Why analyze a firm’s decisions under conditions of perfect competition?

This module is the second in the theory of the firm and the first of three modules examining models of market structure. Market structure means, in a nutshell, how competitive or monopolistic is a particular industry. It should be clear that market structure influences how firms behave. Figure 1 shows the full spectrum of types of markets, from perfect competition with many firms, to a monopoly, with one firm controlling the marketplace.

Figure 1. The Spectrum of Market Structure. Firms face different competitive situations. At one extreme—perfect competition—many firms are all trying to sell identical products. At the other extreme—monopoly—only one firm is selling the product, and this firm faces no competition. Monopolistic competition and oligopoly fall between the extremes of perfect competition and monopoly. Monopolistic competition is a situation with many firms selling similar, but not identical, products. Oligopoly is a situation with few firms that sell identical or similar products.

We start by looking at the ideal model of perfect competition. This model is a bit of a head scratcher since there are, actually, very few examples of industries like this in the real world. Why then do we study it? Here’s a question for you to think about as you move through the module: what’s so perfect about perfect competition? Hint: the model has certain ideal features that you will learn and apply to the other markets.

Figure 2. The cost of tomatoes at a farmer’s market is an example of a perfectly competitive market. Farmer’s Market by Andre Natta, CC-BY. Firey Tomatoes by Swaminathan, CC-BY. NorthCharleston Farmer’s Market by NorthCharleston, CC-BY-SA. What’s Better than Love CC torbakhopper, CC-BY.

Have you ever noticed that all the tomatoes of the same type in a farmer’s market cost about the same price? The same thing is true of roadside vegetable stands in the countryside. If one stall in a locality has tomatoes for $3 per pound, they all do. Now the price may change from week to week, but it’s always the same across the different vendors in the market. You will soon learn why this is.

There are more similarities than differences between this module and the others that follow it. What you learn in this module will carry over and help you understand the next ones, so the more effort you put into learning this one, the easier the next three modules will be.