Perfect Competition What You Will Learn! What a market structure is. SS.912.E.1.6. What is perfect competition, and its characteristics. SS.912.E.1.6. In the last few units, we examined how consumers make choices about the products they buy, how producers make choices about the products they make, and how the interaction between consumers and producers in the market determine prices. In this unit, we re going to take a closer look at the producer side of things, specifically how producers compete (if they compete at all), and what the effect of that competition is on consumers. Key Point #1. A market structure is how competition in a particular market, or industry, is organized. Company 2013 Market Share Samsung 31.3% Apple 15.3% Huawei 4.9% LG 4.8% Lenovo 4.5% Others 39.3% Quick, thinking about the market for smartphones, how many companies can you think of off the top of your head that make them? Apple and Samsung may very well come to mind, and maybe a few companies like LG and Huawei. For the most part though, Apple and Samsung rule the industry. Apple s iphone is seemingly everywhere, but Samsung seems to make up the rest of smartphones out on the market. In fact, according to research firm International Data Corporation, Apple and Samsung control a large part of the market, with Samsung having a market share of 31.3% and Apple having a market share of 15.3%. A market share is how much of the market is controlled by a company or dominated by a product. In the smartphone market, Samsung and Apple combined make for a market share of 46.6% of the entire market. Their closest competitor is Huawei at 4.9%. Given how much of the market goes to Apple and Samsung, we can say that there s not a lot of competition going on in this market. That s where market structure comes in. A market structure is how competition in a particular market, or industry, is organized. Some market structures are very competitive; some are not. In this unit, we will look at four market structures: perfect competition, monopoly, oligopoly, and monopolistic competition. With each market structure, there are four characteristics that help us identify what type of market the industry is in: Number of producers Product similarity Entry into market Control over price 1
Key Point #2. Perfect competition is a market structure where a large number of producers supply the same product. The first market structure we ll discuss is perfect competition. In perfect competition, a large number of producers supply the same product. In terms of efficiency, perfect competition is considered the most efficient, and the most competitive. The price of the products are determined by the market, and sold at equilibrium, or market price. Many producers. Perfect competition has lots and lots of producers. The large number of producers promotes competition in the market. When we talked about the smartphone market earlier, we saw that Samsung and Apple controlled almost half the market, with the rest of the competitors having less than 5% market share each. There just aren t that many producers of cellphones, and a quick scan of the wall of phones at an AT&T or Sprint store can confirm that. Because of that dominance, Samsung and Apple have a large amount of influence on the smartphone market. If Samsung or Apple (or both) make any kind of changes in production it will have a significant effect on the market because they control so much of it. Case in point, Apple s introduction of the color iphone at $99, compared to their more expensive phones, could attract more consumers to the Apple brand. In a perfectly competitive market, however, the amount of influence is limited because of the large amount of producers. In perfect competition, even significant changes by a producer in what they produce would have no influence in the market. No one single producer has a large market share because there are so many producers competing with each other over the same identical product. Identical products. And that brings us to the second characteristic: identical products. Products in perfect competition are identical, or, at the very least, very similar. Consumers do not see a difference between the product sold by one producer or another. These products are considered commodities. A commodity is a product that is the same regardless who sells it. How would a product be the same no matter who sells it? Look at the tasty beverage of milk. Milk comes from cows. A cow in Florida is the same as a cow in California. Cows produce milk. If we were to make a comparison between the milk produced by a Florida cow and a California cow, we ultimately would not see a difference. It s milk. We drink it, put it in coffee, pour it on cereal. No matter how happy the California cows might be in providing milk, you can rest assured that the milk produced by our local dairy T.G. Lee is just as tasty and creamy. Free entry and exit into the market. In perfect competition, there are no real barriers to entry on entering the market. A barrier to entry is anything that makes it difficult to enter into a market. High start-up costs, government regulations, and limited resources to make the product are examples of barriers to entry. At the same time, 2
there s nothing stopping a particular company from shutting down their business and leaving the market altogether. In other words, businesses can come and go as they please. Why would this be important? Well, let s revisit Orange City s pizza market from Lesson 5.3 for a second. Bumbino s is the only pizzeria in town, and they re making a fairly hefty profit per pie. Assuming that this was a perfectly competitive market and that all pizza is identical, that is, pizza is a commodity, we could see other pizza makers enter the market to sell pizza and make money too: Stavro s and Jay s. Of course, now that there s more competition, the three pizzerias will also end up sharing the market, which means that profits can and will drop, and will do so as more pizza guys enter the market. Eventually, so many pizzerias will enter the market that profits start to become losses. Once they start taking losses, we ll see pizza guys exiting the market to go do something else, like make Chinese food or tacos, or maybe even a Chinese taco. Free entry and exit into the market helps ensure competition among producers, which causes them to adapt to any change in the market. At the same time, it prevents existing producers from keeping somebody new out. No control over price. Finally, in perfect competition, producers have no control over price. Why? First off, there are so many producers. Since there are lots of producers, no one producer really dominates the market with a huge market share and can t really influence price. Additionally, producers will come and go as profits increase or decrease. Second, the products in perfect competition are commodities, identical, and consumers don t see a difference between them. Because of that, they ll buy whatever is cheapest. If a producer were to raise his price, the consumer would just find someone else to buy from. If Wal-Mart brand milk and Publix brand milk were sitting side by side, and the Wal-Mart milk was $3.79 a gallon, and the Publix milk was $4.29 a gallon, it s a good bet that you re going to choose the Wal-Mart milk because you wouldn t see a difference. Number of Producers Product Similarity Entry and Exit Control over Price Market Structure Characteristics Perfect Monopoly Oligopoly Competition Many identical, commodities free none Monopolistic Competition 3
So what s a good example of a perfectly competitive market? When you re driving past citrus groves in DeLeon Springs or Oak Hill, you re looking at a relatively perfectly competitive market. The citrus industry in Florida has lots of producers in almost every county and across the state from Miami to Pensacola. When you buy an orange off the side of the road on State Road 44, there is no difference between that orange and the one you buy at the New Smyrna Farmers Market. An orange is an orange. There s no real barriers to entry or exit in the citrus industry, other than start-up costs of buying land, planting trees, and, of course, time. Finally, because there s so much competition in the market, the average price for a box of Florida oranges was $9.73 in 2012. 4
Wait, why relatively? Here s where things get interesting. When we started our discussion on perfect competition, we said that prices and quantity were set at equilibrium. All that competition between producers drives down prices to the bare minimum. What we mean is that in perfect competition, the profits that producers make are just enough to cover their costs, both fixed and variable, and no more. So, in perfect competition, nobody makes any real profit? It all just zeroes out? Yes, that s correct. Sellers are selling the product for the exact amount that it costs to make it and buyers are buying the product for that exact amount. How realistic is this? If you were to open your own business, it s a good bet that you d want to make more money than just enough to cover your costs. You probably want to make mountains of cash like every good red-blooded American, right? In the real world, perfectly competitive markets don t really exist. Wait, you just made me read this for 15 minutes, and you re telling me, it isn t real? You mad, bro? Why in the world would we even discuss this if it doesn t really matter? Well, actually, perfect competition does matter. Economists want to model the economy the best they can so that they can make accurate predictions about consumer and producer behavior what choices they will make given a certain set of circumstances. Perfect competition gives us a model of what happens in a market where everything is, well, perfect. Producers are producing the exact amount consumers want at the exact price, with absolutely nothing going to waste, the very picture of efficiency. No one is taking advantage of another, everyone is behaving appropriately and as they should be. In the end, perfect competition is a baseline of how the market should be when everybody is behaving. We need this baseline to make a comparison, so that we can see what happens when somebody is misbehaving, that is when competition is imperfect: monopoly, oligopoly, and monopolistic competition. 5