To model markets with many buyers and sellers, we started with supply and demand curves, telling us how much of the good sellers supply and buyers demand at any given price, and found the market-clearing price. Then we argued that:
- the market-clearing price is a competitive equilibrium, because no one can benefit from asking or offering a different price, and
- when the market is not in competitive equilibrium, buyers and sellers will adjust prices and quantities in pursuit of rents, until the equilibrium is reached.
Characteristics of competitive equilibrium
- All transactions take place at the same price. This is known as the Law of One Price.
- The market clears (supply equals demand).
- All participants are price-takers (they can buy or sell as many items as they like at the market price, but no one can benefit from trading at a different price).
- Law of One Price
- The Law of One Price states that in equilibrium, identical goods or services will be traded at the same price by all buyers and sellers.
This model is widely used in economics. To decide whether it can be applied to the case of a particular market, we should consider whether conditions in the market resemble the theoretical conditions required for a competitive equilibrium.
Conditions for competitive equilibrium
The theoretical requirements for a market to be in competitive equilibrium are as follows:
- many buyers and sellers, all acting independently
- identical (hom*ogeneous) goods
- all the buyers and sellers are aware of the prices at which others are trading
- buyers and sellers always seek the best price available.
If these conditions hold, then at the market-clearing price, competition between sellers and between buyers will ensure that no one will trade at any other price—that is to say, they will be price-takers and the market will be in competitive equilibrium.
- perfectly competitive
- A market may be described as perfectly competitive if (i) there are many buyers and many sellers of identical goods, all acting independently, who are aware of prices and always choose the best price they can get, and (ii) the market is in competitive equilibrium, with supply equal to demand and all buyers and sellers acting as price-takers.
A market satisfying these conditions is sometimes described as perfectly competitive, in recognition that they are idealized conditions that rarely hold in practice:
- Although oil is a hom*ogeneous product and there are quite a lot of buyers and sellers in the world oil market, there were not sufficiently many to prevent a group of large producers gaining market power through a cartel.
- Many goods are differentiated in some way; reducing the intensity of competition.
- Buyers are not always so well informed and responsive to prices that they choose the lowest available, and hence force sellers to compete. If it takes time and effort to check prices, consumers may decide to buy as soon as they find something suitable, rather than continuing to search.
Exercise 8.10 Price-fixing
In 2014, producers of best-selling chocolate bars worldwide were accused of colluding with each other to keep prices high. Use the information in this article to help you answer the following questions.
- In which ways does the market for chocolate bars fail to satisfy the theoretical requirements for a market to be in competitive equilibrium?
- Even though each brand of chocolate bar faces competition from many other similar brands, why do some producers have considerable market power?
- Describe some market conditions under which price-fixing behaviour (like the chocolate bar producers were suspected of) is more likely to occur, and explain why.
Competitive equilibrium as a useful benchmark
- perfect competition
- Perfect competition is the type of interaction between buyers and sellers that takes place in the equilibrium of a market when (i) there are with many buyers and sellers of identical goods, and (ii) supply equals demand and all participants act as price-takers.
Although the theoretical conditions for perfect competition rarely hold, competitive equilibrium provides a useful benchmark because it generates the maximum total surplus available in the market. The conditions for competitive equilibrium point us towards market characteristics that we would expect to favour competition and lead to beneficial outcomes. The previous section gave an example of how increasing the number of firms in a market destroyed a cartel, leading to lower prices. From Unit 7, we know that firms face more competition and have less market power when close substitutes are available for their product.
With the arrival of online shopping, economists hypothesized that retail markets would be more competitive: consumers would easily be able to check the prices of many suppliers before deciding to buy. But even in this environment, consumers are not so sensitive to prices that they force firms to sell at the same price.1 According to a price comparison site, BoardGamePrices, for board games, Monopoly—made by only one producer but sold by many retailers—was available from UK online retailers in May 2022 at prices ranging from £20.59 to £37.20 (including shipping within the UK).
Exercise 8.11 The Law of One Price
Test the Law of One Price for yourself, by checking online prices for a product that should be the same wherever you buy it—such as a book, game, or household appliance. (For example, you could choose a published textbook that you have been using in your studies.) Use the internet to find the selling price of the product from a number of different suppliers.
To what extent does the Law of One Price hold for your chosen product? Suggest some explanations for what you observe.
Where the model of competitive equilibrium can be applied
There are markets where conditions are close to those required for intense competition and price-taking. Agricultural products such as wheat, rice, coffee, or tomatoes have many buyers and sellers, and are relatively hom*ogeneous. Goods are not truly identical, and it is unlikely that everyone is aware of all prices. But it is nevertheless clear that they have very little power to affect the price at which they trade. So the supply and demand model helps us to understand the market for quinoa, and for cotton in the American Civil War.
In other cases—where there are small differences in the quality or characteristics of goods—there may be enough competition that firms’ demand curves are elastic and the range of feasible prices is narrow. Then we can assume price-taking as an approximation, to obtain a simple model of the market: for example, in retail goods and services, where many small shops sell very similar products that consumers buy regularly—such as a loaf of bread, or a cup of coffee.
A simplified model can provide useful predictions when the underlying assumptions are only approximately true. In the example of the 1970s oil market, the OPEC sellers did not act independently. They had considerable market power, which enabled them to restrict supply and raise the market price. However, the price was still determined at the point where demand met the (restricted) supply curve, and was equal to marginal cost, so we were able to use the supply and demand model to understand the outcome. Judging whether or not conclusions about the real world can be drawn from a simplified model is an important skill of economic analysis.
Walras, Hayek, and the debate about competitive equilibrium
Léon Walras, a nineteenth-century French economist, built a mathematical model of a whole economy in which buyers and sellers are price-takers, which has been influential in how many economists think about markets.
Great economists Léon Walras
Léon Walras (1834–1910) was a founder of the neoclassical school of economics. He was an indifferent student, and twice failed the entrance exam to the École Polytechnique in Paris, one of the most prestigious universities in his native France. He studied engineering at the École des Mines de Paris instead. Eventually his father, an economist, convinced him to take up the challenge of making economics into a science.
The pure economic science to which he aspired was the study of relationships among things, not people, and he had notable success in eliminating human relationships from his modelling. ‘The pure theory of economics,’ he wrote, ‘resembles the physico-mathematical sciences in every respect.’
His device for simplifying the economy so that it could be expressed mathematically was to represent interactions among economic agents as if they were relationships among inputs and outputs, and to focus entirely on the economy in equilibrium. In the process, the entrepreneur, a key actor in wealth creation from the Industrial Revolution to today, simply disappeared from Walrasian economics:
Assuming equilibrium, we may even go so far as to abstract from entrepreneurs and simply consider the productive services as being, in a certain sense, exchanged directly for one another… (Elements of Theoretical Economics, 1874)2
Walras represented basic economic relationships as equations, which he used to study the workings of an entire economy composed of many interlinked markets. Prior to Walras, most economists had considered these markets in isolation: they would have studied, for example, how the price of textiles is determined on the cloth market, or land rents on the land market.
Walras created what is now called general equilibrium theory, a mathematical model of an entire economy in which all markets are in competitive equilibrium. His work was the basis of the proof, much later, of the invisible hand theorem, giving the conditions under which such an equilibrium is Pareto efficient.
Walras defended the right to private property, but to help the working poor, he also advocated the nationalization of land and the elimination of taxes on wages.
Question 8.11 Choose the correct answer(s)
Read the following statements about Léon Walras’s approach to modelling and choose the correct option(s).
- Walras’s approach to modelling followed that of the physical and mathematical sciences.
- Walras focused on studying competitive equilibrium.
- Walras’s models accounted for the effects of one market on other markets in the economy.
- Walras’s models accounted for the behaviour of entrepreneurs and other human relationships.
- Walras aimed to make economics into a science, focusing on the study of relationships between things, not people.
- Walras’s approach focused entirely on the economy in equilibrium.
- Walras modelled the entire economy, which was composed of many interlinked markets. In contrast, other economists at the time had considered each market in isolation.
- Walras modelled interactions among economic agents as if they were relationships among inputs and outputs. In doing so, the behaviour of entrepreneurs and other human relationships are not considered in Walras’s models.
Seven years after Walras died, his general equilibrium model played an important role in the debate about the feasibility and desirability of centralized economic planning compared to a market economy. In 1917, the Bolshevik Revolution in Russia put the economics of socialism and central planning on the agenda of many economists, but surprisingly, it was the defenders of central planning, not the advocates of the market, who used Walras’s insights to make their points.
Friedrich Hayek, and other defenders of market competition, criticized the general equilibrium model. They argued that by ignoring the fact that a capitalist economy is constantly changing, and therefore also the contribution of entrepreneurship and creativity, Walras had missed the true virtues of the market.
In Hayek’s view, the concept of a competitive equilibrium with price-taking did not capture what was important about competition. ‘The modern theory of competitive equilibrium,’ he wrote, ‘assumes the situation to exist which a true explanation ought to account for as the effect of the competitive process.’
Defining competition as ‘the action of endeavouring to gain what another endeavours to gain at the same time’, he argued:
Now, how many of the devices adopted in ordinary life to that end would still be open to a seller in a market in which so-called ‘perfect competition’ prevails? I believe that the answer is exactly none. Advertising, undercutting, and improving (‘differentiating’) the goods or services produced are all excluded by definition—‘perfect’ competition means indeed the absence of all competitive activities. (The Meaning of Competition, 1946)
In practice, economies are a mixture of more and less competitive markets. But, as Hayek claimed, many competitive activities are more likely to be undertaken by firms with market power (as in Unit 7), than by firms in more competitive markets.
A firm with a unique product will advertise (Buy Nike!) to shift the demand curve for its product to the right. But why would a single competitive firm advertise (Drink milk!)? This would shift the demand curve for all of the firms in the industry. Messages like ‘Drink milk!’ are probably paid for by an association of dairies, not by a particular one.
The same is true of expenditures to influence public policy. If a large firm with market power is successful in relaxing environmental regulations, then it will benefit directly. Campaigning and lobbying will be unattractive to the competitive firm because almost all the benefit will go to its competitors.
Similarly, research and development are more likely to be undertaken by firms facing less competition, because if they are successful in finding a profitable innovation, the benefits will not be lost to competitors also adopting it.
How economists learn from facts Fishing for perfect competition
From the early nineteenth century, the catches of Atlantic fishermen landed in the port of New York were sold to restaurants and retailers at the Fulton Fish Market. It is still the largest market for fresh fish in the US, although fish are now brought in by road or air. Dealers do not display prices. Instead, the market works by pairwise trading: customers can inspect the fish and ask for a price before making their decision.
Kathryn Graddy, an economist who specializes in how prices are set, studied the Fulton Fish Market. There were about 35 dealers, with stalls close to each other, so customers could easily observe the quantity and quality of fish available and ask several dealers for a price. She collected details of 3,357 sales of whiting by one dealer, including price, quantity, and quality of fish, and characteristics of the buyers.34
Of course, prices were not the same for every transaction: quality varied, and fish supplies changed from day to day. But her surprising observation was that, on average, Asian buyers paid about 7% less per pound than white buyers. (All of the dealers were white.) There seemed to be no differences between the transactions with white and Asian buyers that could explain the different prices. Watch our interview with Graddy to find out how she collected her data, and what she discovered about the model of competitive equilibrium.
Exercise 8.12 The Fulton Fish Market
Use Kathryn Graddy’s video to answer the following questions.
- Summarize what she discovered about the Law of One Price in the fish market. What explanation does she provide for her findings?
- Why did buyers and sellers not search for better deals?
- Why did new dealers not enter the market in pursuit of economic rents?
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Glenn Ellison and Sara Fisher Ellison. 2005. ‘Lessons About Markets from the Internet’. Journal of Economic Perspectives 19 (2) (June): pp. 139–158.↩
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Leon Walras. (1874) 2014. Elements of Theoretical Economics: Or the Theory of Social Wealth. Cambridge: Cambridge University Press.↩
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Kathryn Graddy. 2006. ‘Markets: The Fulton Fish Market’. Journal of Economic Perspectives 20(2): pp.207–220.↩
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Kathryn Graddy. 1995. ‘Testing for Imperfect Competition at the Fulton Fish Market’. The RAND Journal of Economics 26(1): pp.75–92.↩
