What you’ll learn to do: describe the characteristics of perfect competition and calculate costs, including fixed, variable, average, marginal, and total costs

Imagine the 7-year old you had a lemonade stand. It was one of several on the street. Your neighbor, Julie, also had a lemonade stand and she typically sold her lemonade for 25 cents. You figured that in order to make more money, you would charge 50 cents and steal all her customers. Sadly, everyone bought from Julie and you had no customers at all.

Welcome to the world of perfect competition. You will see in this section that because your lemonade stands were essentially identical, in order to remain in business and make any profit, you needed to be a price-taker instead of a price-maker.

When you were younger did you babysit, deliver papers, or mow lawns for money? If so, you faced stiff competition from other competitors who offered identical services. There was nothing to stop others from offering their services too. All of you charged the “going rate.” If you tried to charge more, your customers would simply buy from someone else. These conditions are very similar to the conditions agricultural growers face.

Figure 1. Depending upon the competition and prices offered, a wheat farmer may choose to grow a different crop. (Credit: modification of work by Daniel X. O’Neil/Flickr Creative Commons)

Growing a crop may be more difficult to start than a babysitting or lawn mowing service, but growers face the same fierce competition. In the grand scale of world agriculture, farmers face competition from thousands of others because they sell an identical product. After all, winter wheat is winter wheat. But it is relatively easy for farmers to leave the marketplace for another crop. In this case, they do not sell the family farm, they switch crops.

Take the case of the upper Midwest region of the United States—for many generations the area was called “King Wheat.” According to the United States Department of Agriculture National Agricultural Statistics Service, statistics by state, in 1997, 11.6 million acres of wheat and 780,000 acres of corn were planted in North Dakota. In the intervening 15 or so years has the mix of crops changed? Since it is relatively easy to switch crops, did farmers change what was planted as the relative crop prices changed? We will find out at module’s end.

In the meantime, let’s consider the topic of this module—the perfectly competitive market. This is a market in which entry and exit are relatively easy and competitors are “a dime a dozen.”

All businesses face two realities: no one is required to buy their products, and even customers who might want those products may buy from other businesses instead. Firms that operate in perfectly competitive markets face this reality. In this module you will learn how such firms make decisions about how much to produce, what price to charge, whether to stay in business or not, and many others. Industries differ from one another in terms of how many firms there are, how easy or difficult it is for a new firm to enter, and the type of products that are sold. This is referred to as the market structure of the industry. In this module we focus on perfect competition. However, in other modules we will examine other market structures, including monopoly, oligopoly and monopolistic competition.

What is Perfect Competition?

Firms are said to be in perfect competition when the following conditions occur: (1) the industry has many firms and many customers; (2) all firms produce identical products; (3) sellers and buyers have all relevant information to make rational decisions about the product being bought and sold; and (4) firms can enter and leave the market without any restrictions—in other words, there is free entry and exit into and out of the market.

A perfectly competitive firm is called a price taker, because the pressure of competing firms forces them to accept the prevailing equilibrium price in the market. When a wheat grower wants to know what the going price of wheat is, he or she has to go to the computer or listen to the radio to check. The market price is determined solely by supply and demand in the entire market and not the individual farmer. If a firm in a perfectly competitive market raises the price of its product by so much as a penny, it will lose all of its sales to competitors, since no rational consumer would pay a higher price for an identical product. Perfectly competitive firms, by definition, are very small players in the overall market, so that it can increase or decrease output without noticeably affecting the overall quantity supplied and price in the market. Since they can sell all the output they want at the going market price, they never have an incentive to offer a lower price. What this means is that a perfectly competitive firm faces a horizontal demand curve at the market price, as shown in Figure 1 below.

Figure 2. Perfectly Competitive Price. Since a perfectly competitive firm is so small relative to the market that however much output it supplies will have no effect on the market price, it can sell all it wants at the going market price. In short, a perfectly competitive firm faces a horizontal demand curve at the market price.

A perfectly competitive market is a hypothetical extreme; however, producers in a number of industries do face many competitor firms selling highly similar goods; as a result, they must often act as price takers. Economists often use agricultural markets as an example of perfect competition. The same crops that different farmers grow are largely interchangeable. According to the United States Department of Agriculture monthly reports, in 2015, U.S. corn farmers received an average price of $6.00 per bushel. A corn farmer who attempted to sell at $7.00 per bushel, would not have found any buyers. A perfectly competitive firm will not sell below the equilibrium price either. Why should they when they can sell all they want at the higher price? Other examples of agricultural markets that operate in close to perfectly competitive markets are small roadside produce markets and small organic farmers.

This module examines how profit-seeking firms decide how much to produce in perfectly competitive markets. Such firms will analyze their costs. In the short run, the perfectly competitive firm will seek the quantity of output where profits are highest or, if profits are not possible, where losses are lowest. In this example, the “short run” refers to a situation in which firms are producing with one fixed input and incur fixed costs of production. (In the real world, firms can have many fixed inputs.)

In the long run, perfectly competitive firms will react to profits by increasing production. They will respond to losses by reducing production or exiting the market. Ultimately, a long-run equilibrium will be attained when no new firms want to enter the market and existing firms do not want to leave the market, as economic profits have been driven down to zero.