Buyer power is likely to be high when some of the following conditions prevail, except

Learning Objectives

• Explain the conditions and implications of a perfectly competitive market

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.

Watch this video for an overview on how and why firms act the way they do in a perfectly competitive market. You’ll learn about the graphs for a perfectly competitive industry and a perfectly competitive firm, then see how cost curves are used to help identify a firm’s profits. We’ll dive deeper into each of these concepts in the pages that follow.

market structure: the conditions in an industry, such as number of sellers, how easy or difficult it is for a new firm to enter, and the type of products that are sold perfect competition: market structure where each firm faces many competitors that sell identical products so that no firm has any market power price taker: firms in a perfectly competitive market; since no firm has any market power they must take the prevailing market price as given

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The law of one price is an economic concept that states that the price of an identical asset or commodity will have the same price globally, regardless of location, when certain factors are considered.

The law of one price takes into account a frictionless market, where there are no transaction costs, transportation costs, or legal restrictions, the currency exchange rates are the same, and that there is no price manipulation by buyers or sellers. The law of one price exists because differences between asset prices in different locations would eventually be eliminated due to the arbitrage opportunity.

The arbitrage opportunity would be achieved whereby a trader would purchase the asset in the market it is available at a lower price and then sell it in the market where it is available at a higher price. Over time, market equilibrium forces would align the prices of the asset.

• The law of one price states that in the absence of friction between global markets, the price for any asset will be the same. 
• The law of one price is achieved by eliminating price differences through arbitrage opportunities between markets.
• Market equilibrium forces would eventually converge the price of the asset.

The law of one price is the foundation of purchasing power parity. Purchasing power parity states that the value of two currencies is equal when a basket of identical goods is priced the same in both countries. It ensures that buyers have the same purchasing power across global markets.

In reality, purchasing power parity is difficult to achieve, due to various costs in trading and the inability to access markets for some individuals.

The formula for purchasing power parity is useful in that it can be applied to compare prices across markets that trade in different currencies. As exchange rates can shift frequently, the formula can be recalculated on a regular basis to identify mispricings across various international markets.

If the price of any economic good or security is inconsistent in two different free markets after considering the effects of currency exchange rates, then to earn a profit, an arbitrageur will purchase the asset in the cheaper market and sell it in the market where prices are higher. When the law of one price holds, arbitrage profits such as these will persist until the price converges across markets.

For example, if a particular security is available for $10 in Market A but is selling for the equivalent of $20 in Market B, investors could purchase the security in Market A and immediately sell it for $20 in Market B, netting a profit of $10 without any true risk or shifting of the markets.

As securities from Market A are sold on Market B, prices on both markets should change in accordance with the changes in supply and demand, all else equal. Increased demand for these securities in Market A, where it is relatively cheaper, should lead to an increase in its price there.

Conversely, increased supply in Market B, where the security is being sold for a profit by the arbitrageur, should lead to a decrease in its price there. Over time, this would lead to a balancing of the price of the security in the two markets, returning it to the state suggested by the law of one price.

In the real world, the assumptions built into the law of one price frequently do not hold, and persistent differentials in prices for many kinds of goods and assets can be readily observed. 

When dealing in commodities, or any physical good, the cost to transport them must be included, resulting in different prices when commodities from two different locations are examined.

If the difference in transportation costs does not account for the difference in commodity prices between regions, it can be a sign of a shortage or excess within a particular region. This applies to any good that must be physically transported from one geographic location to another rather than just transferred in title from one owner to another. It also applies to wages for any employment where the worker must be physically present at the worksite to perform the job. 

Because transaction costs exist and can vary across different markets and geographic regions, prices for the same good can also vary between markets. Where transaction costs, such as the costs to find an appropriate trading counterparty or costs to negotiate and enforce a contract, are higher, the price for a good will tend to be higher there than in other markets with lower transaction costs.

Legal barriers to trade, such as tariffs, capital controls, or in the case of wages, immigration restrictions, can lead to persistent price differentials rather than one price. These will have a similar effect to transportation and transaction costs, and might even be thought of as a type of transaction cost. For example, if a country imposes a tariff on the importation of rubber, then domestic rubber prices will tend to be higher than the world price. 

Because the number of buyers and sellers (and the ability of buyers and sellers to enter the market) can vary between markets, market concentration and ability of buyers and sellers to set prices can vary as well.

A seller who enjoys a high degree of market power due to natural economies of scale in a given market might act like a monopoly price setter and charge a higher price. This can lead to different prices for the same good in different markets even for otherwise easily transportable goods.