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
- 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:
- 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?
- 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."
- Currency values are determined solely by market demand and supply
factors.
- 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.
- 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.
What are the limitations of currency trading as an example of a
competitive market?
- 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
- 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.
- 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.
- 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.
- 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
- If most firms are making abnormal profits in the short run,
this encourages the entry of new firms into the industry
- This will cause an outward shift in market supply forcing down the price
- 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.
- 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.
- 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
- 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:
- 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.
- Low barriers
to entry – the entry of new firms provides competition and ensures
prices are kept low in the long run.
- Lower total profits and profit margins than in markets
which dominated by a few firms.
- 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”.
- 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.
- 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
