Home > Micro concepts, Perfect Competition > What makes a market competitive?

What makes a market competitive?

The idea of perfect competition is like the Holy Grail in economics, many economic models start from the premise of perfect competition as a fundamental assumption, which is pretty unrealistic. But it is really important to understand perfect competition because it is the centrepiece of anything to do with markets in microeconomics.

A perfectly competitive market will have these four characteristics:

Sellers are price takers – each seller is sufficiently small in relation to the overall market that they can’t influence the market price by their own production decisions. Because of this no firm believes that it can influence the behaviour of other firms. This isn’t the case with other forms of market structure where there is some element of market power…and a firm with a large market share can influence the market price by varying the level of output it chooses to produce.

Buyers are price takers – each buyer is sufficiently small in relation to the overall market that they can’t influence the market price by the amount they consume.

Sellers do not engage in strategic behaviour – when a firm makes its own output decisions, it does not take into consideration the response of other firms (as it doesn’t expect them to change their behaviour as a result of their decisions).

Firms can enter and exit the market freely – there are no barriers to entry such as prohibitive start up costs or difficulties obtaining licences to produce.

In order for these four characteristics to be present, you will usually need to have:

A large number of sellers and buyers – so that the first two assumptions hold, no individual can influence the market price.

Highly substitutable goods – if one seller reduced the price, consumers would switch away from the other firms, because the good in question is easily substitutable from one firm to another. This will not happen if the firms can differentiate between their brands, ie a firm with market power may be able to get away with charging a higher price than a rival and still get sales, because consumers prefer that brand. But if they are producing something which is basically identical (eg ball bearings of standard size) then people will just buy from the firm that sells it cheapest. This characteristic pushes price down to the lowest possible level that firms can still cover their costs to produce the good.

Buyers must have full information – if a firm were to raise its price, consumers would know that rival firms sell it cheaper and could switch away to them. They have to have full information available about the alternatives.

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