Suppose that Yves and Zoe are neighboring 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 fewer tomatoes? Almost certainly not: there are hundreds or thousands of organic tomato farmers (let’s not forget Jennifer and Jason from Module 53!), 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 fewer, there would be no measurable effect on market prices.

When people talk about business competition, they often imagine a situation in which two or three rival firms are struggling for advantage. But economists know that when a business focuses on a few main competitors, it’s actually a sign that competition is fairly limited. As the example of organic tomatoes suggests, when the number of competitors is large, it doesn’t even make sense to identify rivals and engage in aggressive competition because each firm is too small within the scope of the market to make a significant difference.

We can put it another way: Yves and Zoe are price-takers. A price-taking firm is one whose actions cannot affect the market price of the good or service it sells. As a result, a price-taking firm takes the market price as given. When there is enough competition—when competition is what economists call “perfect”—then every firm is a price-taker. 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 is a model of a perfectly competitive market. It depends fundamentally on the assumption that no individual buyer or seller of a good, such as coffee beans or organic tomatoes, believes that it is possible to individually affect the price at which he or she can buy or sell the good. For a firm, being a price-taker means that the demand curve is a horizontal line at the market price. If the firm charged more than the market price, buyers would go to any of the many alternative sellers of the same product. And it is unnecessary to charge a lower price because, as an insignificantly small part of the perfectly competitive market, the firm can sell all that it wants at the market price.

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

Under what circumstances will all firms be price-takers? As we’ll discover next, there are two necessary conditions for a perfectly competitive industry and a third condition is often present as well.

The markets for major grains, such as 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 two necessary conditions for perfect competition.

First, for an industry to be perfectly competitive, it must contain many firms, none of whom have a large market share. A firm’s market share is the fraction of the total industry output accounted for by that firm’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 firms: Kellogg’s, General Mills, Post, and Quaker Foods. Kellogg’s alone accounts for about one-third of all cereal sales. Kellogg’s executives know that if they try to sell more corn flakes, they are likely to drive down the market price of corn flakes. That is, they know that their actions influence market prices—due to their tremendous size, changes in their production will significantly affect the overall quantity supplied. It makes sense to assume that firms are price-takers only when they are numerous and relatively small.

Second, an industry can be perfectly competitive only if consumers regard the products of all firms as equivalent. This clearly isn’t true in the breakfast cereal market: consumers don’t consider Cap’n Crunch to be a good substitute for Wheaties. As a result, the maker of Wheaties 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, sometimes known as a commodity, which is a product that consumers regard as the same good even when it comes from different firms. Because wheat is a standardized product, consumers regard the output of one wheat producer as a perfect substitute for that of another producer. This means that 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 perfectly competitive industry is that the industry output is a standardized product. (See the FYI that follows.)

What’s a Standardized Product?

All perfectly competitive industries have many firms 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 firms 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.

Free entry and exit is not strictly necessary for perfect competition. However, it ensures that the number of firms in an industry can adjust to changing market conditions. And, in particular, it ensures that firms in an industry cannot act to keep other firms out.

To sum up, then, perfect competition depends on two necessary conditions. First, the industry must contain many firms, 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.