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Perfect Competition

We know how the consumers make their decisions, and what the producers’ production possibilities and cost of production look like. The consumers often take prices as given and choose quantities based on the prices. The question is how prices arise. One factor is, of course, the cost of production. The price cannot be below the cost, at least not in the long run. The price is, however, very dependent on the structure of the market. Among the most important questions one can ask about the market structure are:

  • The degree of concentration of buyers and sellers. Do we have many, a few, or one?
  • The degree of product differentiation. Are the products identical to each other, or how different are they from each other?
  • Are there any barriers to entry in the market?

The answers to these questions largely determine which kind of market we get, and this, in turn, largely determines the price. Here, we will look at one type of market, a perfectly competitive market.

Conditions for Perfect Competition

For a market to be perfectly competitive, it has to fulfill the following conditions:

  • All agents are price takers. No single buyer or seller can affect the price of the good. Everyone takes the price as given, and, depending on the price, decides about quantity. This condition will be true if there are many small buyers and sellers.
  • Homogenous products. Each seller’s products are identical to every other seller’s products. Furthermore, there are no extra costs, such as transportation costs, for some sellers. The buyers are therefore neutral between different sellers.
  • All factors of production are completely variable. There are no barriers to entry for new firms or barriers to leave for existing firms.
  • All buyers and sellers have complete information about existing alternatives in the market.
  • There are no agreements to collude in the market. For instance, the sellers cannot form a cartel.

These conditions are hard to satisfy and few, if any, real markets do that. Even so, the model is very informative and delivers several interesting results. Furthermore, many economists are highly in favor of competition and some of the most important reasons for that will be revealed as we use this model.

Profit Maximizing Production in the Short Run

The goal of an individual firm is to maximize its profit, i.e. the difference between revenues and costs. In the short run, it does that under the restriction that it cannot change the amount of capital.

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