A market is said to be perfectly competitive when all firms act as price-takers — when they can sell as such as they like at the going price but nothing at a higher price. This is so because every firm is so small a part of the market that it can exert no influence on market price by selling a little more or little less of its product. This is usually observed in markets for agricultural commodities like jute, cotton, wheat, etc. The stock market is another example of this.
A market is said to be perfectly competitive when all firms in that market act as price-takers — i.e., they can sell as much as they like at the going market price, and nothing at any higher price. A set of conditions that must be satisfied to guarantee this result is sometimes known as the assumptions of perfect competition.
1. A homogeneous product:
A production which is the same for every firm in the industry is called a homogeneous product. One farmer’s carrots are indistinguishable from those produced by any other farmer. They are homogeneous. By contrast, the Maruti Udyog’s Gypsy model is distinct from car models of all other motor manufacturers, and from Maruti’s other models. The product is differentiated.
2. Many sellers:
For firms to be price-takers, the number of sellers must be large enough so that no single firm acting by itself can exert any perceptible influence on the market price of its product by selling a little more or little less of the product. This is another key distinction between, for example, the car industry and the carrot industry.
A single farmer’s contribution to the total production of carrots is a very small portion of the total. He could double his production; or produce some other crop with no large effect on the total market supply, and, therefore, the price of carrots.
In contrast, Maruti Udyog’s car output is a significant part of total car production in India. The company does have the power to influence price by varying the number of cars it produces. Of course, the power is not unlimited (because there are other producers of cars), but it certainly exists.
3. Perfect information:
When buyers of the product are fully informed about the prices and quantities of goods offered for sale by sellers, they are said to have perfect information. As a consequence, if any firm raises the price of its (homogeneous) product above the prices charged by other producers, it is sure to lose all its customers.
This is so because people will not buy a commodity from a firm at one price if they know that the same product can be obtained at a lower price from another firm. Hence, the same price prevails in all parts of the market.
4. Freedom of entry and exit:
Assumptions 1, 2 and 3 relate to individual’ firms. The fourth assumption relates to the whole industry. Freedom of entry means that a new firm is free to start production if it so desired. There are no barriers to the entry of new firms in the industry. There are no legal or other restrictions on entry. Freedom of exit means that any existing firm partly is free to stop production and leave the industry if it so desires. There are no restrictions on exit, legal or otherwise.
In a perfectly competition market information and mobility of factors of production and commodity are assumed to be costless. Decision makers — both consumers and producers—possess perfect information regarding the choices they must make. Also, as supply and demand conditions change in individual markets, resources are assumed to move between markets until equilibrium is once again reached.
However, in most situations information and mobility are not costless. In addition, consumers have heterogenous (varied) tastes, exhibiting preferences for a wide variety of goods and services with varying characteristics. These facts explain why competition often becomes imperfect.
Joan Robinson of Cambridge University introduced the term ‘imperfect competition’. An imperfectly competitive market refers to rivalous competitive behaviour among firms that have a significant degree of market power. As Lipsey has put it, “The word ‘competitive’ emphasises that we are not dealing with monopoly, and the word ‘imperfect’ emphasises that we are not doing with perfect competition”.
Edward Chamberlin, who first introduced the term ‘monopolistic competition’ used the term ‘product differentiation’ to refer to “a group of products that are similar enough to be considered variations on one generic product but dissimilar enough that they can be sold at different prices.
For example, although one brand of toilet soap is similar to most others, soaps differ from each other in their chemical composition, colour, smell, softness, brand name, reputation and a host of other characteristics that matter to customers. So all soaps taken together are one differentiated product.” In Lipsey’s language, “Most firms in imperfectly competitive market structures sell differentiated products. In such industries, the firm itself must decide on the characteristics of the products it will sell”.
Competition becomes imperfect for various reasons such as:
1. Costly information and mobility:
Costly information and mobility have important and predictable implications for the structure of a market. Because resources are not perfectly mobile, different producers of the same good may end up paying different prices for what is essentially the same resource. Consequently, it is possible for different prices to exist for the same good across different locations.
In addition, since information gathering itself is costly, consumers (and factor owners) may not be aware of the fact that different prices exist for the same good. In either event, the result is that there is no single equilibrium price for the good in question.
For many goods and services, there exists a set of prices, rather than one single price, even within the same city. In most real life markets we see the existence of a range of prices for the same product. One reason is that consumers are not aware of all the prices being asked for a given item. This is partly a result of the fact that it takes time to observe all the prices for the good in question.
Opportunity cost of time:
Finding the lowest price for a given product is costly; it takes time and effort. To the extent that time is spent gathering information on competing prices, that time cannot be spent doing anything else. Consequently, an efficient use of time requires the consideration of the opportunity cost of time spent in a specific Endeavour.
Furthermore, travelling to a location of the firm offering the lowest price also takes time. In many cases, a consumer may be aware that the lowest price for a particular good is charged at a distant place, while the same good can be obtained for a slightly higher price from a nearly market. In this case, the savings in travel costs associated with going to the nearby firm may outweigh the extra cost paid for the good. Consequently, even if a product is homogeneous in respects other than location, firms may have some control over price.
2. Heterogeneous consumer tastes:
Variations in consumers’ tastes also affect product price and the range of products offered by firms by expanding the market for substitute goods and services. Firms respond to variations in consumers’ tastes through product differentiation on the basis of one or more characteristics of the product.
Product differentiation enables a firm to fill a niche in a particular market. To the extent that consumers attach different values to specific characteristics of a product or service, firms can charge different prices depending on the characteristics their product offers.
In a most real life markets, product prices differ on the basis of consumers’ valuations of the different characteristics each firm offers. However, product differentiation can allow firms to satisfy a greater range of tastes and preferences than a homogeneous product could. In this sense, firms are simply responding to market forces.
The real commercial world is clearly different from the world implied by perfect competition. A perfectly competitive market is characterised by a large number of small firms that produce a homogeneous product. As a result, each firm is a price-taker and, in the long run, economic profit is equal to two.
However, in many instances markets are characterised by a large number of small firms that produce a heterogeneous product. In fact, this type of market pervades our economy. This market structure is referred to as imperfect (monopolistic) competition.
While perfectly competitive firms product a homogeneous product, firms in a monopolistically competitive market produce differentiated products. As a result, monopolistically competitive firms are able to exercise some degree of control over price, regardless of the source of the product differentiation.
Since, the monopolistically competitive firm somehow distinguishes its product from that of its competitors; it acts as a price-searcher. However, because there are many close, if not perfect, substitutes for its product, the demand curve faced by the monopolistic competitor is affected by the decisions of other firms.
Because there are so many small firms in a monopolistically competitive market, individual firms face the threat of competition. The high degree of resource mobility in these markets increases this threat. The individual firm must therefore constantly strive to distinguish itself from its competitors in an effort to earn economic profits.
3. Market price vs. administered price:
In perfect competition, firms are price-takers and quantity-adjusters. In all other market forms, firms face negatively sloped demand curves and thus face a trade-off between the price that they charge and the quantity that they sell.
Since firms’ products are not perfect substitutes for one other, each firm must quote a price. Since any one manufacturer will typically have several product lines that differ more or less from each other and from the competing product lines of other firms, firms are said to be administering (managing) their prices and are price-makers-rather than price-takers. An administered price, a term introduced by Means, “is a price set by conscious decision of an individual firm rather than by impersonal market forces”.
As Lipsey put it, “In markets other than perfect competition, firms set their prices and then demand determine sales. Changes in market conditions are signalled to the firm by changes in the quantity that the firm sells at its current administered price.”
4. Short-run price stability:
In imperfectly competitive markets, we find production fluctuations in the face of fluctuating demand. We do not find price fluctuations. While in perfect competition, prices change continually in response to changes in demand and supply, in markets for differentiated products, prices often change less frequently.
5. Other aspects of Imperfect Competition:
Three other important aspects of observed behaviour of firms in imperfect competition would not occur under perfect competition.
These are the following:
(i) Non-price competition:
Firms under imperfect competition spent huge sums on advertisement. They also offer competing standards of quality and product guarantees and discount coupons. So, firms adopt other practices such as sales through representatives. Some companies give free gifts to customers. These are all planned efforts to increased line sales level. All these attempts are made both to shift the demand curves for the industry’s products and to attract customers from competing firms.
(ii) Unexploited Economies of Scale:
Firms under perfect competition operate at the lowest possible of their LRAC curves. By contrast, firms in imperfect competition operate on the downward-sloping portions of the long-run average cost curves. This denotes that they have unexploited economies of scale.
(iii) Entry prevention:
Finally, in perfect competition entry is free. So excess profits disappear completely in the long run. But imperfect competition arises due to entry-restricting (preventing) policies of rival firms. As Lipsey put it, “Firms in many industries engage in activities that appear to be designed to hinder the entry of new firms, thereby preventing pure profits from being eroded by entry”.