Perfect competition is at one extreme with many small firms selling identical products. Monopoly is at the other extreme with just one firm. The intermediate cases are monopolistic competition (which involves many small sellers producing slightly differentiated products)and oligopoly (which involves a small number of large firms). Most U.S. firms operate under monopolistic competition (e.g., novels, movies, clothing, etc.) or oligopoly (tennis balls, crude oil, automobiles, etc.). However, this review will focus on the two extremes: perfect competition and monopoly. There are three conditions required for perfect competition. (1) Numerous small firms and customers.The decisions of individual producers and buyers do not affect the price of the good.
(2) Homogeneity of product. The products offered by sellers are identical. For example, wheat of a particular grade is homogeneous (while ice cream is not). If the product is homogeneous, consumers don't care from which firm they buy the good because their products are identical. (3) Freedom of entry andexit. There are no barriers to enter the industry, so new firms can compete with old ones relatively easily. They do not have to match the advertising of the existing firms to secure customers. Nor are there large fixed costs that require large investments in equipment before production can start. There is also freedom to exit, so firms can leave the industry if the business proves unprofitable.These three conditions are infrequently met, so perfect competition is pretty rare in the U.S. One good example is a company's stock. There are millions of buyers and sellers, the shares are identical, and entry into the market is easy. Other examples include fishing and farming. If this market structure is so rare, then why are we bothering to study it? First, perfect competition often provides areasonable approximation of what happens in markets that are less than perfectly competitive. Second, perfect competition is the standard by which all other markets are judged. We will see that markets work most efficiently under perfect competition. It insures that the economy produces what consumers want while using society’s scarce resources most effectively. By studying perfect competition, wewill see what an ideally functioning market system can accomplish. Later on, we will see how far monopolies deviate from this ideal. The Perfectly Competitive Firm and its Demand Curve Under perfect competition, the firm must accept the price determined in the market. The firm is a price taker --it can produce as much or as little as it likes without affecting the market price. Each firm must matchthe price offered by its competitors because the products are identical. Otherwise, consumers will shift their purchases to another firm. The price in the industry as a whole, which is comprised of all the individual firms and consumers, is determined by supply and demand. For a basic discussion of supply-anddemand, see the notes for Micro Topics 3 and 4. Figure 7-2 shows how a single firm’s...