When we last visited our hypothetical hot dog business (Lesson 7), it was booming. We had just invested our profits in a second stand across town, and we'd continued to increase production until people had enough hot dogs. We found that we could actually increase our price a little bit, and people would still buy our dogs; we were the hottest dog around.
But did it seem like our profits were coming too easily? Sure enough, it wasn't long before others noticed that hot dogs were selling like hot cakes, and it didn't require too big an investment for them to set up stands of their own. Soon, competitors were undercutting our prices. When there were just a couple of other stands, we tried to get together with them and agree to keep prices up (we tried, in other words, to form a cartel). But it was no good, because it was just too easy for any old body to set up a stand and start selling dogs.
We were now in a competitive market. In fact, we were in a situation very much like what economists would call "perfect competition". There were a large number of sellers, each selling a product that was pretty much the same. At that point, we noticed an interesting thing about our pricing. When we added up all our production costs, we found that it cost us a dollar to bring a hot dog onto the market. In the good old days, we'd been able to sell the dogs for as much as $1.75 apiece. But with all this new competition, we had to lower our price. And we found that to sell our hot dogs, we had to keep lowering the price all the way down to our marginal cost -- all the way down to one buck! Why? Because if our price was any higher, the competitor -- whose production costs were the same as ours -- could always undercut it. An economist would describe our plight thusly: "In a perfectly competitive market, profit is maximized when price equals marginal cost."
Maximized? Well, I guess you could say our profit was maximized, because our alternative was selling nothing at all. But it quickly dawns on us that selling goods in a perfectly competitive market is not a way to make much profit! The only way we can make any profit at all is to produce the same hot dogs more efficiently than our competitors. But it won't be long before the competition discovers our innovations and copies them. (We'd do the same!) To stay in this business, we would have to find some sort of competitive edge. Some possible edges, in the hot dog trade:
Note that all of our ideas for getting an edge actually would result in improved value for the consumer: more variety, entertainment or convenience (the only exception being last one, the attempt to limit competition). So we see that the tendency of competitive markets is to provide consumers with the best quality at the lowest prices.
It is often said that "perfect competition" doesn't actually happen in the real world, that it is merely a theoretical notion used by econ teachers to illustrate points. Producers of the goods that textbooks tend to cite as examples of perfect competition -- agricultural goods such as wheat, corn, soybeans, etc. -- are often provided with public support in the form of subsidies or protective tariffs! The fact is that there are few, if any, goods that are sold in perfectly competitive markets, and firms seek to limit the pressure of competition in any way they can.
There is one market, though, in which perfect competition reigns supreme, and has for hundreds of years. In this market, the quality of one seller's product is extremely similar to that of any other seller, and the number of sellers is very, very large. Competition forces the price right down to the good's marginal cost, every time. Not only that -- this market is very important and ubiquitous; it is actually a fundamental building block of the economy.
What is it? The market for unskilled labor. We'll turn to that in the next lesson.
Background Questions