A market is a set of sellers and buyers whose behavior affects the price at which a good is sold. For example, Cisco stock sold in California and Wisconsin is considered to take place in the same market, so markets don’t necessarily refer to a geographical area. If you bought Ben and Jerry’s ice cream and a package of Rayovac batteries at a local Ralphs store, then you are transacting in two different markets.
Economists describe different types of markets by:
- the number of firms
- whether the products of different firms are identical or different
- how easy it is for new firms to enter the market.
Perfect competition is at one extreme with many small firms selling identical products. Monopoly is at the other extreme with one firm. The intermediate cases are monopolistic competition involving many small sellers producing slightly differentiated products and oligopoly, which has a few large firms.
There are 4 conditions required for perfect competition.
- Numerous small firms and customers — the decisions of individual producers and buyers does not impact the price of the good.
- Homogeneity of product –products offered by sellers are identical. For example, wheat of a particular grade is homogenous, while ice cream is not. Consumers don’t care from which firm they buy the good because their products are identical.
- Freedom of entry and exit –there are no barriers to enter the industry, so a new firm does not have to match the advertising of the existing firms to secure customers. Nor are there large sunk costs that require large investments in equipment before production can start. There is also freedom to exit, so firms can leave the industry if the business proves unprofitable.
- Perfect information –each firm and customer is well informed about the prices and products. They know if one seller is offering the product at a lower price.
These conditions are infrequently met. A good example is a company’s stock. There are millions of buyers and sellers, the shares are identical, entry into the market is easy, and information about the price of the stock is available over the Internet. Other examples include fishing and farming.
If this market is so rare, then why are we bothering to study it? Perfect competition is a benchmark –it is the standard by which all other markets are judged. We will see that markets work most efficiently under perfect competition. It insures that the economy produces what society wants using scarce resources most effectively. By studying perfect competition, we will see what an ideally functioning market system can accomplish.
Principles of Economics, N.Gregory Mankiw, 7th edition.
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