The Myth of Perfect Competition

In a bazaar in Sylhet, millions of oranges are being sold. Hundreds of buyers and sellers have assembled in the orange market. Everybody in the market knows all the oranges are of the same colour, same size, and same breed. Each orange is identical. No matter how many oranges each seller sells or each buyer buys, that amount is a very, very small part of all the oranges in the market. Thus no single seller and no single buyer can influence the price at which oranges are sold. Everybody knows the market price of the oranges. No seller can charge a price higher than the market price. If a seller does, as a buyer you'll just go to another seller. Similarly, no buyer can offer a price lower than the market price. If a buyer does, no seller will sell you their oranges. Fierce competition means no seller makes a decent profit-margin and no buyer makes a good deal. The market price just covers costs of sellers. This is how Perfect Competition is introduced in an economics primer. This benchmark of markets in economic theory leaves no incentive for sellers in particular to be creative.

Perfect competition emerged in the middle of the nineteenth century. Dropouts from mathematics, physics, and engineering schools applied calculus to what would become the Marginal Revolution. These mathematicians and physicists based their analysis on laws of thermodynamics. Each molecule behaves the same way. Each molecule is so small that no molecule can influence motion on its own. This creates problems when we apply the law to people. 

In class, I sometimes declare I'll give everybody the same flat grade. How would you respond? If you're not worth that flat grade, you'll remain silent. If you think otherwise, you'll protest that you're worth better. Indeed, if everybody receives the same flat grade like all the oranges in the bazaar in Sylhet selling at the same price, there wouldn't be an incentive to work hard and be different and better. Humans aren't identical molecules. Some are better than others. Let's revisit the orange market in Sylhet.

Some clever or lucky sellers made profit last year. Those who made losses left the market. What does this mean? We now have fewer sellers. Some of the lucky sellers worth more than the flat grade also turn out to be creative. With the profits from last year, some decide to invest in packaging. Some sellers are selling oranges in boxes of ten. This is where the fun starts. 

As a buyer, would you see the oranges as the same this year? No. If so, wouldn't some buyers be willing to pay a little extra for the convenience of packaging? Yes. If you're one of the creative sellers from last year, wouldn't you be able to get away by asking for a little bit more than the market price for the packaging? Yes. Some of the creative sellers now have Market Power. 

If this carries on, what will happen? After some time, the clever and creative sellers would have established a brand image and charge more than the market price and do business. The remaining orange sellers will be selling oranges at the same market price and just breaking even with a very low profit margin. 

Like exams, markets also reward the more creative sellers with profits, which they reinvest in creative ways for their own sake to stay in business. When competition is cut-throat, sellers seldom have the additional resources to reinvest. As time goes by, the perfectly competitive orange market in Sylhet will see the rise of monopoly and dominant firms. Are such firms necessarily bad? Let's save that for the next instalment of Echoes.

Asrar Chowdhury teaches economic theory and game theory in the classroom. Outside he listens to music and BBC Radio; follows Test Cricket; and plays the flute. He can be reached at: asrar.chowdhury@facebook.com