Perfectly Competitive Markets

As mentioned earlier in the course, the kind of market we have been examining in the past few lessons, the simplified supply-and-demand diagram, and the underlying assumptions about rational utility maximization, supply being defined by marginal cost, and the law of one price, are all part of what we call "perfect competition.” As I have said, this is an idealization. It does not exist in real life, but is a good starting place to study markets.

When we talk about "perfect," we mean that this form of market gives the best possible outcome with respect to "aggregate wealth," which is just consumer surplus and producer surplus added together. There are many ways in which markets can generate less than optimal quantities of wealth - cost can be too high, people might not know certain information, costs can be borne by others, people can manipulate markets to charge a price that is either higher or lower than the market equilibrium, and so on. In real life, it is safe to say that there is no such thing as a perfect market; that, in every case, there is a distortion of some sort that adversely affects prices, quantities, or wealth. At this point, we will go over, once again, the four things that we assume for perfectly competitive markets to exist, and over the next few weeks we will look at what happens if one or more of these assumptions is violated.

If a market produces less than the optimal (maximum) amount of wealth, then we say we have "market failure." This sounds a bit extreme - anything less than perfection is called "failure." It's a good thing college isn't like this - anything less than 100% is a fail. So, we have to consider that there are "degrees" of market failure, just like there are degrees of success in a course. Getting 90% in a class is better than getting 40%. My car having a broken clock is a lot better than having a broken transmission, even though both represent some degree of "failure." So, when we think about market failure, we have to understand when it is serious, and thus needs some fixing, or when it is not, and trying to fix it will only make things worse.

So, let's go through the four assumptions of perfect competition, and their meanings.

Nobody Has Market Power

This means that nobody has the ability to change the market equilibrium price based on their own behavior. This means that there must be many buyers and many sellers. We also say “everybody is a price-taker,” which means that they must accept the market price, and they are not “price-setters.” When we say that "nobody has the ability to affect price based upon their own decisions," then each market entrant must be small compared to the size of the market in general, such that one consumer choosing to consume or not does not "meaningfully" change the market price based upon his/her decisions. As we have seen, a market is an aggregation of individual desires and actions, and, in theory, a change in the consumption habits of some part of the market will be reflected in the form of the market as a whole. In theory, me choosing to buy peaches instead of oranges at the grocery store will affect the markets for both peaches and oranges. However, since I am only one of several hundred people that buy fruit daily in that store, my consumption choices will have a very small, almost imperceptible, effect on the price of either good.

This is sometimes called "atomistic" competition, referencing the idea of elementary particles from physics. We, and everything around us, are composed of atomic particles, but the adding or changing of a few particles does not change us in a "meaningful" manner. So, to reiterate: "nobody has market power" means that everybody is a price-taker, not a price setter, and it means that there are so many individual buyers and sellers that the actions of one or a few will not meaningfully change the market equilibrium.

Perfect Information

This means two things – first, that everybody knows what their own choices are, and also that they know everything about the product. When we say "know your own choices," we mean that you are capable of knowing what amount of marginal utility you will receive from consuming a product, and you will also know the amount of marginal utility you will obtain from consuming every possible other consumption choice. This means that when you consume something, you will definitely be spending money on the thing that maximizes your utility.

Clearly, this is an unreasonable assumption. We do not spend every waking minute calculating the marginal utility of consumption. We can't, for several reasons. Firstly, the universe of choices is too large to consider every option. Secondly, some of your consumption choices take place in the future (that is, should I spend now or save my money and spend later?) We do not know the future. We do not know how much money we will have in the future; we do not know how our tastes and needs will change in the future. The final point is, it can be difficult to measure "happiness" from a consumption choice. Smoking a cigarette might make somebody happy today but very unhappy in a few years if he gets lung cancer. How can we calculate and assign values to such things? We can't.

A great deal of work on the frontiers of economics (the part that intersects with psychology) is about trying to figure out how and why we make choices. This is not something we can address here. That is fine - we are interested in studying what kind of market outcomes we have from the results of those choices, and trying to come up with some general observations, with a bit of predictive power, about how people behave in markets. If you are interested in this area of study, you might want to take a look at a field called "behavioral economics," which concerns itself with examining why people make choices that seem, on the surface, to be against their own best interests. Many people who study in this area claim that their findings undermine the axiomatic assumption about rational utility maximization, but I prefer to think that most "irrational" behavior can be tied back to imperfect information.

A second component of information is a bit simpler to understand: information about a product. That is, when we buy something, do we understand what we are getting? If I buy a Rolex watch, I expect something made in the Rolex factory in Switzerland, not something made in China. If I buy the Chinese Rolex, thinking that it is a Swiss one, I do not have perfect information. On a more mundane level, with reference to the law of one price, am I able to get the best price? For example, I recently moved to a new city. I like to send my shirts out to be laundered, mostly because I am very bad at ironing shirts. There are several dry cleaners near where I live, so how do I know that I am getting the best price? Well, I have to invest some time and effort into discovering the prices at each of these places. What if there is a place that I missed? What if a place does not have an informative website, or will not tell me their prices over the phone? These are all types of information market failure, some more serious than others.

Speaking of the supply side of the market, the most important type of information is cost information. This may seem like a simple idea - a firm can figure out what it's spending money on - but sometimes it can be very difficult figuring out the marginal cost - the cost of producing one more item. It can also be very difficult to make production function and investment choices: should a firm expand, or buy more machinery, or hire more staff? This can be difficult to assess because the alternate states of the world that they entail in the future are unknown.

Product Homogeneity

This means that in a specific market, all products are identical. In real life, no two things are identical, and people make “differentiation” between products. But, for purposes of modeling, we assume that certain groups of products are close enough to being the same.

In many industries, firms go to great efforts to differentiate their products from others. Some of the best examples are soft drinks, hair care products, and cars. The primary tool for product differentiation is advertising. The reason that firms do this is to be able to charge higher prices. For example, a four door car with a four cylinder engine may be an undifferentiated product, but if it is a four-door, four-cylinder car with a badge on the front that says "Toyota" or "Ford," then it is a differentiated product, and each of those manufacturers will try to charge more by convincing you that the name on the front has some extra value. This is another case where modeling consumer choice becomes a bit more difficult.

Free Entry and Exit

This means that people only make production and consumption decision based upon their own free will. They are not forced to buy or sell things they do not want. It also means that people are not negatively affected by other people’s market decisions. In situations where a private economic transaction negatively affects a person who is not a willing participant in that economic transaction, we have something called an "externality." This is a very important type of market failure, and one we will study at length in the next few weeks. The most important externality we will study is pollution, which is a major issue in energy markets and is the basis for the field of environmental economics.

Another aspect of free entry is that competitors can not put up "barriers to entry".

As mentioned above, there is no such thing as a perfectly competitive market. Probably the closest we get to perfect competition is a large stock market like those in New York or London. Think about why: there are usually many buyers and sellers, there is a lot of information about the value of a company behind the stock, a share of a company is identical to any other share of that company, and there are no externalities.

Reiteration

A perfectly competitive market gives the greatest possible wealth – the sum of consumer and producer surplus. Any market that fails to get this full amount is not perfect, and we say that we have a “market failure.” By “failure” we simply mean “not perfect.” All markets are in failure, but some more than others.

Many people wish to correct market failure, and to do this, they usually decide that government must act, since no individual has enough power to correct the failures.

However, sometimes, in their attempt to fix the problem, government actually makes things worse (that is, they make the consumer and/or producer surplus even smaller). When this happens we have what we call “government failure.” We have government failure when a government tries to fix a problem, but only makes it worse. Even if government has good intentions, it usually makes things worse.

In the next few sessions, we will talk about market failure and then move on to studying government failure.