perfect competition - introduction
Introduction
A perfectly competitive industry is highly unlikely to exist in its entirety given the strong assumptions made about the operation of the market.
All markets are “competitive” to one degree or another, but the vast majority of markets are characterised as “imperfectly competitive”. We do, though get closer to perfect competition in many markets for agricultural and other primary commodities. These are the only markets where there are enough sellers of products that are near perfect substitutes for each other.
Main Assumptions of Perfect Competition
• Each firm produces only a small percentage of total market output. It therefore exercises no control over the market price. For example it cannot restrict output in the hope of forcing up the existing market price. Market supply is the sum of the outputs of each of the firms in the industry
• No individual buyer has any control over the market price - there is no monopsony power. The market demand curve is the sum of each individual consumer’s demand curve – essentially buyers are in the background, exerting no influence at all on market price
• Buyers and sellers must regard the market price as beyond their control
• There is perfect freedom of entry and exit from the industry. Firms face no sunk costs that might impede movement in and out of the market. This important assumption ensures all firms make normal profits in the long run
• Firms in the market produce homogeneous products that are perfect substitutes for each other. This leads to each firms being price takers and facing a perfectly elastic demand curve for their product
• Perfect knowledge – consumers have perfect information about prices and products.
• There are no externalities which lie outside the market
Evaluation: The Realism of Perfect Competition as a Model
Many economists have questioned the validity of studying perfect competition. However the theory does yield important predictions about what might happen to price and output in the long run if competitive conditions hold good.
There are still markets that can be considered to be highly competitive and in which competition has strengthened in recent years. Good examples of competitive markets include:
• Home and car insurance
•
Internet service providers
•
Road haulage
Such markets are likely to exhibit the following features:
• Lower prices - because of the large number of competing firms. Suppliers face highly elastic demand curves and any rise in price will lead to a large fall in demand and total revenue. The cross-price elasticity of demand for one product with respect to a change in the relative price of another will be high
• Low barriers to entry – new firms will find it easy to enter markets if they feel there is abnormal (economic) profit to be made. The entry of new firms provides extra competition and ensures prices are kept low
• Lower profits than those in markets dominated by a few firms
• Economic efficiency – competition will ensure that firms attempt to minimise their costs and 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 needs of consumer. This is known as dynamic efficiency
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