellers in the perfectly competitive market is totally
impersonal, which is what makes it ideal. The supply of homogeneous product ensures that the
products are available for consumers whenever they wish to make a purchase. Illegal pricing
tactics and hoarding find no place in a purely competitive market.
Economists have every reason to believe that perfect competition is the best market structure to
protect the interests of the common consumers. Profit maximization remains the sole aim of the
sellers in a perfectly competitive market. Due to the existence of many sellers, the market share of
each seller automatically reduces in a perfectly competitive market, leaving them with ample
freedom to enter and exit from the market whenever they wish.
Examples of Perfect Competition
Having examined the definition of perfect competition, it can be understood that such markets do
not exist in the real world. However, we can certainly find a few approximations, which have
been listed below Agricultural markets are the closest representation of perfectly competitive markets. These are
marketplaces which have a large number of vendors selling fruit, vegetables, and poultry namely, identical produce. The prices of goods are competitive, and no single seller can yield an
influence over the pricing. Consumers are free to pick any seller, depending upon their choice.
Free software also functions along similar lines as agricultural marketplaces. In this case,
software developers are free to enter and exit the market according to their will. Pricing is also
determined by market conditions, rather than the sellers.
Street food vendors are also considered to be a part of a perfectly competitive market. Their
products are homogeneous in nature, and they are priced accordingly. Consumers are free to
make purchases at any vendor they prefer, and entry/exit barriers for sellers are virtually nonexistent.
What Makes Perfect Competition Unrealistic?
The biggest criticism for competitive markets remains the fact that it is extremely passive. It
allows no space for innovation or advertising, which are considered to be the pillars of any profitmaking enterprise. Product homogeneity is also viewed as an unfair condition which stunts the
growth of the trade, and has an adverse effect on human lifestyle in the long run.
In the real world, companies are constantly engaged in a battle, wanting to outdo their
competitors. They resort to innovation, price hikes, and advertising to achieve a stronghold in the
market. Some of these practices may benefit the consumers, whereas some may not.
Perfect competition is an unrealistic concept, which leaves out the very core of economic
development - improvement through innovation. It is an ideal which is impossible to attain in the
real world, and is also unnecessary, owing to its rigid parameters.
Read more at Buzzle: http://www.buzzle.com/articles/perfect-competition-examples.html
Perfect Competition - Economics of Competitive Markets
Author: Geoff Riley Last updated: Sunday 23 September, 2012
Perfect competition – a pure market
Perfect competition describes a market structure whose assumptions are strong and therefore
unlikely to exist in most real-world markets. Economists have become more interested in pure
competition partly because of the growth of e-commerce as a means of buying and selling goods
and services. And also because of the popularity of auctions as a device for allocating scarce
resources among competing ends.
Assumptions for a perfectly competitive market
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Many sellers each of whom produce a low percentage of market output and cannot
influence the prevailing market price.
Many individual buyers, none has any control over the market price
Perfect freedom of entry and exit from the industry. Firms face no sunk costs and entry
and exit from the market is feasible in the long run. This assumption means that all
firms in a perfectly competitive market make normal profits in the long run.
Homogeneous products are supplied to the markets that are perfect substitutes. This leads
to each firms being “price takers” with a perfectly elastic demand curve for their
product.
Perfect knowledge – consumers have all readily available information about prices and
products from competing suppliers and can access this at zero cost – in other words,
there are few transactions costs involved in searching for the required information
about prices. Likewise sellers have perfect knowledge about their competitors.
Perfectly mobile factors of production – land, labour and capital can be switched in
response to changing market conditions, prices and incentives.
No externalities arising from production and/or consumption.
Evaluation – Understanding the real world of imperfect competition!
It is often said that perfect competition is a market structure that belongs to out-dated textbooks
and is not worthy of study! Clearly the assumptions of pure competition do not hold in the vast
majority of real-world markets, for example, some suppliers may exert control over the amount of
goods and services supplied and exploit their monopoly power.
On the demand-side, some consumers may have monopsony power against their suppliers
because they purchase a high percentage of total demand. Think for example about the buying
power wielded by the major supermarkets when it comes to sourcing food and drink from food
processing businesses and farmers. The Competition Commission has recently been involved in
lengthy and detailed investigations into the market power of the major supermarkets.
In addition, there are nearly always some barriers to the contestability of a market and far from
being homogeneous; most markets are full of heterogeneous products due to product
differentiation – in other words, products are made different to attract separate groups of
consumers.
Consumers have imperfect information and their preferences and choices can be influenced by
the effects of persuasive marketing and advertising. In every industry we can find examples of
asymmetric information where the seller knows more about quality of good than buyer – a
frequently quoted example is the market for second-hand cars! The real world is one in which
negative and positive externalities from both production and consumption are numerous – both of
which can lead to a divergence between private and social costs and benefits. Finally there may
be imperfect competition in related markets such as the market for key raw materials, labour and
capital goods.
Adding all of these points together, it seems that we can come close to a world of perfect
competition but in practice there are nearly always barriers to pure competition. That said there
are examples of markets which are highly competitive and which display many, if not all, of the
requirements needed for perfect competition. In the example below we look at the global market
for currencies.
Currency markets - taking us closer to perfect competition
The global foreign exchange market is where all buying and selling of world currencies takes
place. There is 24-hour trading, 5 days a week. Trading volume in the Forex market is around $3
trillion per day – equivalent to the annual GDP of France! 31% of global trading takes place in
London alone. Most trading in currencies is ‘speculative.’
The main players in the currency markets are as follows:
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Banks both as “market makers” dealing in currencies and also as end-users demanding
currency for their own operations.
Hedge funds and other institutions (e.g. funds invested by asset managers, pension
funds).
Central Banks (including occasional currency intervention in the market when they buy
and sell to manipulate an exchange rate in a particular direction).
Corporations (for example airlines and energy companies who may use the currency
market for defensive ‘hedging’ of exposures to risk such as volatile oil and gas prices.)
Private investors and people remitting money earned overseas to their country of origin /
market speculators trading in currencies for their own gain / tourists going on holiday
and people traveling around the world on business.
Why does a currency market come close to perfect competition?
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Homogenous output: The "goods" traded in the foreign exchange markets are
homogenous - a US dollar is a dollar and a euro is a euro whether someone is trading it
in London, New York or Tokyo.
•
Many buyers and sellers meet openly to determine prices: There are large numbers of
buyers and sellers - each of the major banks has a foreign exchange trading floor which
helps to "make the market". Indeed there are so many sellers operating around the
world that the currency exchanges are open for business twenty-four hours a day. No
one agent in the currency market can, on their own influence price on a persistent basis
- all are ‘price takers’. According to Forex_Broker.net "The intensity and quantity of
buyers and sellers ready for deals doesn't allow separate big participants to move the
market in joint effort in their own interests on a long-term basis."
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Currency values are determined solely by market demand and supply factors.
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High quality real-time information and low transactions costs: Most buyers or sellers are
well informed with access to real-time market information and background research
analysis on the factors driving the prices of each individual currency. Technological
progress has made more information immediately available at a fraction of the cost of
just a few years ago. This is not to say that information is cheap - an annual
subscription to a Bloomberg or a Reuter’s news terminal will cost several thousand
dollars. But the market is rich with information and transactions costs for each batch of
currency bought and sold has come down.
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Seeking the best price: The buyers and sellers in foreign exchange only deal with those
who offer the best prices. Technology allows them to find the best price quickly.
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What are the limitations of currency trading as an example of a competitive market?
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Firstly the market can be influenced by official intervention via buying and selling of
currencies by governments or central banks operating on their behalf. There is a huge
debate about the actual impact of intervention by policy-makers in the currency
markets.
Secondly there are high fixed costs involved in a bank or other financial institution when
establishing a new trading platform for currencies. They need the capital equipment to
trade effectively; the skilled labour to employ as currency traders and researchers.
Some of these costs may be counted as sunk costs – hard to recover if a decision is
made to leave the market.
Despite these limitations, the foreign currency markets take us reasonably close to a world of
perfect competition. Much the same can be said for trading in the equities and bond markets and
also the ever expanding range of future markets for financial investments and internationally
traded commodities. Other examples of competitive markets can be found on a local scale – for
example a local farmers’ market where there might be a number of farmers offering their produce
for sale.
The internet and perfect competition
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Advances in web technology have made markets more competitive. It has reduced
barriers to entry for firms wanting to compete with well-established businesses – for
example specialist toy retailers are better able to battle for market share with the
dominant retailers such as ToysRUs and Wal-Mart.
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One of the most important aspects of the internet is the ability of consumers to find
information about prices for many goods and services. There are an enormous number
of price comparison sites in the UK covering everything from digital cameras to
package holidays, car insurance to CDs and jewellery.
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That said the price comparison web sites themselves have come under criticism. For
example the sites offering to compare hundreds of different motor insurance policies or
mortgage products draw information from the insurance and mortgage brokers but
might use limiting assumptions about the different types of consumers looking for the
best price – the result is a range of prices facing the consumer that don’t accurately
reflect their precise needs – and consumers may only realise this when, for example,
they make a claim on an insurance policy bought over the internet which turns out not
to provide the specific cover they needed.
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And in the market for price comparison sites there is monopoly power too!
Moneysupermarket.com currently has around 40% of the overall comparison site
market, with Confused.com its nearest rival with a share of about 10%.
Price and output in the short run under perfect competition
• In the short run, the interaction between demand and supply determines the “market-clearing”
price. A price P1 is established and output Q1 is produced. This price is taken by each
firm. The average revenue curve is their individual demand curve.
• Since the market price is constant for each unit sold, the AR curve also becomes the marginal
revenue curve (MR) for a firm in perfect competition.
• For the firm, the profit maximising output is at Q2 where MC=MR. This output generates a
total revenue (P1 x Q2). Since total revenue exceeds total cost, the firm in our example is
making abnormal (economic) profits.
• This is not necessarily the case for all firms in the industry since it depends on the position of
their short run cost curves. Some firms may be experiencing sub-normal profits if average
costs exceed the price – and total costs will be greater than total revenue.
The adjustment to the long-run equilibrium in perfect competition
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If most firms are making abnormal profits in the short run, this encourages the entry of
new firms into the industry
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This will cause an outward shift in market supply forcing down the price
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The increase in supply will eventually reduce the price until price = long run average
cost. At this point, each firm in the industry is making normal profit.
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Other things remaining the same, there is no further incentive for movement of firms in
and out of the industry and a long-run equilibrium has been established. This is shown
in the next diagram.
We are assuming in the diagram above that there has been no shift in market demand.
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The effect of increased supply is to force down the price and cause an expansion along
the market demand curve.
But for each supplier, the price they “take” is now lower and it is this that drives down
the level of profit made towards normal profit equilibrium.
In an exam question you may be asked to trace and analyse what might happen if
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There was a change in market demand (e.g. arising from changes in the relative prices of
substitute products or complements.)
There was a cost-reducing innovation affecting all firms in the market or an external
shock that increases the variable costs of all producers.
Adam Smith on Competition
“The natural price or the price of free competition ... is the lowest
which can be taken. [It] is the lowest which the sellers can commonly afford to take, and at the
same time continue their business.”
Source: Adam Smith, the Wealth of Nations (1776), Book I,
Chapter VII
Characteristics of competitive markets
The common characteristics of markets that are considered to be “competitive” are:
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Lower prices because of many competing firms. The cross-price elasticity of demand for
one product will be high suggesting that consumers are prepared to switch their
demand to the most competitively priced products in the marketplace.
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Low barriers to entry – the entry of new firms provides competition and ensures prices
are kept low in the long run.
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Lower total profits and profit margins than in markets which dominated by a few firms.
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Greater entrepreneurial activity – the Austrian school of economics argues that
competition is a process. For competition to be improved and sustained there needs to
be a genuine desire on behalf of entrepreneurs to innovate and to invent to drive
markets forward and create what Joseph Schumpeter called the “gales of creative
destruction”.
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Economic efficiency – competition will ensure that firms move towards productive
efficiency. The threat of competition should lead to a faster rate of technological
diffusion, as firms have to be responsive to the changing needs of consumers. This is
known as dynamic efficiency.
The importance of non-price competition
In competitive markets, non-price competition can be crucial in winning sales and protecting or
enhancing market share.
Perfect competition and efficiency
Perfect competition can be used as a yardstick to compare with other market structures because it
displays high levels of economic efficiency.
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2.
3.
Allocative efficiency: In both the short and long run we find that price is equal to
marginal cost (P=MC) and thus allocative efficiency is achieved. At the ruling price,
consumer and producer surplus are maximised. No one can be made better off without
making some other agent at least as worse off – i.e. we achieve a Pareto optimum
allocation of resources.
Productive efficiency: Productive efficiency occurs when the equilibrium output is
supplied at minimum average cost. This is attained in the long run for a competitive
market. Firms with high unit costs may not be able to justify remaining in the industry
as the market price is driven down by the forces of competition.
Dynamic efficiency: We assume that a perfectly competitive market produces
homogeneous products – in other words, there is little scope for innovation designed
purely to make products differentiated from each other and allow a supplier to develop
and then exploit a competitive advantage in the market to establish some monopoly
power.
Some economists claim that perfect competition is not a good market structure for high levels of
research and development spending and the resulting product and process innovations. Indeed it
may be the case that monopolistic or oligopolistic markets are more effective long term in
creating the environment for research and innovation to flourish. A cost-reducing innovation from
one producer will, under the assumption of perfect information, be immediately and without cost
transferred to all of the other suppliers.
That said a contestable market provides the discipline on firms to keep their costs under control,
to seek to minimise wastage of scarce resources and to refrain from exploiting the consumer by
setting high prices and enjoying high profit margins. In this sense, competition can stimulate
improvements in both static and dynamic efficiency over time.
The long run of perfect competition, therefore, exhibits optimal levels of economic efficiency.
But for this to be achieved all of the conditions of perfect competition must hold – including in
related markets. When the assumptions are dropped, we move into a world of imperfect
competition with all of the potential that exists for various forms of market failure