Module 13: Perfect Competition

Policy Example: Should the Government Allow Oil Companies to Merge Retail Gas Stations?

In the late 1990s and early 2000s, there were a number of mergers of big oil companies in the United States: Exxon acquired Mobil, BP Amoco acquired Arco, Chevron acquired Texaco, and Phillips merged with Conoco. This led to massive consolidation in the oil business. In response, U.S. government regulators required the sell off of some refineries to maintain competitiveness in regional refined gas markets. For the most part, however, the same regulators were unconcerned about the reduction in competition in the retail gas market. In this module we will explore perfectly competitive markets and, in so doing, will be able to better understand why regulators were relatively unconcerned about concentration in the retail gas industry.

Exploring the Policy Question

1. Why were retail gas stations not considered a main concern of regulators?
2. Does the merger of major oil companies necessarily lead to higher gas prices? Why or why not?

13.1 Conditions for Perfect Competition

Learning Objective 13.1: Describe the characteristics of a perfectly competitive market.

13.2 Perfect Competition and Efficiency

Learning Objective 13.2: Explain how perfectly competitive markets lead to Pareto efficient outcomes.

In perfectly competitive markets firms and consumers are all price takers: their supply and purchasing decisions have no impact on the market price. This means that the market is so big that any one individual seller or buyer is such a small part of the overall market that their individual decisions are inconsequential to the market as a whole. It is worth mentioning here at the start that this is a very strong assumption and thus this is considered an almost purely theoretical extreme along with monopoly at the other extreme. We can and will describe markets that come pretty close to the assumptions underlying perfect completion, but most markets will lie somewhere in between purely competitive and monopolistic. It is important to study these extremes to better understand the full range of markets and their outcomes.

Before we describe in detail perfectly competitive markets, let’s consider how we categorize market structure, the competitive environments in which firms and consumers interact. There are three main metrics by which we measure a market’s structure:

• The number of firms. More firms mean more competition, more places to which consumers can turn to purchase a good.

• The similarity of goods. The more similar are the goods sold in the market the more easily consumers can switch firms to buy from and the more competitive the market is.

• The barriers to entry. The more difficult is it to enter a market for a new firm, the less competitive it is.

The first is relatively straightforward; more firms mean more competition in the sense that it is hard to charge more for a product that consumes can find easily from other sellers. The second is a little subtler because products can be differentiated by something as simple as a brand or more tangible aspects like colors, features and other characteristics. Finally the third can be barriers of law like patents, or technology even if not covered by legal patent protection, or more natural barriers like a very high cost of starting up a firm that is not justified by the expected revenue.

We will study four market types in more detail where these metrics will be discussed further, but for now they are described along the three metrics in Table 13.1

Table 13.1: The Four Basic Market Structures Described

With this categorization in place we can turn to the definition of perfect competition. Perfect competition is a market with many firms, an identical product and no barriers to entry. Let’s take these three metrics one by one.

Many firms. Many firms means that from the perspective of one individual firm there is no way to raise or lower the market price for a good. This is because the individual firm’s output is such a small part of the overall market that it does not make a difference in terms of price. Firms are, therefore, price takers, meaning that their decision is simply how much to sell at the market price. If they try and sell for a higher price, no one will buy from them, and they could sell for a lower price, but if they did so, they would only be hurting themselves because it would not affect their quantity sold. Thus from an individual firm’s perspective, they face a horizontal demand curve. We assume they can sell as much as they want but only at the market price. This is an extreme assumption, as mentioned before, but there are some markets that resemble this description. Take the market for corn in the United States. The annual U.S. corn crop is roughly 12 billion bushels, and there are roughly 315,000 corn farms in the country. Thus average output per farm is about 38 thousand bushels annually or about 0.000003% of the total supply of corn in the U.S. If one farmer, of average corn acreage decided to withhold output there would not likely be any effect on the market price. It is also true that consumers are price takers as well, meaning no one consumer has a large enough impact to affect prices.

Identical goods. Identical goods means there is nothing to distinguish one firms goods from another. To use the corn example, once all the corn is dumped into the grain elevator there is absolutely no way to tell from which farm a particular kernel of corn came. This means there is no way for one seller to differentiate their output to try and sell it at a different price on the premise that it is different. Contrast this to the automotive market where the products are heterogeneous. Cars manufactured by Audi are very different than cars manufactured by Kia. An Audi A6 is very different than a Kia Optima in many substantive ways. Even when there is very little of substance that is different, branding can be used to differentiate. Take, for example, polo shirts from Lacoste and Ralph Lauren. The shirt might be almost identical in terms of style, fabric, color, etc., but through branding them with a logo – a crocodile or polo player – the manufacturers are able to differentiate them in the minds of consumers.

Free entry and exit. It is very easy for firms to start and stop selling in this market. For example, if a farmer decides to plant corn instead of soybeans, there is nothing preventing them from doing so. Likewise a farmer who wishes to plant soybeans instead of corn faces no barriers. In general free entry and exit mean that there are no legal barriers to entry, like needing a special permit only given to a limited number of firms, and no major cost obstacles, like needing to invest millions of dollars in a manufacturing plant as a new car manufacturer would. This ensures that firms remain price takers even when demand increases. If there is suddenly more demand for corn, perhaps from ethanol producers, farmers can quickly adjust their crops so existing growers do not have an opportunity to raise prices. Free exit is important as well because if firms know they cannot exit easily, they might be reluctant to enter in the first place.

There are two other implicit assumptions worth mentioning here. The first is that we assume that buyers and sellers have full information meaning that they know the prices charged by every firm. This is important because without it a firm could possibly charge an uninformed consumer more and this violates the price taker condition. The second is that there are negligible transaction costs meaning it is easy for customers to switch sellers and vice-versa. This is also important to ensure price taking for if transactions costs were high customers might accept higher process from existing suppliers to avoid the cost of initiating a new transaction with s supplier at a lower price.

Take a moment and think about the policy example, retail gas, and how well it matches with our definition of a perfectly competitive market.

• Are there many sellers?
• Is the product identical?
• Are there barriers to entry?
• Is there full information and are transactions costs low?

Your answers to these questions will be the basis of our evaluation of the policy stance the federal government took in assessing the oil company mergers.

In Module 10 we studied profit maximization for a price taking firm. We now know in what type of market we find price-taking firms, perfectly competitive markets. In the three other market types we will consider, firms will all have some control over the price of the goods they sell. It is worth taking a moment to review the principles of profit maximization for price-taking firms.

We now know clearly what leads to the firm’s demand curve to be horizontal and thus the same as the Marginal Revenue curve, the fact that the firm is in a perfectly competitive market and has no influence on prices.

13.2 Perfect Competition and Efficiency

LO 13.2: Explain how perfectly competitive markets lead to Pareto efficient outcomes.

In module 11.4 we studied the concepts of consumer and producer surplus and defined Pareto efficiency. We saw how prices adjust to conditions of excess supply and excess demand until a price that equates supply and demand is reached. What this means is that the market ensures that everyone who values the good more than or equal to the marginal cost of producing it will find a seller willing to sell the good and that all opportunities for consumer and producer surplus will be exploited. This is how we know that total surplus is maximized.

In a perfectly competitive market, neither consumers nor producers have any influence over prices in the market leaving them free to adjust to supply and demand excesses. Because of this there is no deadweight loss, total surplus is maximized and the outcome of the market is Pareto efficient. Prices in competitive markets act as demand and supply signals that are independent of institutional control and ensure that in the end there are no mutually beneficial trades that do not happen. By mutually beneficial we mean that buyers and sellers wish to engage in them because they will both be made better off.

It is in this sense that ‘free’ markets are considered efficient. By ‘free’ we mean that prices freely adjust, that there are no institutional or competitive controls that prevent prices adjusting to equilibrate the market until the efficient outcome is achieved. By efficient we mean Pareto efficient or that there is no dead weight loss. With this Module we understand the conditions that must hold for a market to achieve the efficient outcome. There must be many buyers and sellers, the good must be homogenous, there must be free entry and exit, and that there is complete information about the good and prices on the part of buyers and there are no transactions costs. If this sounds like a lot, it is. In later Modules, we will examine the effects of other market structures and when assumptions like complete information fail to hold.

SUMMARY

Review: Topics and Related Learning Outcomes

13.1 Conditions for Perfect Competition

Learning Objective 13.1: Describe the characteristics of a perfectly competitive market.

13.2 Perfect Competition and Efficiency

Learning Objective 13.2: Explain how perfectly competitive markets lead to Pareto efficient outcomes.

Learn: Key Terms

Terms

Market structure

Perfect competition

Supplemental Resources