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Perfect Competition and the Real World

24 April, 2015 - 15:35

The assumptions of identical products, a large number of buyers, easy entry and exit, and perfect information are strong assumptions. The notion that firms must sit back and let the market determine price seems to fly in the face of what we know about most real firms, which is that firms customarily do set prices. Yet this is the basis for the model of demand and supply, the power of which you have already seen.

When we use the model of demand and supply, we assume that market forces determine prices. In this model, buyers and sellers respond to the market price. They are price takers. The assumptions of the model of perfect competition underlie the assumption of price-taking behavior. Thus we are using the model of perfect competition whenever we apply the model of demand and supply.

We can understand most markets by applying the model of demand and supply. Even though those markets do not fulfill all the assumptions of the model of perfect competition, the model allows us to understand some key features of these markets.

Changes within your lifetime have made many markets more competitive. Falling costs of transportation, together with dramatic advances in telecommunications, have opened the possibility of entering markets to firms all over the world. A company in South Korea can compete in the market for steel in the United States. A furniture maker in New Mexico can compete in the market for furniture in Japan. A firm can enter the world market simply by creating a web page to advertise its products and to take orders.

In the remaining sections of this chapter, we will learn more about the response of firms to market prices. We will see how firms respond, in the short run and in the long run, to changes in demand and to changes in production costs. In short, we will be examining the forces that constitute the supply side of the model of demand and supply.

We will also see how competitive markets work to serve consumer interests and how competition acts to push economic profits down, sometimes eliminating them entirely. When we have finished we will have a better understanding of the market conditions facing farmers and of the conditions that prevail in any competitive industry.

KEY TAKEAWAYS

The central characteristic of the model of perfect competition is the fact that price is determined by the interaction of demand and supply; buyers and sellers are price takers. The model assumes: a large number of firms producing identical (homogeneous) goods or services, a large number of buyers and sellers, easy entry and exit in the industry, and complete information about prices in the market. The model of perfect competition underlies the model of demand and supply.

TRY IT!

Which of the following goods and services are likely produced in a perfectly competitive industry? Relate your answer to the assumptions of the model of perfect competition.

  1. International express mail service
  2. Corn
  3. Athletic shoes

Case in Point: Entering and Exiting the Burkha Industry

© 2010 Jupiterimages Corporation 

Muhammed Ibrahim Islamadin was driving a cab in Kabul, Afghanistan, when the Taliban took over the country.He foresaw the repression that would follow and sensed an opportunity.

He sold his taxicab and set up a shop for sewing and selling burkhas, the garments required of all women under the Taliban’s rule. Mr. Islamadin had an easy task selling, as women caught outdoors with exposed skin were routinely beaten by the Taliban’s religious police. He told The Wall Street Journal, “This was very bad for them, but it was good for me.”

Of course, Mr. Islamadin was not the only producer to get into the industry. Other Afghani merchants, as well as merchants from Pakistan and China, also jumped at the opportunity.

The entry of new firms exemplifies an important characteristic of perfect competition. Whenever there is anopportunity to earn economic profits—even an unexpected opportunity—new firms will enter, provided that entry is easy.

The model of perfect competition also assumes that exit will be easy if and when a firm experiences economic losses. When the Taliban rulers were ousted by the United States and its allies in 2001, Mr. Islamadin expected that the demand for burkhas would begin to fall. It did. The sales fell 50% almost immediately. Prices fell as well, generally by about 20%.

It was simple for Mr. Islamadin to leave the industry. He gave his remaining stock of burkhas to a brother whowas producing them in the countryside where women continued to wear them. As for Mr. Islamadin, he has made plans to go into the glassware business. He expects the demand for glass teacups to be strong whatever happens in Afghanistan’s critical future.

Source: Andrew Higgins, “With Islamic Dress, Out Goes the Guy Who Sold Burkhas,” The Wall Street Journal, December 19, 2001, p. A1.

ANSWERS TO TRY IT! PROBLEMS

Not perfectly competitive–There are few sellers in this market (Fedex, UPS, and the United States

Postal Services are the main ones in the United States) probably because of the difficulty of entry and exit. To provide these services requires many outlets and a large transportation fleet, for example. Perfectly competitive—There are many firms producing a largely homogeneous product and there is good information about prices. Entry and exit is also fairly easy as firms can switch among a variety of crops. Not perfectly competitive—The main reason is that goods are not identical.