2. Perfect Competition

The concept, competition, is used in two ways in economics. One way is as a state, or type of market structure. The other way is as a process. As a process, competition is prevalent throughout our economy.

Competition as a process is a rivalry among firms. It involves one firm trying to figure out how to take away market share from another firm.

Competition as a state, or market structure, is the end result of the competitive process under certain conditions.

A perfectly competitive market is a market in which economic forces operate absolutely. For a market to be called perfectly competitive, it must meet some stringent conditions:

1. Buyers and sellers are price takers.

2. No influence.

3. The number of firms is large.

4. There are no barriers to entry.

5. Firms' products are homogeneous (identical).

6. Exit and entry are instantaneous and costless.

7. There is complete information.

8. Selling firms are profit-maximizing entrepreneurial firms.

These conditions are needed to ensure that economic forces operate instantaneously and are unlimited by other invisible or visible forces.

To give you a sense of these conditions, let's consider them a bit more carefully.

1. Both buyers and sellers are price takers.

A price taker is a firm or individual who takes the market price determined by market supply and demand as given.

When you buy, say, toothpaste, you go to the store and find that the price of toothpaste is, say $1.38 for the medium-size tube: you're a price taker. The firm, however, is a price maker since it set the price at $1.38. So even though the toothpaste industry is highly competitive, it's not a perfectly competitive market. In a perfectly competitive market, market supply and demand determine the price; both firms and consumers take the market price as given.

2. No influence.

• If any action taken by the firm has any effect on price, that's influence.

• If a firm, by withholding half its output from the market was able to push up price, that would be influence.

• If a firm doubled its output and forced down price, that too would be influence.

• If a firm left the industry, which would make price go up, that would be influence on price.

3. The number of firms is large.

The industry under perfect competition includes many firms. So many that no one firm has any influence on price. This assumption rules out the possibility of collusion among buyers or sellers to affect price and output in the industry. Moreover, the large number of buyers and sellers ensures that the purchases or sales of any one buyer or seller will not affect the market price. Each buyer and seller is small relative to the total market for the commodity and exerts no perceptible influence on the market.

4. No barriers to entry.

Barriers to entry are any things that prevent other firms from entering a market. They might be legal barriers such as exist when firms acquire a patent to produce a certain product. Barriers might be technological, such as when the minimum efficient scale of production allows only one firm to produce at the lowest average total cost. Or barriers might be created by social forces, such as when bankers will lend only to certain types of people and not to other types. Perfect competition can have no barriers to entry.