Perfect Competition

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 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 its actions cannot affect 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.

Defining Perfect Competition

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 no individual buyer or seller of a good, such as coffee beans or organic tomatoes, believes that it is possible to 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 8. So the model of perfect competition is appropriate for some but not all markets. An industry in which 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.

Two Necessary Conditions for Perfect Competition

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 has 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 accounts 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 about one-third 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: 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, 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, 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).

Free Entry and Exit

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.

Free entry and exit is not strictly necessary for perfect competition. In Chapter 4 we described the case of New Jersey clam fishing, where regulations limit the number of fishing boats, so entry into the industry is limited. Despite this, there are enough boats operating that the fishermen 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.

What’S a Standardized Product?

In the end, only kimchi eaters can tell you if there is truly a difference between Korean-produced kimchi and the Japanese-produced variety.

AP/Wide World Photos

A perfectly competitive industry must produce a standardized product. But is it enough for the products of different firms actually to be the same? No: people must also think that they are the same. And producers often go to great lengths to convince consumers that they have a distinctive, or differentiated, product, even when they don’t.

Consider, for example, champagne—not the superexpensive premium champagnes but the more ordinary stuff. Most people cannot tell the difference between champagne actually produced in the Champagne region of France, where the product originated, and similar products from Spain or California. But the French government has sought and obtained legal protection for the winemakers of Champagne, ensuring that around the world only bubbly wine from that region can be called champagne. If it’s from someplace else, all the seller can do is say that it was produced using the méthode Champenoise. This creates a differentiation in the minds of consumers and lets the champagne producers of Champagne charge higher prices.

Similarly, Korean producers of kimchi, the spicy fermented cabbage that is the Korean national side dish, are doing their best to convince consumers that the same product packaged by Japanese firms is just not the real thing. The purpose is, of course, to ensure higher prices for Korean kimchi.

So is an industry perfectly competitive if it sells products that are indistinguishable except in name but that consumers, for whatever reason, don’t think are standardized? No. When it comes to defining the nature of competition, the consumer is always right.

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.

The Pain of Competition

Patents allow drug makers to have a legal monopoly on new medications for 20 years.

© Todd Bennett/Journal Communications Inc.

Sometimes it is possible to see an industry become perfectly competitive. In fact, it happens frequently in the case of pharmaceuticals when the patent on a popular drug expires.

When a company develops a new drug, it is usually able to receive a patent, which gives it a legal monopoly—the exclusive right to sell the drug—for 20 years from the date of filing. Legally, no one else can sell that drug without the patent owner’s permission. When the patent expires, the market is open for other companies to sell their own versions of the drug, known collectively as generics. Generics are standardized products, much like aspirin, and are often sold by many producers.

The shift from a market with a single seller to perfect competition, not coincidentally, is accompanied by a sharp fall in the market price. For example, when the patent expired for the painkiller ibuprofen and generics were introduced, its price eventually fell by nearly 75%; the price of the painkiller naproxen fell by 90%. On average, drug prices are 40% lower after a generic enters the market.

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Not surprisingly, the makers of patent-protected drugs are eager to forestall the entry of generic competitors and have tried a variety of strategies. One especially successful tactic is for the original drug maker to make an agreement with a potential generic competitor, essentially paying the competitor to delay its entry into the market. As a result, the original drug maker continues to charge high prices and reap high profits. These agreements have been fiercely contested by many government regulators, who view them as anti-competitive practices that hurt consumers. As of the time of writing, drug makers, consumers, and government officials were anticipating a review by the Supreme Court of the legality of these agreements.