14.2 Perfect Competition
While there are many equilibrium concepts in economics, the one we’re going to concentrate on here is the model of perfectly competitive markets. Such a market is characterized by four key assumptions:
- Lots of buyers and sellers: no one agent has any market power
- A homogoeneous good: sellers are not differentiated by quality or any other metric; everyone is selling an identical product
- Perfect information: all agents know the price being asked by all sellers
- Free entry and exit: there are no barriers to entry, so firms can enter (or leave) the market at any time
The first three assumptions imply that all buyers and sellers are price takers. Importantly, this does not mean that any agent is forced to accept a price. Rather, it means:
- All sellers believe that there is a market price at which they can sell as much of their goods as they would like. This price then becomes the optimal price for them to charge: if they charged more, they would sell no goods (because perfect information and homogeneity mean that consumers would just buy at the market price from one of their competitors), while if they charged less, they would earn less revenue for any given quantity sold for no reason.
- All buyers know that sellers can sell as much of their product as they like at the market price, so there is no sense in trying to negotiate lower prices.
In fact, we have already analyzed the behavior of buyers and sellers under these assumptions. In Chapter 8 we derived the demand function for an individual who took prices as given, and in Chapter 13 we derived the supply function for an individual firm that took prices as given. In this chapter we’ll bring consumers and firms together and analyze market equilibrium. In order to do that, though, we need to move from these individual demand and supply curves to market demand and supply curves.