This is the first of our “toe-dips” into the world of economics for the website. Having last studied economics at undergrad many years ago, it’s not an area of expertise by any stretch. Nonetheless, it has been an area of great interest over many years and one we will build on through the website in the years to come. So the first topic we are going to look at is that dealing with perfect competition and in particular what its five characteristics are.
Background to Perfect Competition
When looking at competition in theory and practice we are concerned with unplanned economies, not ones dictated or “planned” from above. Where decisions are about how resources are used, or as the accountants might say economic benefits, and distributed are largely made by the individual rather than the state. However, even in the freest countries around the world this is very difficult to find.
In this type of economy it is prices that drive changes by producers and consumers, rather than some central committee or department.
But of course we find no economy where all of the economic decisions are made by the individual or by the state. Instead we find examples of “mixed economies” that sit along this line between 100% free market and 100% planned.
Prices, Markets and Perfect Competition
The interaction of buyers (demand) and producers (supply) produces prices. And where they produce these prices is known as a market. Or perhaps another way of looking at it, all a market is is a place of price discovery.
This is one of the first things taught in economics 101 and is fundamental to the understanding of how markets work. And this is fundamental to understanding what competition is, and in particular for today, perfect competition within a given market model.
A concept economists use is that of perfect competition. Which, as we noted above, does not tend to be found in the real world, but it still provides a very useful model to help explain how markets, as imperfect as they are, operate.
In the development of models, such as perfect competition for a given market, the economist will take the tenants or characteristics of this model and compare it to what is found in the real world. The model provides an explanatory tool in analysis of past market performance and a potential predictive tool based on certain conditions going forward. Part of the reason for this approach is that the real world is far more complex than we are able to develop models for. Nonetheless, they provide a tool that can help us understand the real world.
So always be wary when someone tells you with great certainty that x or y is going to happen in the future based on some model. No matter the field or discipline, models are just models – they are not crystal balls of prediction.
The Five Common Characteristics of Perfect Competition
So with some background pf how prices are derived and what markets we move into what are the underlying assumptions of perfect competition, in particular the five common characteristics of the model.
Commodities are Alike
In a perfectly competitive market the first thing we need is the items being bought and sold are effectively identical. Or in other words, any differences between them are of such little interest to the buyers and sellers, any differences that do exist have no impact upon the supply and demand.
An example of this in a market would be say a company’s stock. Setting aside the different between the company and others in that market, a particular company’s shares will be identical (company ordinary A shares) with the buyers and sellers indifferent to which share in particular they buy or sell.
Many Buyers and Sellers
The second characteristic is that there must be many buyers and sellers in the market. This provides continuous, ongoing, supplier of both consumers and producers and so at no time there is no matching willing seller for every willing buyer.
The crypto market provides us with a good example here. In large cap currencies, such as Bitcoin (BTC) and Ethereum (ETH), there is an “endless” supply both sides of a trade, with the price reflecting this interaction. Where the much smaller stocks, such as the recent (at time of writing) Vehicle Data Artificial Intelligence Platform (VAIP) coin, it will be difficult to find someone to take the other side of the trade you wish to make.
Closely tied to characteristic two is that of market share. With many buyers and sellers no one party will have influence over the price – no matter their actions. Their share of the market activity cannot be that their buy or sell order will move the price.
Again, if we used BTC and VAIP from above. There are some players, or crypto whales as they are referred to in crypto speak, that can move BTC’s price. However, this is limited to very few individuals. In general, the “normal” individual BTC trade does not move the price (ie people are price takers, not price makers). However with VAIP, looking at current trading volume, any individual buying or selling would significantly move VAIP’ price.
Perfect Market Knowledge
The forth common characteristic of perfect competition is each participant in the market having access to and being able to process all relevant information. In other words they have perfect knowledge. I couldn’t think of an example here because we are dealing with a problem in the model with humans. Even if each person had access to the same information, each would process it in different ways based on their experience, ability, time pressures, etc.
This problem is attempted to be dealt with in the world’s major markets, in particular equities, where insider-trading is illegal and criminal. I’m suspecting this still doesn’t stop it going on, but the legislation and regulations in different jurisdictions do try to create as level a playing field as possible.
Zero Barriers to Entry
The fifth and final characteristic that is comment to perfect competition is that of buyers and sellers mobility in and out of the market. More frictionless a move is for a buyer or a seller from one market to another the greater the competition a market will face; and better place it will be for price discovery.
By removing barriers to entry of a market participants can better pursue their own self-interest in determining their allocation of resources, in both buying and selling. Adam Smith wrote about this point in his Wealth of Nations, where he postulated where the opportunity for us to pursue those goals of greatest value and importance to us leads to the most optimum allocation of resources within a society, without the need for co-ordination or coercion.
Where a market operates in a state of perfect competition then a single price will be established for that good or service. Perfect knowledge will mean buyers will not pay different prices. Perfect mobility of participants means where a price difference arises buyers and sellers can move to take advantage of it. And where the products or services are the same preferences will not arise causing differences in price.
Therefore an equilibrium price will be established, one established purely by the demand and supply. And not a price influenced by a single actor, or group colluding together, to establish a price difference to their advantage.