Download Perfect Competition The Basic Assumptions of Competitive Markets

Perfect Competition
The Basic Assumptions of Competitive Markets
Understanding the Role of Price
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We’ve been talking about a firm’s total revenue, that is, the price it charges for its product multiplied
by the quantity of its product it sells in a given period. But what determines the price a firm can
charge for its product? That turns out to depend on whether or not the firm has market power.
Market power simply means the ability to influence the price of your product. Said another way, a
firm has market power if it can raise the price of its product without losing all of its customers to a
competitor. Or a firm has market power if it can lower the price of its product without attracting the
entire market. Market power means the ability to set the price of your product. Now, what
determines whether or not a firm has market power? And that turns out to depend on how large the
firm is relative to the pool of customers.
Let’s look at an extreme case, an abstraction that economists call perfect competition. We say that
an industry is perfectly competitive if it’s made up of a large number of small firms each selling an
identical product. Let’s break that definition down. First of all, a large number of small firms. What
that means is that the output of any given firm is small relative to the market demand, so that the
market wants to buy a whole lot more than any one firm could produce. In order to serve the entire
market, in that case, you’re going to need a whole lot of firms and that means a lot of competition.
No one can afford to charge a price that’s too high when all of these competitors are ready to step in
and meet the market’s demand at a lower price. What does it matter that they’re all producing an
identical product? It matters because when customers care about the color or the shape or the
particular texture of a product, when customers care about the subtle differences between the
offerings of different firms they may be willing to pay a slightly higher price for a product that looks
better or smells better. But when you’re competing with a whole lot of firms and you’re all making
an identical product, competition is very intense, and it is unlikely that you could achieve any
market power. You’re going to have to price your product right in with the competition.
Now, there’s one additional assumption we make when we call a market perfectly competitive, and
that is that there are no barriers to entry. That is, that any firm can enter and exit whenever it
likes. We’re going to talk about that in subsequent lectures, but for now let’s focus on the first two
assumptions, a large number of firms small relative to the market and each firm producing the same
identical product. What happens in that case is that supply and demand in the market will interact
to determine the equilibrium price for the product and each firm in that market takes that
equilibrium price as given. That is, there’s nothing they can do. If they raise their price relative to
the competition they’ll loss all their customers. If they lower their price they’ll attract the whole
market at once and they can’t serve the whole market because they’re small relative to the market.
Why charge a lower price when you can sell all that you can produce at a higher price?
Here’s how it looks in a diagram. Demand in this market and supply intersect to determine the
equilibrium price and quantity. If we take this picture of market supply and demand and we project
it over into an adjacent diagram that has the output of a single firm on the axis and the price that
that firm can charge on the vertical axis, we’ll get a picture that looks like this. That is, at the going
market price of P*, the going equilibrium price, this firm can sell as much output as it wants. That is
the individual demand curve then of our firm. The individual demand curve says that at this price P*
our firm is able to sell as much output as it wants. This is the nature of perfect competition: a large
number of small firms, each producing an identical product, and each firm facing an individual
demand curve that is horizontal at the market equilibrium price.