Market Structure Types: Perfect Competition
Don't Say I Never Told You ...
The first thing I want to tell you about Perfect Competition as a market structure is that it is virtually never seen in the real world. This is very important to understand.
Unfortunately, this fact is often misused as a criticism of the field of Economics in general -- as if we're out of touch with reality or trying to mislead the public with deceptive constructs.
Nothing could be further from the truth. All students of Economics are taught in their first weeks of classes that the market type we call Perfect Competition is rarely, if ever, observed in the real world. And when it is, it is often unstable and fleeting -- an idyllic occurrence that is often too-soon spoiled by anti-competitive machinations (sometimes necessary and well-intended).
Why Study Something That Is So Ephemeral?
Studying Perfect Competition allows us to establish attributes and conditions that make markets more competitive (and efficient).
Also, as we discuss Perfect Competition here, we'll see why this type of market is so fleeting on those rare occasions when it can be found in the real world (Hint: Certain parties actively seek to destroy perfectly competitive markets -- usually by perfectly legal and moral means. I'll discuss how and why they do this below.)
This understanding is imminently useful for consumers, especially.
Wait, Don't You Mean Commodity Market?
So what is Perfect Competition, Anyway?
Because perfectly competitive markets are so rare and fleeting, it will be difficult to give examples. The best we can hope for are approximations and examples of individual attributes of this type of market.
In contemporary classrooms, an example that is often held as the closest to a real-world example of a perfectly competitive market is the market for strawberries in North America.
A perfectly competitive market is one with the following defining features:
- Many sellers who are price-takers: In a perfectly competitive market structure, there are many sellers and no individual seller or cartel has the power (monopoly power) to affect the prevailing market price.
Technically speaking, the perfectly competitive market will not support any price higher than the marginal costs of production -- the cost of producing that last unit the seller is willing to produce. In other words, no seller has market power or monopoly power. (Let's get used to this terminology because we will use this term in all our discussions of market types. Monopoly power isn't reserved for monopolies or monopsonies.) - Perfect Information: All participants (buyers and sellers) have perfect information. Costs of production are known by all parties (this includes costs of transport, carrying costs, etc). Costs of ownership and the utility of the product are also known by all parties (including maintenance, insurance, licensing, and other costs).
- No product differentiation: All sellers sell an identical or indistinguishable product. The wheat or milk sold by one producer is identical to that of every other producer. In contrast, think of the product differentiation in the wine industry or the market for jeans.
- No barriers to market entry or exit: Producers may enter the market with no entry costs -- no prohibitive up-front investment requirements, no licensing fees, inspections, certifications, or mandatory insurance are required. Think about growing squash or starting out as a street performer. As a counter-example, imagine breaking into the air transport market or starting out as a doctor.
- Labor and Capital are perfectly mobile: Workers can move from one producer to another without cost or restriction within this market -- there are no non-compete clauses in labor contracts, no blacklists, or labor unions (for better or worse, labor unions frequently restrict the entry of labor into markets).
- No government subsidies, tariffs, or special taxes on the product or service being sold. This criteria immediately invalidates many farm products in the US as being sold in "perfectly competitive" markets. If not for government subsidies, the markets for milk, wheat, and many other agricultural products would be examples of perfect competition. As it is, these products are traded in markets that would be categorized as "Imperfect Competition".
Given these defining features, perhaps we can already see why it is so rare to actually find an example of a perfectly competitive market in the real world. But it remains valuable to understand as something that could exists if only certain conditions could be arranged, perhaps by changes to public policy.
As a result of the defining attributes mentioned above, a perfectly competitive market has these identifying attributes:
- No advertising or marketing by producers: Sellers do not advertise. There is no branding. The buyer may very well not know the name of the producers of the product they are buying. Indeed, a single unit of product may come from multiple, unnamed producers. The distributor or middleman may be identifiable, but the individual manufacturer often is not identified.
Products like milk, flour (wheat), and strawberries are examples of this attribute. Although milk and flour (wheat) producers receive government subsidies which immediately invalidates them as examples of a perfectly competitive market product.
I'd like to point out here one very interesting phenomenon that signals a nearly perfectly competitive market: When producers band together to advertise as an industry without creating product differentiation between themselves. An example of this is the famous Got Milk? campaign, which began in the 1990s. This type of advertising is most typically seen in some imperfectly competitive markets, indicating that it is a signal of a nearly perfectly competitive market. (Again, we cannot consider dairy to be a perfectly competitive market in the US because of subsidies. But we can see that this is an example of imperfect competition.)
We probably won't see Levi's, Lee, and Gap pooling their marketing funds any time soon to induce consumers to buy more jeans. No, the market for jeans is an example of monopolistic competition -- where producers actually influence the price by vehemently promoting product differentiation. - No discounts (temporary or conditional): In a perfectly competitive market, we won't see any offers like "50% of this week only" or "Senior Citizen Discount". No coupons, rebates or others discounts.
You probably have never seen a "Veteran's Discount" for potatoes or flour, right? Or a manufacturer's rebate on celery, have you? - Little or no Profits: This is the root cause of the attributes mentioned above. Because of perfect information, buyers are able to know the costs of production. This puts tremendous downward pressure on prices. Firms that cannot bring their average total costs below the market price would rationally choose to stop doing business (losing money) in that market. Because producers cannot push the market price higher than the marginal cost of production, they can have little or no profit margin.
This doesn't mean they don't make money producing the item in question. It only means that the the seller's revenues only cover costs of production (including labor, transport, storage, etc). So the person growing the carrots enjoys payment for their labor -- a payment that is sufficient to induce them to continue growing carrots. (In technical terms, we would say, "a payment that exceeds the opportunity cost of them growing carrots.")
The revenues from the sale of the carrots also include enough to induce a trucker to continue transporting the product to market (perhaps this is also the grower), and perhaps a distributor who packages products from many producers.
But the revenues of the sales do not cover marketing costs (branding, advertising, etc).
Nor is there any opportunity for the seller to offer a discount ("sale" or coupon). If they offered a discount, they would end up selling below their marginal cost and would lose money. Note: This is a stunt used by large sellers who can operate at a loss temporarily to push other smaller sellers out of the market and thereby convert a competitive market into another type of market where they could make a profit.
Later we'll talk about coupons and discounts as signals of a market type called "monopolistic competition".
Winners and Losers?
Who benefits from a perfectly competitive market? And who loses?
In the short run, the buyer benefits from a perfectly competitive market and the seller is almost completely deprived of the opportunity to earn any profit. There is still room for sellers to make money, but they are unable to muster the monopoly power to push the price above their marginal cost and create a profit margin.
In the medium run or the long run, though, this buyer advantage becomes murky. If producers cannot make any profits -- if they cannot push the price above their marginal cost of producing that last unit of product -- how can they invest in research and development. How can producers in a perfectly competitive market ever produce a new and better product?
Do buyers (or consumers) always benefit from perfectly competitive markets in the long run? Probably not always. But in many cases, they may.
Thought Lab: Let's go back to strawberries -- our closest example to a perfectly competitive market -- to study whether a perfectly competitive market quashes innovation -and- how a producer might shift their product to a less competitive market to make higher profits:
Let's say a farmer who has 10 acres of strawberry fields and makes (gross) $8,000 per acre per year ($80,000 on her 10 acres). Then she decides to set aside 3 acres for future production of "organic" strawberries because her reading indicates that she can make $10,000 / acre on that land with almost no increase to her costs of production. She simply stops using certain chemicals on her 3-acre "organic plot" and continues production on the entire 10 acres. The organic plot requires a little bit more labor, but she and her family are able to find the extra time.
Three years later, with only an investment of extra labor, she is legally allowed to label the strawberries from her organic plot as "Organic Strawberries" and just like that, part of her harvest is now differentiated from other strawberries and can be sold in an imperfectly competitive market.
She ends up with a yield of $10,500 / acre for that portion of her harvest. Because there was almost no increase to her costs for those three acres, our farmer, June, is able to pocket $2,000 per acre, which she astutely invests in a marketing and branding campaign.
The following year she sells those strawberries under the label "June's Organic Strawberries", again shifting her product to a less competitive market type -- monopolistic competition. This allows her even more profit margin.
Even though she was not making any profits, she was able to create an improved product and shift a portion of her product to increasingly less-competitive market types where she could make profits.
Why Is This Type of Market Inherently Unstable and Fleeting?
Once a seller is able to gain a foothold by transforming a perfectly competitive market into an imperfectly competitive one, they are able to make profits that they may use to further gain monopoly power, which is in the interest of all sellers -- to legally acquire monopoly power. (Remember, the term "monopoly power" refers to the ability to influence the price of a product. This is not exclusive to monopolies. Technically speaking, any producer that can influence the price of their product -- even by saying "Our product is better!" -- is exercising monopoly power to some degree.)
Creating Product Differentiation: One common way in which sellers transform the market for their product is to introduce some perceived product differentiation. This differentiation may be real or imaginary. Any product differentiation transforms a perfectly competitive market into an imperfectly competitive one or some other, less-competitive market type.
Labels like "hormone free", "organic", "vegan", "USDA Prime" are examples of product differentiation that would shift a product from a perfectly competitive market squarely into an imperfectly competitive market. (Again, we're not judging the legitimacy of these labels. But we are pointing out that sellers can and do use these labels to transform the market that their product trades in to a less competitive market type.)
An even simpler way to establish product differentiation is to combine two products that are traded in nearly perfectly competitive markets into a single product, say, pancake mix. Mix flour and sugar (and a couple other ingredients) and you can now sell your flour and sugar in an imperfectly competitive market and make some profits.
Next, slap a name on the label (say, "Aunt Jemima") and just like that, you're selling your flour and sugar in a monopolistically competitive market, making much higher profits.
Erecting Barriers to Entry: Another way to transform a market away from a model of perfect competition is by erecting barriers to entry. By convincing the public that licensing should be required to sell a product or service (think doctoring or lawyering ... even haircutting).
Creating a barrier to market entry is a common way in which a perfectly competitive market is transformed into a less-competitive market type.
Trade barriers are a special case of this. Trade barriers create a barrier only for foreign producers to enter a market within a home country. This puts upward pressure on prices which may or may not spill over to other markets.
Seeking Subsidies: Farmers in the developed world have successfully lobbied for government subsidies. Since 1933, US farmers have received government subsidies on a broad range of agricultural products. The same practice was introduced in many countries in the developed world.
In the absence of subsidies and tariffs, many of these products would trade in something approaching a perfectly competitive market. But subsidies and tariffs immediately invalidate these as perfectly competitive markets and transform these to imperfectly competitive markets.
Summary and Conclusions
Perfect Competition is a market type which is rarely encountered in the real world, but is very useful to study.
In the short run, buyers have a strong advantage and sellers have little or no opportunity to make economic profits in perfectly competitive markets.
In longer time frames, in some cases, overly competitive markets may do a disservice to buyers by quashing innovation and progress. But this is probably not true in all cases.
It is relatively easy and strongly desirable for sellers to disrupt a perfectly competitive market. (Desirable for sellers, not for buyers.) This can be done simply by combining two competitive products into one product or by placing a producer's name on the package -- even a fictional name like "Uncle Ben's Rice" or "Aunt Jemima's Pancake Mix".
Sources
EconLib.com, "Perfect Competition"
Wikipedia.org, "Perfect competition"
Khan Academy, "Economic profit for firms perfectly competitive markets"
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