2.2.

3 The assumptions of a perfectly competitive market

Given that a perfectly or purely competitive market is generally seen as a good thing, the
question is ‘what are the preconditions that must be met for this type of market to exist?’

 Strong competition and the absence of market power

Perfectly competitive markets require that there are lots of rival sellers of
an identical product so that no one seller has market power enabling them to fix
or set the market price. Firms are simply price takers in the market. Of course, in
the real world, pure or perfectly competitive markets do not usually exist because
as we shall soon see, all industries have some barriers to entry or there is
usually some product differentiation. Examples of competitive markets, like
the wheat or share market, are only approximate ones. The opposite to the
perfectly competitive market is the perfect monopoly where a single firm controls
the entire output of an industry, has much market power, and is a price maker.
The closest examples here might include the NBN, Australia Post or Melbourne
Water. More commonly we find oligopolies (e.g. cardboard packaging, oil,
banking, supermarkets, aviation and power companies) and monopolistic
competition (e.g. restaurants, retail, clothing manufacture).
 Low barriers or ease of entry into the market
There is limited competition in monopoly or oligopoly-type markets because
there are significant barriers to entry that restrict the setting up of new
competing businesses. A common reason for this is that existing firms are large
and well established. New businesses would find start-up costs expensive. In
addition, in some industries other barriers exist like government red tape, safety
requirements, licensing and paperwork. By contrast, it is generally cheaper and
easier for new firms to gain entry into perfectly competitive markets.
 No product differentiation (homogeneous product)
Competition is usually more intense when producers are selling identical
products not distinguished by brand names, advertising, product appearance or
special packaging. That is, the market is for a homogeneous product. Hence,
the lack of differentiation in the wheat or wool markets, for example, more
closely approximates perfect competition than is found in the market for
products such as designer clothes, petrol or cars.
 Consumer sovereignty exists
Consumer sovereignty is where the particular types of goods and services
produced (i.e. the ‘what to produce’ question) closely reflect what consumers
purchase, rather than this decision being made through government control or
the decisions of firms about what to supply.
 Absence of government controls and restrictions
The price system generally works best when there are no government regulations
or restrictions affecting prices or limiting competition in an industry. To be
competitive, markets must usually be free or deregulated.
 Good or perfect knowledge of the market
Clearly, the price system can work properly only when both buyers and sellers
 have complete, accurate or perfect knowledge about current trends in market
prices and the features of the products involved. A lack of good information by
consumers results in poor and irrational decisions being made and resources
being misallocated. In such instances the price signals coming from the market
are not a reliable guide to what consumers actually want firms to produce or
supply.
 Firms use resources to try and maximise their profits
It is assumed that business decisions are mainly motivated by self-interest and a
desire to maximise profits and incomes. Therefore, in perfectly competitive
markets, the owners of resources should shift their resources from one use to
another, in order to reflect changing prices and fortunes in different industries,
and changes in consumer demand. This requires that there be no major barriers
to the entry or exit of firms into or out of an industry. In addition, resources need
to be mobile so they can be redirected to areas of highest profitability.
 Consumers behave rationally
In a perfectly competitive market, it is assumed that buyers will behave in a
financially rational way to promote their own self-interest, by being attracted by
low prices for finished products and discouraged by high prices.
In Australia, it is fairly obvious that most of our markets fail to fully satisfy all these
preconditions required for perfect competition. Perhaps the best examples
of almost perfect competition in Australia are the markets for fruit, vegetables and some
rural products, shares and property. However, pure or perfect competition does not
exist in markets involving steel, chemical, banking and finance, petroleum, shipping and
transport, groceries, cardboard packaging, glass, the post, the broadband network and
water supply. Here, monopolies and oligopolies are more common. Even the general
store in isolated small country towns, or your own school canteen, can face little
competition in their respective markets.