Chapter 8: Problem 12

What are the four basic assumptions of perfect competition? Explain in words what they imply for a perfectly competitive firm.

Short Answer

Expert verified

The four basic assumptions of perfect competition are: (1) a large number of buyers and sellers, meaning no single firm can influence the market price; (2) identical products, requiring firms to maintain low production costs and compete on price; (3) perfect information, making it necessary for firms to monitor the market and remain transparent with their customers; and (4) free entry and exit, which implies that firms cannot rely on barriers to entry or exit to prevent competition. In a perfectly competitive market, firms are price takers and must remain efficient to stay profitable.

Step by step solution

1. Explanation of Perfect Competition

Perfect competition is a market structure characterized by a large number of small firms, identical products, perfect information, and ease of entry and exit from the market. In a perfectly competitive market, individual firms are price takers and have no market power.

2. List the four basic assumptions of Perfect Competition

The four basic assumptions of Perfect competition are: 1. Large number of buyers and sellers 2. Identical products 3. Perfect information 4. Free entry and exit

3. Large number of buyers and sellers

This assumption implies that there are so many buyers and sellers in the market that no single buyer or seller can influence the market price. Each firm is a price taker, meaning they must accept the market price for their product, which is determined by the interaction of demand and supply. For a perfectly competitive firm, this implies that they have no control over the price they receive for their product and cannot set prices above or below the market price, as they will lose customers to competitors.

4. Identical Products

Identical products assumption means that all firms in the market produce and sell homogeneous goods that are perfect substitutes. Customers see no differences in products from one firm to another within the market. For a perfectly competitive firm, this implies that they must be highly efficient and maintain low production costs. Since they cannot differentiate based on the quality or features of their product, they need to compete on price. If their costs are high, they may struggle to remain profitable in such an environment.

5. Perfect Information

This assumption posits that all market participants, buyers, and sellers have complete information about prices and product quality. Firms are aware of the best production techniques, and consumers know the best prices available. For a perfectly competitive firm, this implies that they must constantly monitor the market and react to changes in prices and technology. They must also strive to maintain high transparency with their customers, as any deviation from the market price or quality could lead to lost sales.

6. Free Entry and Exit

Perfect competition assumes that there are no barriers to entry or exit for firms in the market. New firms can freely enter the market, and existing firms can exit without any cost. For a perfectly competitive firm, this implies that they must remain competitive in the long run since a new firm can easily enter the market and compete with them for customers. Additionally, they cannot rely on barriers to entry, like patents or government regulations, to prevent competition. If a firm is not profitable, it will eventually exit the market since there are no barriers to exit.

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