Perfect Competition

Assumptions of Perfect Competition

The most competitive market structure is pure or perfect competition, which is as competitive as possible.  As previously mentioned, market structures are models that summarize how certain markets are organized and behave.  For each market structure we have a set of assumptions or characteristics that tell us what kind of industries the model will explain.  Only industries that meet the assumptions will behave in the way the model predicts.  The assumptions of perfect competition are:

Many buyers and sellers:  There are so many buyers and sellers in perfect competition that no one of them has any influence whatsoever on the market.  The number of consumers and producers is so great that any one of them is like a cup of water in the ocean – their presence or absence makes no difference at all to the market.

Identical or homogenous product:  Every producer in the market makes exactly the same product – consumers are not able to distinguish between the output of one firm and the output of another.  There are no labels, brands or any other distinguishing features used to make a product look distinct.

Excellent information:  Both buyers and sellers in this market have good information about the product, especially the fact that there are many other producers all making the same product.

Relatively free entry and exit:  Firms are able to move resources in and out of this market relatively easily with little expense.  This makes firms especially quick to respond to changing consumer demand.

As you would expect from this list, there are few markets that come close to fitting these assumptions.  The most common example used for perfect competition is agriculture.  While agriculture does not fit these assumptions perfectly, it comes closer to perfect competition than to any other market structure. 

In the major commodity markets, there are so many producers that any one producer has no effect on the market.  If you are one producer of hard red winter wheat out of thousands, it does not affect market supply or price if you produce more or less this year.  You are so insignificant to the market that you cannot even set your own price, but have the price set for you in the market – perfectly competitive firms are price takers, their only choice is to take the market price and sell, or leave it and sell nothing.

In the major commodity markets the product is identical from producer to producer – there is no difference in the hard red winter wheat of Farmer Smith in Nebraska and Farmer Jones in South Dakota.  If consumers were presented with a bucket of each, they could not tell any difference.

In the major commodity markets, all the buyers know that the product is identical, they know what current prices are, and they know how to grade the product.  If the going price of hard red winter wheat were $3 a bushel, a farmer who tried to set his/her price at $3.01 a bushel would sell no wheat.  All the buyers know they can get all the wheat they want at $3.  Producers have no power over the market price.

In the major commodity markets there is relatively free entry and exit, stress on the word relatively.  While it is expensive to enter and exit farming in general, it is relatively inexpensive to move from one agricultural market to another related one.  For example, areas suitable to growing corn are generally also very suitable to grow soybeans.  Similar equipment is used to plant, cultivate and harvest corn and soybeans.  If corn prices have been low, corn farmers could easily switch to growing soybeans the next year.

In recent years we have seen a growing deviation from the perfect competition pattern in agriculture in that the buyers of agricultural crops are consolidating in some markets.  For example, there are a limited number of meat processors that handle pork and poultry reducing the competition on the buying side of the market.  In time, we may have to adjust our interpretation of at least some of the agricultural markets, but for the moment the best fit still appears to be perfect competition.

In general, the pattern for this market is a very large number of small powerless producers making absolutely the same product in a market where they have no influence on price.  Competition is so great that individual firms have no alternative but to operate efficiently in order to survive.