Suppose that Yves and Zoe are neighbouring farmers, both of whom grow organic tomatoes. Both sell their output to the same grocery store chains that carry organic foods; so, in a real sense, Yves and Zoe compete with each other.

Does this mean that Yves should try to stop Zoe from growing tomatoes or that Yves and Zoe should form an agreement to grow less? Almost certainly not: there are hundreds or thousands of organic tomato farmers, and Yves and Zoe are competing with all those other growers as well as with each other. Because so many farmers sell organic tomatoes, if any one of them produced more or less, there would be no measurable effect on market prices.

When people talk about business competition, the image they often have in mind is a situation in which two or three rival firms are intensely struggling for advantage. But economists know that when an industry consists of a few main competitors, it’s actually a sign that competition is fairly limited. As the example of organic tomatoes suggests, when there is enough competition, it doesn’t even make sense to identify your rivals: there are so many competitors that you cannot single out any one of them as a rival.

We can put it another way: Yves and Zoe are price-taking producers. A producer is a price-taker when it controls so little of the market that its actions will not have any influence on the market price of the good or service it sells. As a result, a price-taking producer considers the market price as given. When there is enough competition—when competition is what economists call “perfect”—then every producer is a price-taker. And there is a similar definition for consumers: a price-taking consumer is a consumer who cannot influence the market price of the good or service by his or her actions. That is, the market price is unaffected by how much or how little of the good the consumer buys.

In a perfectly competitive market, all market participants, both consumers and producers, are price-takers. That is, neither consumption decisions by individual consumers nor production decisions by individual producers affect the market price of the good.

The supply and demand model, which we introduced in Chapter 3 and have used repeatedly since then, is a model of a perfectly competitive market. It depends fundamentally on the assumption that the actions of an individual buyer or seller of a good, such as coffee beans or organic tomatoes, cannot affect the price at which he or she can buy or sell the good.

As a general rule, consumers are indeed price-takers. Instances in which consumers are able to affect the prices they pay are rare. It is, however, quite common for producers to have a significant ability to affect the prices they receive, a phenomenon we’ll address in Chapter 13. So the model of perfect competition is appropriate for some but not all markets. An industry in which all producers are price-takers is called a perfectly competitive industry. Clearly, some industries aren’t perfectly competitive; in later chapters we’ll learn how to analyze industries that don’t fit the perfectly competitive model.

Under what circumstances will all producers be price-takers? In the next section we will find that there are two necessary conditions for a perfectly competitive industry and that a third condition is often present as well.

The markets for major grains, like wheat and corn, are perfectly competitive: individual wheat and corn farmers, as well as individual buyers of wheat and corn, take market prices as given. In contrast, the markets for some of the food items made from these grains—in particular, breakfast cereals—are by no means perfectly competitive. There is intense competition among cereal brands, but not perfect competition. To understand the difference between the market for wheat and the market for shredded wheat cereal is to understand the importance of the two necessary conditions for perfect competition.

First, for an industry to be perfectly competitive, it must contain many producers, none of whom have a large market share. A producer’s market share is the fraction of the total industry output accounted for by that producer’s output. The distribution of market share constitutes a major difference between the grain industry and the breakfast cereal industry. There are thousands of wheat farmers, none of whom account for more than a tiny fraction of total wheat sales.

The breakfast cereal industry, however, is dominated by four producers: Kellogg’s, General Mills, Post Foods, and the Quaker Oats Company. Kellogg’s alone accounts for more than 40% of all cereal sales. Kellogg’s executives know that if they try to sell more cornflakes, they are likely to drive down the market price of cornflakes. That is, they know that their actions influence market prices, simply because they are so large a part of the market that changes in their production will significantly affect the overall quantity supplied. It makes sense to assume that producers are price-takers only when an industry does not contain any large producers like Kellogg’s.

Second, an industry can be perfectly competitive only if consumers regard the products of all producers as equivalent. This clearly isn’t true in the breakfast cereal market: Cap’n Crunch isn’t considered a good substitute for Multi Grain Cheerios. As a result, the maker of Multi Grain Cheerios has some ability to increase its price without fear that it will lose all its customers to the maker of Cap’n Crunch.

Contrast this with the case of a standardized product, which is a product that consumers regard as the same good even when it comes from different producers, sometimes known as a commodity. Because wheat is a standardized product,¹ consumers regard the output of one wheat producer as a perfect substitute for that of another producer. Consequently, one farmer cannot increase the price for his or her wheat without losing all sales to other wheat farmers. So the second necessary condition for a competitive industry is that the industry output is a standardized product (see the upcoming For Inquiring Minds).

All perfectly competitive industries have many producers with small market shares, producing a standardized product. Most perfectly competitive industries are also characterized by one more feature: it is easy for new firms to enter the industry or for firms that are currently in the industry to leave. That is, no obstacles in the form of government regulations or limited access to key resources prevent new producers from entering the market. And no additional costs are associated with shutting down a company and leaving the industry. Economists refer to the arrival of new firms into an industry as entry; they refer to the departure of firms from an industry as exit. When there are no obstacles to entry into or exit from an industry, we say that the industry has free entry and exit. For example, in the convenience store market, the set-up cost of a corner shop is relatively low, which allows owners to enter and leave the market easily.

Free entry and exit is not strictly necessary for perfect competition. In Chapter 5 we described the case of lobster fishing in Atlantic Canada, where regulations limit the number of licences and thus lobster traps, so entry into the industry is limited. Despite this, there are enough boats operating that the fishers are price-takers. But free entry and exit is a key factor in most competitive industries. It ensures that the number of producers in an industry can adjust to changing market conditions. And, in particular, it ensures that producers in an industry cannot act to keep new firms out. To sum up, then, perfect competition depends on two necessary conditions. First, the industry must contain many producers, each having a small market share. Second, the industry must produce a standardized product. In addition, perfectly competitive industries are normally characterized by free entry and exit.

How does an industry that meets these three criteria behave? As a first step toward answering that question, let’s look at how an individual producer in a perfectly competitive industry maximizes profit.