A competitive market is one in which a large numbers of producers compete with each other to satisfy the wants and needs of a large number of consumers. In a competitive market no single producer, or group of producers, and no single consumer, or group of consumers, can dictate how the market operates. Nor can they individually determine the price of goods and services, and how much will be exchanged. Competitive markets will form under certain conditions.
For markets to form a number of necessary conditions must be met, including:
The profit motive. Free markets form when the profit motive can be satisfied .... more
The principle of diminishability. Stocks of pure private goods will diminish as the good is purchased. .... more
The principle of rivalry. Consumers must compete with each other to get the benefit provided by the good or service... more
The principle of excludability. For markets to form it is essential that consumers can be excluded from gaining the benefit that comes from consumption. .... more
The principle of rejectability. It is also necessary that consumers can reject goods if they do not want or need them.... more
The necessary conditions for market formation and success:
Free markets form when the possibility of profits provides an incentive for firms to enter the market. Basic economic theory states that profits are earned when firms gain a revenue which exceeds the costs of production. However, more advanced micro-economic theory offers two definitions of profit - normal and super-normal. When revenue exceeds costs supernormal profit is earned, and when revenue equals costs the firm makes normal profits.
A further condition for market formation is that stocks of goods will diminish as the good is purchased. For example, the purchase of a laptop computer by one consumer means there is one less available for other consumers. This is referred to as the principle of diminishability. Eventually, stocks will diminish to zero and as this happens, price will be driven up. Higher prices create an incentive for the producer to increase production.
In addition, free markets will only form when consumers are forced to compete with obtain the benefit of the the good or service. For example, to be guaranteed a good seat at a restaurant, or at a music venue, consumers need to book in advance, or get there early - there is clearly a need to be competitive to secure the benefit of the good. This is called the principle of rivalry, and is clearly closely related to the principle of diminishability. Indeed, many consider it to be just another way to explain the need for consumers to compete when stocks diminish.
For markets to form it is essential that consumers
can be excluded from gaining the benefit that comes from consumption. A
storekeeper can stop consumers gaining the benefit of a product if they
are unable or unwilling to pay. For example, a market for music can only
be formed if the musicians perform in a venue where access is denied to
those without a ticket, or where the songs can be recorded and sold
through shops, via downloads, or through other media. This is called the
principle of excludability. If consumers cannot be excluded
they may become free-riders and, as will be seen later, the
possibility of free riders can prevent the formation of fully fledged
It is also necessary that consumers can reject goods if they do not want or need them. For example, a supermarket employee could not place an unwanted product into a shopper’s basket and expect the shopper to pay for it at the checkout. This is called the principle of rejectability.
When the conditions of diminishability, rivalry, excudability and rejectability are present it is possible for a market to form and for the seller to charge the buyer a price and for the buyer to accept or reject that price. It is also possible for the buyer to make a bid for a good or service, and for it to be accepted or rejected by the seller.
For markets to work effectively there can be no significant information failure affecting the decisions of consumers and producers. It is assumed that the consumer of a private good or service knows what they are getting - they are able to estimate accurately the net benefit they are likely to derive. Net benefit is the private benefit to a consumer in terms of satisfaction, or utility, less the private cost associated with buying the product. It equates to the concept of consumer surplus.
For example, when a consumer purchases a coffee from their favourite cafe they will feel that they clear about the net benefit they will derive. Consciously or instinctively they will make a calculation that buying a coffee is worth the £2 they are asked to pay. It can be assumed that the decision to make this, and similar purchases, is guided by the consumer’s rational expectations. In other words, consumers base their decision to consume on a complete range of information gathered over the past, together with a prediction of the future. In terms of the coffee example, the consumer may have bought many coffees at this cafe before, and has always been satisfied with the quality of the coffee, and the service provided - hence the £2 expenditure is a ‘safe bet’. As will be seen, there may be many situations where not all the information regarding the product is available to the consumer, and in these cases markets may fail to work efficiently. For example, what if consuming coffee on a regular basis increases blood pressure and might trigger other health problems? This is unknown information to the individual consumer at the point of consumption, and because there is a gap in knowledge, there is information failure, and choices may be irrational - perhaps the consumer should cut back on their coffee consumption? Free markets do not work effectively when significant gaps in knowledge exist when either the producer or consumer can exploit.
No time lags
For markets to form and work effectively there will be no significant time lags between the purchase of the private product and the net benefit derived by the consumer. For example, if a consumer buys a newspaper with their morning coffee they can read it immediately. Who would bother to purchase a newspaper if they could not read it for several days? Of course, where mail order or online deliveries are concerned, a short time lag is acceptable.
Markets are said to work at their best when there are no effects on parties not involved in the market transaction. This means that during the production of the good, and during its consumption and disposal after use, there is no positive or negative impact on other citizens. A positive impact is called a positive externality or external benefit, and a negative impact is called a negative externality or external cost. For example, a positive externality associated with a cafe would be the benefit to a nearby newsagent of customers purchasing their newspaper to read with their morning coffee. An example of a negative externality is the litter created outside the cafe when consumers throw away their used coffee cups into the street. When such externalities exist, free markets may not form or, more likely, may not work efficiently.
However, even when negative externalities exist, such as waste or potential damage to the environment, markets may form to eliminate the waste or prevent damage to the environment. For example, the cafe owner may install a litter bin outside the cafe so that litter can be disposed of. This may help attract more customers, and so the profit motive may come into play to help deal with the externality.
For markets to form and operate successfully, consumers and producers must have property rights. Property rights mean that they have the right to own private property and protect it from theft or damage, or from other people’s waste, and from the pollution of others. If property rights cannot be established, the good is not a pure private good.
Incentives for entrepreneurs
The combined effects of the above characteristics means that markets
will form because
will be willing to take risks associated with producing and supplying pure
private goods. This is because consumers would be prepared to pay for the good ,
, andproducers can charge consumers at the point of consumption, from which they can earn revenue and make a profit.
When some of these conditions are absent, it is likely that market failure will exist.