Question

List each of the five characteristics of a perfectly competitive market and briefly explain each. What are the implications of these characteristics for firm behavior, market prices, and efficiency? Discuss how common it is for each of these assumptions to be met in actual market situations. Based on that discussion, what role might government have to play in regulating markets towards achieving efficient (socially optimal) outcomes?  Use graphical analysis when appropriate.

Answer 1

1. Large Number of Buyers and Sellers:

In a perfectly competitive market, the number of buyers and sellers should be large. However, there is no hard and fast rule about how ‘large’ the number should be. But the number should be so large that each buyer buys, on average, a negligibly small fraction of the total quantity bought and sold in the market and each seller also, on an average, sells a negligibly small fraction.

The significance of this assumption is this. If each buyer buys a small fraction of the total quantity bought and sold, then he would not be able to exercise an individual influence on the process of determination of the market price of the product.

Characteristic # 2.Homogeneous Product:

It is assumed that in a perfectly competitive market, the firms produce and sell a homogeneous product. In other words, in a competitive market, the buyers do not discriminate between the sellers. They accept the products of all the sellers as homogenous or identical.

Because of this assumption, the buyers do not show preference for any particular seller(s). To them all the sellers appear to be equally preferred. That is why it is said that in a perfectly competitive market, the sellers sell not only a homogeneous product, they also sell an identical behaviour.

Characteristic # 3. Perfect Knowledge about the Market:

It is assumed that in a perfectly competitive market, the buyers and sellers possess perfect knowledge about the conditions prevailing in the market. This assumption has been made because, if the buyers do not have the knowledge about the price of the product or about the sellers of the product, then some sellers may take this opportunity to charge a higher price for their products.

Consequently, the market would experience the circumstances where some sellers are taking relatively larger prices, and some are taking relatively smaller prices. In that case, there would be nothing like a ‘particular’ market price of the product. This is not compatible with the concept of perfect competition.

The sellers should also have perfect knowledge about market conditions. Otherwise some of them would sell the product at a lower or higher price than others. In that case also, a unique market price would not prevail in the market.

Characteristic # 4. Free Entry and Free Exit:

Another characteristic feature which is assumed to be present in a perfectly competitive market is that of free entry and free exit. This means that any new firm may enter the market for the product, i.e., it may participate in the production and sale of the good. Also, any existing firm may leave the industry or the market. However, free entry and free exit would be possible only in the long run.

For, a firm that intends to enter the market would have to acquire the fixed inputs, which is not possible in the short run. On the other hand, the firm that has decided to leave the industry would have to wait till it is able to dispose of its fixed inputs, and this would require a long run.

Characteristic # 5. Mobility of the Factors:

Next, it is assumed that the factors of production that the firms use are homogeneous and perfectly mobile, The implication Of this assumption is that if the factors are homogeneous and perfectly mobile, then their prices would be the same to all firms. For if they are given lower prices by an employer, they would leave that place and join some other firm where they would get higher prices.

As a result, supply of factors to the first firm would decrease and that to the second firm would increase. Consequently, the prices of the factors would go up in the former and those would come down in the latter. If the process goes on, ultimately all the firms would have to buy all the factors at the same prices. In that case, competition between the firms would be perfect.