Truly Understanding Perfect Competition
WHAT IS THE PERFECT COMPETITION?
If you live in a democracy, you’re witness to ‘free market’ and the ideal perfect competition, which honestly, seldom exists.
Yet, economists vouch for it, and you get to read about it on your Economics Majors or even when you’re doing your MBA.
We have all heard the words “Perfect Competition” at some point in our lives; be it at an Economics class, the news or your intellectual sibling showing off at the dinner table.
We’ve all heard it, but what exactly does it mean and does something like this exist in our current world?
Perfect Competition is a scenario used by the economists and businessmen of the world to illustrate a certain situation, learn about its characteristics and gain insights, which can, in turn, be used in the real world.
The assumptions used in this scenario are very strong, and the chances of it happening in the real world are next to nothing.
A perfectly competitive market means exactly what it says.
Think of it as an opposite of a monopoly, which is where one single business owns all the market share and controls that market for both the consumers and other businesses.
The competition level between the businesses in this market is at the highest possible level and individual businesses are not able to do anything more to improve their level over any of the others.
Therefore, there is not just a single business in control but rather every one of them available in the market will be equal.
You need a leader who makes the right decision, every time. We all know that it cannot happen.
Here is the graph of what a perfectly competitive firm would look like.
According to strategists and economists, these types of markets will be the most beneficial to both consumers and society in general.
So what makes a market perfectly competitive?
Let’s break it down below.
CHARACTERISTICS OF PERFECT COMPETITION
There are several assumptions that are made when this scenario is taken into account.
These assumptions are what make a market perfectly competitive, and as you will see, most of them are almost impossible to achieve in the real world.
Imagine a world where every business knows everything about the running of another business.
We’re talking about production costs, supplier prices, component prices, and even advertising costs and data.
There is no hiding of any information from your supplier, and thus there is no stopping all the businesses using all this data to find the cheapest source for all services and ending up using them themselves.
This would mean that every competitor in that market will have the same costs, the same data and the same strategies totalling from the past, the present and the future.
If you take today’s markets in comparison, we can see that a lot of businesses can go out of business if we had perfect knowledge.
For certain companies, if the supplier prices or the sources where they get their parts from are let out, there will be no stopping their competitors from using the same information which will make their business irrelevant to the consumers.
An example of this could be Samsung with its front screen glass displays.
Even Apple uses Samsung’s technology to create their screens for the XS Model and will continue to use it in the future because of its superiority to their own.
However, if this information was to be publicly known, Apple would not need Samsung for this process and will start to produce their own which reduces Samsung’s brand value significantly, and Samsung will face a reduction in sales and competency.
Another example would be for companies that are centred on their research and patents.
These allow the business to be different from others and helps protect them from competitors looking to steal their ideas.
But in a perfect market, these patents will not exist and any intensive research done will not be exclusive and so the whole foundation of these types of businesses will not exist, and they will not last long in the face of their competitors.
Perfect knowledge in this scenario is available to all market participants which includes the consumers as well, which means that all consumers interacting in that market will have all the information as well and will know everything about each business.
When I first came across this word, I remember someone asking our teacher if it had something to do with evolution, like an evolutionary product.
Coming from an English school, I had never seen a teacher look more mortified at our lack of knowledge with the English vocabulary. We were a year away from our Advanced Level.
All joking aside, what a homogenous product means is that there is a perfect substitute for every product.
This means that all businesses will create the same product, with the same features and without branding.
Therefore, any product can be easily replaced by the product from another company as they will essentially be the same thing.
For example, take Coca-Cola.
In a perfect market there will assumedly be no other competitors like Pepsi or the other copycats that are available in today’s market, but rather there would be just one product called “Cola” which will be produced by all the businesses in this industry and there would be no other variation.
As we spoke about before, there is perfect knowledge, so Coca-Cola’s infamous recipe which no other business knows will be public knowledge and thus everyone will start to follow the same methods.
In a scenario like this, consumers will benefit in the form of low prices as the products are all the same and so suppliers cannot charge a higher price for different variations and because there is perfect competition, the prices will be as low as possible so as to not lose to the other competitors.
However, this will also mean that the different choices that we have in the real world will not exist and consumers are forced to buy only that one particular type of product.
It is also assumed that every unit of input is homogenous and that every business has access to all factors of production.
This means that every cost/input that goes into making a product such as labor costs or electricity costs will be the same for all businesses, and all the raw materials and other FOP (Factors of Production) that are needed are immediately available to any business in the market.
Again, this is a major assumption as this will be impossible in the real world due to the scarcity of FOP as there are not enough resources in the world to satisfy everyone’s needs.
No Barriers to Entry or Exit
Barriers here refers to the problems, rules, costs, and laws that a business will face when they attempt to enter into or exit from a market.
Certain markets can be very easy to enter into but may be hard to leave and the opposite can be true as well.
Barriers to entry will include set-up costs (could be expensive for technology firms, or require large amounts of capital, for instance), government laws, scarce funding methods and price cutting from competitors.
Usually, if a big contender in a particular market sees that more businesses are trying to set up in the same market, they will tend to use their power to stop them from entering or drive them out before they have a chance to set up properly.
They do this by undercutting their prices (selling below costs which may be impossible for a smaller business which is just starting out to do) and intensive marketing.
Barriers to exit can include highly specialized assets which are really difficult to sell off or high exiting costs such as closure costs and writing off assets.
Governments play a big role in the current market by establishing certain regulations and price controls in order to be able to control the entry and exit of businesses into a specific market.
These rules will differ from each market, and thus certain markets will have a really high barrier to entry compared to others such as those that affect the health of consumers directly.
A company which produces pharmaceutical products will have to go through a lot more processes which will lead to higher costs and so will require a high starting capital. In a perfectly competitive market, however, these government regulations do not exist, and so all the barriers are removed.
It’s assumed that any business can easily enter or leave a market without any problems from the government or other suppliers and also certain markets that used to have high costs can enjoy lower rates now as they are free to plan their costs accordingly and not stick to government controls.
A Large Number of Buyers and Sellers
In a perfect market, there are no barriers to entry.
Thus, nothing is stopping any business from entering into a market.
In today’s world, there are many market places, but not all of them have a large number of buyers and sellers.
It all depends on the prices of the commodity and the use or value of it.
Certain markets may have a lot of sellers but not enough buyers to purchase all these products and vice versa.
The reasons as to why there are so many discrepancies are scarcity, lack of information and pricing.
In a perfect market, all of those characteristics are assumed to be equal, and thus it is assumed that all the markets will have a lot of buyers and sellers who work within that market.
Firms are Price Takers
Think about the products that we have in today’s market.
There are so many different variations to a particular type of product, and they all have different prices that vary due to certain functions, brands, value, or even technicality.
There are a lot of reasons as to why a business will charge different prices for a product.
Now, we can even see a large difference in prices of a similar product from which one is from a branded and known name whereas the other is a substitute many people haven’t heard of.
So, we can say that prices are not derived solely from the supply and demand levels of the market but that individual businesses are price-makers and they have the power to change their prices in accordance to their market share, competency level, and brand name and so on.
Each business can price their products differently and still be able to do sales.
In a perfectly competitive market, businesses become price-takers. In this market, competitiveness between businesses is so high that even a small change in the price above that of the competitors would mean that the business would lose all its sales to its competitors.
Since there are so many substitutes and businesses that are of the same value and have the same features, and since consumers also have perfect knowledge on the market, this small change in price will make the consumers just shift to another business as their price would be comparatively lower.
In this market, the price is determined by the demand and supply levels. No individual business can influence how the pricing goes no matter how much of market share they own.
Trying to undercut the price and go below that of their competitors has no value as they could easily sell at the given market price and make more profits.
Since there are so many sellers (competitors) in the market, one individual business making changes to the prices will not affect the market as it will be a very insignificant change overall.
It will account for only a very small percentage in the whole market and will not affect the total quantity supplied and price points in the market.
This is great for the consumers as they will enjoy nominal value for their purchases of any product.
OBJECTIVE, EXTERNALITIES, AND PROFITS
In a perfect market, certain objectives are assumed for both consumers and suppliers due to their being perfect knowledge.
This knowledge is supposed to allow both these groups to form rational decisions and so work for their own self-interest separately.
Thus, consumers are assumed to be always looking to maximize how much utility they get and suppliers are assumed always to be maximizing profits.
The same can be said to a majority of how things are run in the real world, but as of late, there are a lot of businesses which focus on social service and not profit.
There are even consumers who don’t buy all their products for their usefulness but also their story and brand.
Externalities refer to all the third-party influences that are involved in the transactions.
This will include negative externalities (Pollution to the surrounding environment) and positive externalities (Education Received).
A perfectly competitive market assumes that these externalities do not exist.
These are forces that are not always within the businesses control and every business will face these externalities as they are naturally occurring in society, which is why it cannot be applied to real-world contexts.
Finally, the last assumption that is made for a perfectly competitive market is that the businesses can only make super profits in the short-run. In the long-run, all of their profits will fall to a more normal level.
How this works is that when a market becomes perfectly competitive, in the beginning, there will only be a few businesses operating in a particular market.
This market will face all the changes that come with being perfectly competitive and so the businesses that already exist will start to make abnormal profits during this period.
However, due to there being low barriers to entry, other businesses will see the abnormal profits being made in the market and so will flock there. In the long-term, this will increase the supply in the market which will inevitably lead to a fall in price and thus a fall in profits.
A Look at Perfect Competition in the Ecommerce Industry
Today, online shopping is a popular method which customers prefer for a number of reasons.
Different ecommerce companies have started offering all kinds of goods and products which can be bought directly from the website.
The retail ecommerce sales in 2017 across the world reached $2.3 trillion and are expected to grow to $4.88 trillion in 2021.
Many companies operating physical stores have moved to the e-commerce industry to gain a share of the market and increase their profitability.
Online shopping is a common behavior in almost all countries in the world due to advance in technology, mobile devices and high-speed internet.
Here is a video that shows perfect competition in the online industry.
The eBay Company Profile
eBay was established in 1995 as an online platform that connected buyers and sellers across the world. The multinational platform enables sellers to offer their inventory while buyers can find a place to purchase them.
The company does not own its inventory, and the sellers are responsible for shipping the products. eBay charges a small commission on the sale price of an item from the buyers.
eBay own country-specific websites for different countries including USA, UK, Canada, China, Australia, Italy, Netherlands, Portugal, Spain, Singapore, Norway and Vietnam.
The company earned net revenue of $9.7 billion in 2017 increasing from $8.99 billion in 2016.
Competitive Strategy of eBay
eBay employs a cost leadership strategy to gain a competitive advantage in the market.
The company relies on cost minimization to remain competitive in the market offering goods at lower prices or high-profit margins.
Cost leadership model enables a firm to enjoy a competitive advantage by becoming a low-cost producer in the industry.
The firm should be able to explore all avenues of the cost advantage to remain profitable in the market.
eBay has brought changes to its fee and charges to enable the sellers to offer goods at lower prices.
In the early days of operation, eBay used to charge users an insertion fee based on the item price in an auction. It would also charge a final fee when the item had been sold.
However, eBay has removed the insertion fee for the sellers though it continues to charge the final fee.
The company has also provided each seller on the platform with 20 free listings which the sellers can use without any charge.
They have also adjusted the final fee and reduced it to 10% of the sale price of the item.
eBay has also brought affordable packages for the power sellers who can get 150 to 2,500 free listings and charge them a lower final value fee compared to other sellers.
eBay also takes help of technology to minimize the price of goods.
The technology is used to cut back fixed and variable costs in their global e-commerce operations and increase the efficiency of the selling process.
The company does not own any inventory and logistics operations which is another reason it can offer goods at lower prices. eBay also takes help of its marketing mix to develop attractive pricing policies for sellers and buyers who use the online auction and retail platform.
The company makes use of strategic objectives, comprehensive growth strategies and management practices that lower the operating cost and the overall cost of various processes.
The company also follows the strategic objective of using advanced technology to exploit economies of scale. It also employs tactics to increase the number of users so that it can continue to sell goods at lower prices.
A high number of users enable eBay to distribute their fixed costs so that they can earn higher profits by lowering the price of goods.
eBay has also used the market adaptation strategy to gain a competitive advantage over other online portals.
It started as an auction platform selling products only through bidding. Users who had placed the highest bids would be able to buy the item from the seller.
However, gradually eBay understood the importance of retail sales and pioneered the fixed price strategy with their ‘Buy it now’ option.
Buyers could get past the bidding process and buy items at a fixed price from the sellers.
Currently, it offers both fixed price and auction listings to get a significant market share and enjoy a competitive advantage.
eBay has used the cost leadership strategy with market adaptation to become one of the top e-commerce platforms in the world.
eBay faces stiff competition from other e-commerce companies around the world. It has become the second largest marketplace with Amazon leading the ranks.
Amazon needs to work on its seller service and customer service which has been facing issues on many grounds.
Many times dishonest customers have cheated eBay into giving them refunds by claiming a return. The buyers ordered items and returned fake or damaged items claiming refunds.
eBay went ahead and issued the refunds sometimes subtracting the money from seller accounts. eBay has been losing on sellers who are attracted to other platforms with large customer base such as Amazon.
eBay has to work on a more intuitive system to address the problems of the sellers. It needs to bring innovation into its operations to gain the ground it has lost to other e-commerce companies.
The company should invest in research and development to deliver innovation with new technologies to disrupt the industry. It should work on technologies so that online transactions are conducted securely.
eBay should analyze its value chain and network to reposition itself in the market. The analysis will help the firm to identify the actions that will enhance its strategic capabilities to generate more profit.
eBay can also create value by forming an alliance strategy with different partners so that it can come out with advertisements which will bring a competitive advantage.
The firm should try to determine what the customers want to buy and how to attract their attention.
It is crucial as there are many e-commerce platforms to opt for.
The company also needs to work on its logistics so that it can deliver goods to its customer at different locations.
eBay should also look to expand to international markets so that it could raise its revenue and attract more sellers.
ADVANTAGES OF PERFECT COMPETITION
- Businesses will operate at their highest efficiency due to the availability of costs of production and how low these prices are. High competitiveness will force all the businesses to work extra hard to match the quality of the products in the market.
- Consumers will enjoy lower prices as all the businesses will be offering their products at the most nominal rates.
- A business does not have to spend on extra things like advertising or branding as there is no need to and so can save extra
- There is no danger of a monopoly forming as there are no barriers to entry.
- Economic welfare will prosper due to the low price and high-quality
DISADVANTAGES OF PERFECT COMPETITION
- Lack of innovation when it comes to the production of goods. Since there is no reason to create new products in a perfect market, businesses will not put resources into.
- This kind of market may create a monopsony for the consumers as they have the highest buying power against the suppliers and so they can demand whatever they want.
- There are no economies of scale for businesses. Since there is only so much profit that an individual business can make in this market, they can only remain a certain small size as they won’t have the funds to increase their production capabilities. And so, even in the long run, these businesses will not be able to lower costs or increase profit margins.
Now that we understand exactly what perfect competition means, we can see that it is not practical to think of it as a real-world situation.
This scenario is shown to give an example as to how a market will act under certain conditions.
This data is then matched against studies of the real world and is used to find a way to improve the current market process.