Competitive Market

Perfectly Competitive Market

Perfectly competitive market is sometimes used interchangeably with competitive market. For a market to be a perfectly competitive market, three key conditions must be satisfied. Let's list these three conditions.

1. The product must be homogenous.
2. Participants in the market must be price takers.
3. There must be free entry and exit into and out of the market.

The perfectly competitive market model is important to economists because it helps us study various markets to understand both consumer and producer behaviors. Let's take a more in-depth look at the conditions above.

Perfectly Competitive Market: Product homogeneity in a competitive market

Products are homogenous when they can all serve as perfect substitutes for one another. In a market where all products are perfect substitutes for one another, one firm cannot just decide to increase prices, as this will cause that firm to lose a large number of its customers or business.

• Products are homogenous when they can all serve as perfect substitutes for one another.

Agricultural products are usually homogenous, since such products often have the same quality in a given region. This means, for example, that the tomatoes from any producer are often just fine for consumers. Gasoline is also often a homogenous product.

Perfectly Competitive Market: Price taking in a competitive market

Price taking in a competitive market applies to both producers and consumers. For producers, there are so many producers selling in the market that each seller sells only a small fraction of the products traded on the market. As a result, no single seller can influence prices and must accept the market price.

The same applies to consumers. There are so many consumers in a competitive market that one consumer cannot just decide to pay less or more than the market price.

Perfectly Competitive Market: Free entry and exit in a competitive market

The condition of free entry and exit in a competitive market describes the absence of special costs that prevent firms from joining a market as a producer, or leaving a market when it is not making enough profit. By special costs, economists are referring to costs that will have to be paid by only new entrants, with existing firms paying no such costs. These costs don't exist in a competitive market.

It is important to note that in reality, all three conditions for a competitive market are not satisfied for many markets, even though many markets come close. Nonetheless, comparisons with the perfect competition model help economists understand all kinds of different market structures.

Competitive Market Graph

The competitive market graph shows the relationship between price and quantity in a competitive market. As we are referring to the market as a whole, economists show both demand and supply on the competitive market graph.

Figure 1 below shows a competitive market graph.

Fig. 1 - Competitive Market Graph

As shown in Figure 1, we plot the graph with price on the vertical axis and quantity on the horizontal axis. On the graph, we have the demand curve (D) which shows the quantity of output consumers will buy at each price. We also have the supply curve (S) which shows what quantity of output producers will supply at each price.

Competitive Market Demand Curve

The competitive market demand curve shows how much of a product consumers will buy at each price level. Even though our focus is on the market as a whole, let's also consider the individual firm. Because the individual firm is taking the market price, it sells at the same price regardless of the quantity demanded. Therefore, it has a horizontal demand curve, as shown in Figure 2 below.

Fig. 2 - Demand for a firm in a competitive market

On the other hand, the demand curve for the market slopes downward because it shows the different possible prices at which consumers are willing to buy different quantities of the product. All firms sell the same quantity of the product at each possible price level, and the competitive market demand curve slopes downward because consumers buy more product when the price of the product goes down, and they buy less when its price goes up. Figure 3 below shows the competitive market demand curve.

Fig. 3 - Competitive market demand curve

Competitive Market Equilibrium

The competitive market equilibrium is the point where demand matches supply in the competitive market. A simple competitive market equilibrium is shown in Figure 4 below with the equilibrium point marked, E.

Fig. 4 - Competitive market equilibrium

The competitive firm achieves equilibrium in the long run, and for this to happen, three conditions must be satisfied. These conditions are listed below.

1. All producers in the market must be maximizing profit - producers in the market must be earning the highest possible total profit when their production costs, price, and quantity of output are considered. Marginal cost must be equal to marginal revenue.
2. No producer is motivated to enter or exit the market, since all producers are earning zero economic profit - Zero economic profit may sound like a bad thing, but it is not. Zero economic profit means that the firm is currently on its best possible alternative and cannot do any better. It means that the firm is earning a competitive return on its money. Firms earning zero economic profit in the competitive market should remain in business.
3. The product has reached a price level where the quantity supplied equals the quantity demanded - at the long-run competitive equilibrium, the price of the product has reached a point where producers are willing to supply just as much product as consumers are willing to buy.