Perfect Competition

When you hear the word competition what do you think of?

Sports?

Games?

Reality TV?

Rivalries?

Do markets, businesses and sellers come to mind?

Today, we’re going to talk about this market structure continuum, ranging from perfect competition, monopolistic competition, oligopoly, all the way to monopoly. But in this video, I’m going to focus on perfectly competitive markets.

Just like athletes in sports, most businesses in a market compete for your money and attention. But what that competition looks like - how many businesses and what they’re competing about - varies greatly by industry. In fact, looking at industries and markets by how much competition they face is a useful way to learn more about the economy. For example, let’s take a look at a market that faces a lot competition: the wheat market. In fact, this industry faces so much competition that economists call it perfect competition.

An industry is perfectly competitive if it has the following characteristics:

First, there are lots of sellers and lots of buyers in the market. And each seller represents a small share of the overall market. Second, all the sellers in the market are selling roughly the same good or service. And third, it’s easy for new sellers to enter and for existing sellers to leave the market.

While it’s hard to find a truly competitive market, economists usually count products like oil, rice, or whole grain as perfectly competitive. Of course, there are businesses and markets that face imperfect competition or even no competition, but we’ll address those in a different video.

In a perfectly competitive market, where there are lots of sellers and identical items for sale, the only thing a buyer will care about is the price. Think about it: If every seller is selling the exact same thing, and you’re a buyer, you’re just going to buy from the lowest seller. So as a seller in a perfectly competitive market, you don’t have much power in that market. And by power, we mean you pretty much have to take the market price as the price you charge.

Let’s look at a graph to see what this means.

This graph represents the market for wheat. The Y axis is price and X axis is quantity. This is the supply and demand for the entire market. At the intersection of the supply and demand curve, we can see that the market price, or equilibrium price, is seven dollars, so that’s the price you would charge for your wheat. And if we take a closer look, we can see this supply curve is made up of countless sellers. So what does the demand curve look like for just your wheat? Maybe surprisingly, it’s flat!

Remember, the market price is seven dollars, and so that’s your price for any amount of wheat you sell. If you tried to charge a penny more, how much would you be able to sell? Nothing. A buyer would buy from someone who is selling at the lower market price. And, because you can sell everything you produce at the market price, you have no need to spend money on advertising to create demand for your product. But the beauty of the demand curve you face is that you can sell as much as you want at that price. So there’s no reason to charge even a penny less because you can sell as much wheat as you produce at the market price. Because there are so many sellers and the market is so big, one tiny business has no influence on the market’s price.

Think about it, the wheat you grow in your backyard for your stand won’t affect the wheat price worldwide. The only choice you have is to decide how much you want to try to sell at that market price. And, how much you sell will depend on your costs. A business in a perfectly competitive environment chooses to produce at an amount where the business’s marginal cost - the additional cost to produce an additional item - is equal to the market price. In this instance, the business’s marginal cost is its supply curve in the short run. Of course it’s more complicated than this: A business owner has to answer difficult questions like “What is my opportunity cost of staying in this industry?” and “Is there a better way to spend my time and money?” And there are lots of other costs the business has to consider. But if a business stays in the market, it will choose its output at a level where its marginal cost equals the market price.

So to recap, a perfectly competitive environment has many buyers and many sellers. These businesses produce an identical product. In this instance, the seller has no control over prices; prices will be determined by the market and sellers will only choose how much to produce. And because price is determined by the market, these businesses don’t advertise - it offers them no advantage.

But if you want to get into business, in a perfectly competitive environment, it’s generally pretty easy - buy some equipment and start producing.

Is perfect competition realistic? Not for most goods and services. And thank goodness for that! Imagine if there was no variety. Everyone would have the exact same house or haircut. In reality, most sellers make lots of decisions, not just about how much to produce, but also about what to make and sell.

Product differentiation is key: What features does it provide? And how do buyers find out about this great product?

For more resources on economic concepts, visit our website.at stlouisfed.org/education/resources

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