Perfect Competition And Why It Matters

Posted 2023-02-06 13:41:15

Key points

A perfectly competitive firm is a price taker, which means that it must accept the equilibrium price at which it sells goods. If a perfectly competitive firm attempts to charge even a tiny amount more than the market price, it will be unable to make any sales.
Perfect competition occurs when there are many sellers, there is easy entry and exiting of firms, products are identical from one seller to another, and sellers are price takers.
The market structure is the conditions in an industry, such as number of sellers, how easy or difficult it is for a new firm to enter, and the type of products that are sold.

Perfect competition and why it matters

Firms are said to be in perfect competition when the following conditions occur:

Many firms produce identical products.
Many buyers are available to buy the product, and many sellers are available to sell the product.
Sellers and buyers have all relevant information to make rational decisions about the product being bought and sold.
Firms can enter and leave the market without any restrictions—in other words, there is free entry and exit into and out of the market.

A perfectly competitive firm is known as a price taker because the pressure of competing firms forces them to accept the prevailing equilibrium price in the market. If a firm in a perfectly competitive market raises the price of its product by so much as a penny, it will lose all of its sales to competitors. When a wheat grower wants to know what the going price of wheat is, they have to go to the computer or listen to the radio to check. The market price is determined solely by supply and demand in the entire market and not by the individual farmer. Also, a perfectly competitive firm must be a very small player in the overall market so that it can increase or decrease output without noticeably affecting the overall quantity supplied and price in the market.

A perfectly competitive market is a hypothetical extreme. Producers in a number of industries do, however, face many competitor firms selling highly similar goods, in which case they must often act as price takers. Agricultural markets are often used as an example.

The same crops grown by different farmers are largely interchangeable. According to the United States Department of Agriculture monthly reports, in 2015, US corn farmers received an average price of $6.00 per bushel and wheat farmers received an average price of $6.00 per bushel. A corn farmer who attempted to sell at $7.00 per bushel or a wheat grower who attempted to sell for $8.00 per bushel would not have found any buyers.

A perfectly competitive firm will not sell below the equilibrium price either. Why should they when they can sell all they want at the higher price? Other examples of agricultural markets that operate in close to perfectly competitive markets are small roadside produce markets and small organic farmers.

In this tutorial, we'll examine how profit-seeking firms decide how much to produce in perfectly competitive markets. Such firms analyze their costs. In the short run, the perfectly competitive firm will seek the quantity of output where profits are highest or—if profits are not possible—where losses are lowest. In this example, the short run refers to a situation in which firms are producing with one fixed input and incur fixed costs of production. In the real world, firms can have many fixed inputs.

In the long run, perfectly competitive firms will react to profits by increasing production. They will respond to losses by reducing production or exiting the market. Ultimately, a long-run equilibrium will be attained when no new firms want to enter the market and existing firms do not want to leave the market since economic profits have been driven down to zero.

Summary

A perfectly competitive firm is a price taker, which means that it must accept the equilibrium price at which it sells goods. If a perfectly competitive firm attempts to charge even a tiny amount more than the market price, it will be unable to make any sales.
Perfect competition occurs when there are many sellers, there is easy entry and exiting of firms, products are identical from one seller to another, and sellers are price takers.
The market structure is the conditions in an industry, such as number of sellers, how easy or difficult it is for a new firm to enter, and the type of products that are sold.

Self-check questions

Firms in a perfectly competitive market are said to be price takers—that is, once the market determines an equilibrium price for the product, firms must accept this price. If you sell a product in a perfectly competitive market, but you are not happy with its price, would you raise the price, even by a cent?

Would independent trucking fit the characteristics of a perfectly competitive industry?

Review questions

A single firm in a perfectly competitive market is relatively small compared to the rest of the market. What does this mean? How small is small?
What are the four basic assumptions of perfect competition? Explain what they imply for a perfectly competitive firm.
What is a price taker firm?

Critical-thinking questions

Finding a life partner is a complicated process that may take many years. It is hard to think of this process as being part of a very complex market with a demand and a supply for partners. Think about how this market works and some of its characteristics, such as search costs. Would you consider it a perfectly competitive market?
Can you name five examples of perfectly competitive markets? Why or why not?