What it’s: A competitive market refers to a market characterized by intense competition in which no player has a dominant power. It is identified as a perfectly competitive market with many buyers and sellers. And they individually cannot influence the output and market prices. Nonetheless, if a market is close to perfect competition, it might as well be considered a competitive market as under monopolistic competition.
Competition occurs when each party strives to pursue the same goal. And in general, competitive means everyone is trying to be the best. So, for example, firms compete with each other to sell as much output as possible, workers compete for the best, highest-paying jobs, countries compete to capture the largest export market, and so on.
And suppose we relate it to the market. In that case, competitive describes how each company strives to be the best without having the power to influence the results in the market. The market usually consists of many players with a small and even market share.
Conversely, if they are uncompetitive, some firms have power, which can influence output and prices in the market. Usually, there are few players in the market. Or the market share is concentrated in a few players even though there are many players. In extreme cases, there is one supplier in the market as under monopoly or one buyer in the market as under monopsony.
What are the characteristics of a competitive market?
Competitive markets have several characteristics. First, there are many buyers and sellers in the market. Each is small relative to market output. So, from the supply side, suppliers have a low market share. Likewise, from the demand side, buyers also have a relatively small market share.
Second, each buyer and seller are independent. Thus, they have no chance to collude and run unfair competition, for example, by forming a cartel.
Third, the barriers to entry and exit from the market are low. Thus, sellers are free to enter and exit the market in response to profits in the market. So are buyers.
Fourth, the market is liquid. Competitive markets usually have high trading volumes. Thus, the individual buyer or seller has no small influence on the price; if there is, it is small. The foreign exchange market is a good example.
Fifth, market equilibrium determines the market price, namely the price for sellers and for buyers. Market participants do not have the power to influence supply and demand. Thus, output and market prices represent the best possible outcomes for buyers and sellers.
Sixth, products are homogeneous. They are identical to each other. Thus, sellers compete through price. If a company raises prices, consumers turn to competitors for cheaper ones.
In addition, identical products allow consumers to feel the same value. Meanwhile, when selling such a product, producers cannot charge a price higher than the market price.
Seventh, information is widely available. Theoretically, the market provides perfect information. Thus, market participants have the same information to make decisions. There is no information asymmetry where one party has more or better information than the other.
Eighth, there is no external intervention. For example, the government often intervenes in the market to influence the market equilibrium through subsidies, taxes, price ceilings, and price floors. Thus, without such intervention, the market mechanism works to achieve market equilibrium.
What are examples of a competitive market?
Agriculture is a good example of a competitive market. Each farmer has a small market share and is unable to dictate output or market prices.
The market for everyday products such as bread can be considered competitive. You may find many bakeries. They are mostly small and medium businesses. Restaurants, hotels, and clothing are other examples.
Why are competitive markets important?
Competitive markets are important for several reasons. First, it encourages innovation. As companies pursue to be the best, they continue to innovate.
Second, quality and cheap products are more widely available. Innovation doesn’t just give rise to new and never-before-seen products. But, it also encourages some companies to pursue quality, allowing them to beat the competition while charging relatively high prices. In addition, innovation also encourages companies to operate more efficiently, allowing them to charge lower prices.
Third, competitive markets benefit consumers. Due to weak market forces, each company offers prices according to quality. They cannot influence the market to maximize profits, for example, cutting output to raise prices without being accompanied by improvements in quality. Thus, each company only sells products according to what the market pays for.
This market also benefits producers. For example, the company has little chance to run unfair competition. For example, they adopt a predatory pricing strategy to exclude competitors from the market. Or they build strategic barriers to block new players from entering the market.
Fourth, competitive markets increase social surplus. And it is maximized under perfect competition.
What is the most competitive market structure?
Perfect competition is the most competitive market structure. However, such structures are difficult to find in the real world. Meanwhile, the closest to it is monopolistic competition. It’s akin to perfect competition. The difference lies only in the differentiation.
Under monopolistic competition, firms have some power through differentiation, for example, through advertising and other non-pricing strategies. Such differentiation allows them to charge a higher price than the market price.
Competitive markets contrast with non-competitive markets such as oligopoly or monopoly markets, where producers have control over the prices of the products they sell. Under an oligopoly, the greater the market power, the greater the control over prices, and the greater the opportunity to earn higher profits by influencing the outcome in the market.
In some oligopoly markets, firms may use their dominance to influence the market or engage in unfair competition. Meanwhile, in other markets, companies collude, for example forming cartels, to pursue their common interests.
Meanwhile, the monopoly market has no competition. That’s because there is a single player. Thus, the market output equals the monopolist’s output, and so does the market price.
There are also oligopsony and monopsony. Both are also uncompetitive markets. However, unlike oligopoly and monopoly, where power is concentrated on the supply side, market power is concentrated on the demand side under oligopsony and monopsony. In other words, demand is concentrated in one or a few buyers. Under monopsony, for example, one buyer represents the total market demand.
How do you identify a competitive market?
The concentration ratio and the Herfindahl Hirschman Index are two methods for identifying how concentrated market power is and how competitive rivalries are in the market.
Calculating the concentration ratio varies; some use CR4 and CR8. But, in principle, the same. For example, to obtain CR4, we add up the market shares of the four largest firms. Meanwhile, CR8 uses the eight largest companies. If it ranges from 0% to 40%, the market leads to perfect competition to oligopoly. And if it’s close to 0%, the market leads to perfect competition or at least monopolistic competition.
Meanwhile, to calculate the Herfindahl Hirschman Index, we square the market share and add up the results for all companies in the market. The Herfindahl Hirschman index ranges from 0 to 10,000. 0 means perfect competition. On the other hand, 10,000 means a monopoly. If it is less than 1,500, the market is considered competitive.
What to read next
- Competitive Market: Characteristics and Examples
- Why are some markets becoming more competitive?
- How Do Businesses Respond to A More Competitive Market?