Perfect Competition in Economics & Adam Smith's 'Invisible Hand'

Perfect Competition in Economics & Adam Smith's 'Invisible Hand'
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  • 0:08 Perfect Competition
  • 4:15 The Invisible Hand
  • 5:51 Lesson Summary
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Lesson Transcript
Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.

In this lesson, you'll learn how consumers and producers interact in a perfectly competitive economic system. You'll also be introduced to how Adam's Smith concept of an 'invisible hand' can help keep such systems in line.

Perfect Competition

Economic systems differ from one another in how resources are allocated among consumers and producers and how those consumers and producers interact with one another. In a perfectly competitive market, prices are perfect; that is, the price of any good or service is the highest a consumer will pay and the lowest a producer will sell, at that point in time.

There are important criteria that must exist for a market to have perfect competition. These criteria are so strict and specific that in reality, no market is perfectly competitive. Some markets come close, but as in life, in economics, nothing is perfect.

The five requirements for a perfectly competitive market are:

  1. All firms sell the exact same product
  2. All firms are price takers, meaning they don't set their own prices
  3. No single firm has significant market share
  4. Consumers have all accurate information about firms, products, and prices
  5. There are low barriers and costs to entry and exit in the market

Let's pause here and think of an industry that we are all probably familiar with that might come close to perfect competition. Can you think of one? Think about it - identical products, little if any pricing discretion, very fragmented market, accurate information for consumers, and low barriers to entry. Take a second. You've probably been a consumer in this market sometime in the last few weeks. That's it - gas stations!

Okay, so think of gas stations from the perspective of perfect competition. On an average commercial street, how many gas stations do you think there are per mile? Two, maybe three or four, all owned by different firms? So, the market is fragmented and there are many firms. And how about the primary product they sell: fuel? Do they essentially sell the exact same product? The firms may want to differentiate their products by advertising additives or certain brands, but basically, fuel is fuel.

What about prices - can gas stations set their own prices? Of course they can, but what would happen if gas station A set their price at 25 cents more a gallon than their competitor across the street? They probably wouldn't get any business.

When it comes to information about the market, do consumers have all the information they need to make a decision about where to buy gas? Sort of. It's easy enough to compare prices, especially with the Internet and mobile apps that track gas prices constantly. But what about information about the gas? Well, we already said that the products are essentially identical, so there isn't a lot of information needed. Of course, even fuel isn't exactly the same, but if a consumer wanted to know the specific differences between brands of fuel, they could access that information and use it when they decide where to buy.

The last requirement for a perfectly competitive market is low barriers to entry. It's important to note that 'low barriers' is a relative term. What's needed to set up a gas station? Some land, a few pumps, some gas tanks, and a way to collect money. There could be more - a building to hold a convenience store, but it's not absolutely necessary. This may seem like a big investment, but compare it to something like a factory that produces microchips or the refineries that actually make the gasoline out of crude oil. Compared to those industries, a gas station has pretty low barriers to entry.

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