Extract http://tutor2u.net/economics/revision-notes/a2-micro-perfect-competition.html
Perfect competition – a pure market
Perfect competition describes a market structure whose assumptions are strong and therefore unlikely to exist in most real-world markets. Economists have become more interested in pure competition partly because of the growth of e-commerce as a means of buying and selling goods and services. And also because of the popularity of auctions as a device for allocating scarce resources among competing ends.
Assumptions for a perfectly competitive market
Many sellers each of whom produce a low percentage of market output and cannot influence the prevailing market price.
Many individual buyers, none has any control over the market price
Perfect freedom of entry and exit from the industry. Firms face no sunk costs and entry and exit from the market is feasible in the long run. This assumption means that all firms in a perfectly competitive market make normal profits in the long run.
Homogeneous products are supplied to the markets that are perfect substitutes. This leads to each firms being “price takers” with a perfectly elastic demand curve for their product.
Perfect knowledge – consumers have all readily available information about prices and products from competing suppliers and can access this at zero cost – in other words, there are few transactions costs involved in searching for the required information about prices. Likewise sellers have perfect knowledge about their competitors.
Perfectly mobile factors of production – land, labour and capital can be switched in response to changing market conditions, prices and incentives.
No externalities arising from production and/or consumption.
Evaluation – Understanding the real world of imperfect competition!
It is often said that perfect competition is a market structure that belongs to out-dated textbooks and is not worthy of study! Clearly the assumptions of pure competition do not hold in the vast majority of real-world markets, for example, some suppliers may exert control over the amount of goods and services supplied and exploit their monopoly power.
On the demand-side, some consumers may have monopsony power against their suppliers because they purchase a high percentage of total demand. Think for example about the buying power wielded by the major supermarkets when it comes to sourcing food and drink from food processing businesses and farmers. The Competition Commission has recently been involved in lengthy and detailed investigations into the market power of the major supermarkets.
In addition, there are nearly always some barriers to the contestability of a market and far from being homogeneous; most markets are full of heterogeneous products due to product differentiation – in other words, products are made different to attract separate groups of consumers.
Consumers have imperfect information and their preferences and choices can be influenced by the effects of persuasive marketing and advertising. In every industry we can find examples of asymmetric information where the seller knows more about quality of good than buyer – a frequently quoted example is the market for second-hand cars! The real world is one in which negative and positive externalities from both production and consumption are numerous – both of which can lead to a divergence between private and social costs and benefits. Finally there may be imperfect competition in related markets such as the market for key raw materials, labour and capital goods.
Adding all of these points together, it seems that we can come close to a world of perfect competition but in practice there are nearly always barriers to pure competition. That said there are examples of markets which are highly competitive and which display many, if not all, of the requirements needed for perfect competition. In the example below we look at the global market for currencies.
Currency markets - taking us closer to perfect competition;
The global foreign exchange market is where all buying and selling of world currencies takes place. There is 24-hour trading, 5 days a week.
Trading volume in the Forex market is around $3 trillion per day – equivalent to the annual GDP of France! 31% of global trading takes place in London alone.
Most trading in currencies is ‘speculative.’
The main players in the currency markets are as follows:
Banks both as “market makers” dealing in currencies and also as end-users demanding currency for their own operations.
Hedge funds and other institutions (e.g. funds invested by asset managers, pension funds).
Central Banks (including occasional currency intervention in the market when they buy and sell to manipulate an exchange rate in a particular direction).
Corporations (for example airlines and energy companies who may use the currency market for defensive ‘hedging’ of exposures to risk such as volatile oil and gas prices.)
Private investors and people remitting money earned overseas to their country of origin / market speculators trading in currencies for their own gain / tourists going on holiday and people traveling around the world on busine
Why does a currency market come close to perfect competition?
Homogenous output: The "goods" traded in the foreign exchange markets are homogenous - a US dollar is a dollar and a euro is a euro whether someone is trading it in London, New York or Tokyo.
Many buyers and sellers meet openly to determine prices: There are large numbers of buyers and sellers - each of the major banks has a foreign exchange trading floor which helps to "make the market". Indeed there are so many sellers operating around the world that the currency exchanges are open for business twenty-four hours a day. No one agent in the currency market can, on their own influence price on a persistent basis - all are ‘price takers’. According to Forex_Broker.net "The intensity and quantity of buyers and sellers ready for deals doesn't allow separate big participants to move the market in joint effort in their own interests on a long-term basis."
Currency values are determined solely by market demand and supply factors.
High quality real-time information and low transactions costs: Most buyers or sellers are well informed with access to real-time market information and background research analysis on the factors driving the prices of each individual currency. Technological progress has made more information immediately available at a fraction of the cost of just a few years ago. This is not to say that information is cheap - an annual subscription to a Bloomberg or a Reuter’s news terminal will cost several thousand dollars. But the market is rich with information and transactions costs for each batch of currency bought and sold has come down.
Seeking the best price: The buyers and sellers in foreign exchange only deal with those who offer the best prices. Technology allows them to find the best price quickly.
What are the limitations of currency trading as an example of a competitive market?.
imitations of currency trading as an example of a competitive market?
Firstly the market can be influenced by official intervention via buying and selling of currencies by governments or central banks operating on their behalf. There is a huge debate about the actual impact of intervention by policy-makers in the currency markets.
Secondly there are high fixed costs involved in a bank or other financial institution when establishing a new trading platform for currencies. They need the capital equipment to trade effectively; the skilled labour to employ as currency traders and researchers. Some of these costs may be counted as sunk costs – hard to recover if a decision is made to leave the market.
Despite these limitations, the foreign currency markets take us reasonably close to a world of perfect competition. Much the same can be said for trading in the equities and bond markets and also the ever expanding range of future markets for financial investments and internationally traded commodities. Other examples of competitive markets can be found on a local scale – for example a local farmers’ market where there might be a number of farmers offering their produce for sale.
internet and perfect competition
Advances in web technology have made markets more competitive. It has reduced barriers to entry for firms wanting to compete with well-established businesses – for example specialist toy retailers are better able to battle for market share with the dominant retailers such as ToysRUs and Wal-Mart.
One of the most important aspects of the internet is the ability of consumers to find information about prices for many goods and services. There are an enormous number of price comparison sites in the UK covering everything from digital cameras to package holidays, car insurance to CDs and jewellery.
That said the price comparison web sites themselves have come under criticism. For example the sites offering to compare hundreds of different motor insurance policies or mortgage products draw information from the insurance and mortgage brokers but might use limiting assumptions about the different types of consumers looking for the best price – the result is a range of prices facing the consumer that don’t accurately reflect their precise needs – and consumers may only realise this when, for example, they make a claim on an insurance policy bought over the internet which turns out not to provide the specific cover they needed.
And in the market for price comparison sites there is monopoly power too! Moneysupermarket.com currently has around 40% of the overall comparison site market, with Confused.com its nearest rival with a share of about 10%.