What happens when markets do not work perfectly?
Fortunately, most businesses are more consumer friendly than cell phone companies were when Sullivan wrote his 2007 book. Take T-shirt producers, for example. If you go shopping for a T-shirt, you will find hundreds of colors, styles, and designs to choose from, in a wide range of prices. The T-shirt industry is very competitive, with many different producers. It is apparent that cell phone service providers and T-shirt producers operate in different markets, with different levels of competition. What accounts for these differences?
An economist would answer those questions by pointing out that the T-shirt and cell phone industries have different market structures. Market structure refers to the organization of a market, based mainly on the degree of competition among producers.
Economists define market structure according to four main characteristics.
Number of producers. The number of producers in a market helps determine the level of competition. Markets with many producers are more competitive.
Similarity of products. The degree to which products in a market are similar also affects competition. The more similar the products are, the greater the competition among their producers.
Ease of entry. Markets differ in their ease of entry, which is a measure of how easy it is to start a new business and begin competing with established businesses. Markets that are easy to enter, with few restrictions, have more producers and are thus more competitive.
Control over prices. Markets also differ in the degree to which producers can control prices. The ability to influence prices — usually by increasing or decreasing the supply of goods — is known as market power. The more competitive the market, the less market power anyone producer will have.
Based on these characteristics, economists have identified four basic market structures: perfect competition. monopoly, oligopoly, and monopolistic competition. These structures are shown on this spectrum, from most competitive to least competitive. As you read. keep in mind that these four models are not always easy to identify in the actual economy. In some cases, a market will have mixed features, making it hard to tell how competitive it is.
The most competitive market structure is perfect competition. In a perfectly competitive market. a large number of firms produce essentially the same product. All goods are sold at their equilibrium price. or the price set by the market when quantity supplied and quantity demanded are in balance. Economists consider perfect competition to be the most efficient market structure in terms of allocating resources to those who value them most.
Although many markets are highly competitive, perfect competition is relatively rare. It exists mainly among producers of agricultural products. such as wheat. corn. tomatoes. and milk. Other examples of perfectly competitive markets include commercial fishing and the wood pulp and paper industry.
Perfect competition has four main characteristics.
Many producers and consumers. Perfectly competitive markets have many producers and consumers. Having a large number of participants in a market helps promote competition.
Identical products. Products in perfectly competitive markets are virtually identical. As a result. consumers do not distinguish among the products of different producers. A product that is exactly the same no matter who produces it is called a commodity. Examples include grains. cotton. sugar. and crude oil.
Easy entry into the market. I n a perfectly competitive market, producers face few restrictions in entering the market. Ease of entry ensures that existing producers will face competition from new firms and that a single producer will not dominate the market.
No control over prices. Under conditions of perfect competition. producers have no market power. They cannot influence prices because there are too many other producers offering the same product. Instead. the market forces of supply and demand determine the price of goods. Producers are said to be price takers because they must accept. or take. the market price for their product.
In addition to these characteristics, one other feature distinguishes highly competitive markets: easy access to information about products and prices. A person shopping for a car, for example, can easily find out the range of models, features, and prices available. Such information is readily accessible at car dealerships, in published reports, and on the Internet. Information gathering involves tradeoffs, however. Consumers must balance the time and expense of gathering such information with the money saved by finding a good deal.
Economists refer to the costs of shopping around for the best product at the best price as transaction costs. The Internet has helped reduce transaction costs by making product and price information more readily available. Instead of driving to various stores or making multiple phone calls, consumers can often make price comparisons over the Internet with less time and effort.
To get a better idea of how perfect competition works, consider the market for milk. To begin with, the milk market has many producers — about 51,000 dairy farms in the United States. They all offer the same basic commodity. Milk from one farm is pretty much the same as milk from any other farm.
Furthermore, no farm produces enough milk to dominate the market and achieve market power. There are simply too many farms, and the overall quantity of milk produced is too great for any one producer to influence prices by increasing or decreasing supply, so dairy farmers must be price takers and accept the market price for their milk. If they were to charge more than the market price, their buyers — firms that process milk into dairy products — would simply buy milk from some other producer.
Milk production also offers relative ease of entry. Anyone who wants to become a dairy farmer can enter the market, assuming that he or she has the resources. Even a farmer with only a few cows can sell milk to a local milk processor.
Thus, milk production satisfies the four criteria for perfect competition: many producers, identical product, no control over prices, and easy entry into the market.
Our look at dairy farming hints at some of the obstacles that can restrict access to a market and limit competition. Such obstacles are known as barriers to entry.
One possible barrier is start-up costs, or the initial expense of launching a business. It is much less expensive, for example, to open a bicycle repair shop than it is to open a bicycle factory. An entrepreneur with little financial capital might find it difficult to get into bicycle manufacturing because of the high cost of building a factory.
The mining industry offers an example of another barrier to entry: control of resources. If existing mining companies already control the best deposits of iron, copper, or other minerals, it will be hard for new firms to enter the market.
Technology can pose yet another barrier. Some industries are more technology driven than others. The need for specialized technology or training may make it difficult to enter these markets. The computer industry is one example. Not only does the manufacture of computers require advanced technology, it also requires specialized knowledge that can be obtained only through years of education. These factors may act as a barrier, keeping new firms out of the computer market.
As the name suggests, perfect competition is rare in its purest form. Because it is the most efficient market structure, economists consider perfect competition to be the benchmark, or standard, for evaluating all markets. That said, many markets are competitive enough to be “nearly perfect.“
Such nearly perfect markets are beneficial in two ways. First, they force producers to be as efficient as possible. When producers can sell only at the equilibrium price, the only way to maximize profits is by allocating resources to their most valued use and by keeping production costs as low as possible. Second, because perfect competition is efficient, consumers do not pay more for a product than it is worth. The equilibrium price of a product in a perfectly competitive market accurately reflects the value the market places on the productive resources — land, labor, and capital — that have gone into it.
Economists Robert Heilbroner and Lester Thurow summed up the benefits of perfect competition: