(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 305

280 PART 2 • Producers, Consumers, and Competitive Markets
product was determined by the intersection of the market demand and market
supply curves. Underlying this analysis is the model of a perfectly competitive
market. The model of perfect competition is very useful for studying a variety of
markets, including agriculture, fuels and other commodities, housing, services,
and financial markets. Because this model is so important, we will spend some
time laying out the basic assumptions that underlie it.
The model of perfect competition rests on three basic assumptions: (1) price
taking, (2) product homogeneity, and (3) free entry and exit. You have encountered these assumptions earlier in the book; here we summarize and elaborate
on them.

• price taker Firm that has no
influence over market price and
thus takes the price as given.

• free entry (or exit)
Condition under which there
are no special costs that make it
difficult for a firm to enter (or exit)
an industry.

PRICE TAKING Because many firms compete in the market, each firm faces a
significant number of direct competitors for its products. Because each individual
firm sells a sufficiently small proportion of total market output, its decisions have no
impact on market price. Thus, each firm takes the market price as given. In short,
firms in perfectly competitive markets are price takers.
Suppose, for example, that you are the owner of a small electric lightbulb distribution business. You buy your lightbulbs from the manufacturer and resell
them at wholesale to small businesses and retail outlets. Unfortunately, you are
only one of many competing distributors. As a result, you find that there is
little room to negotiate with your customers. If you do not offer a competitive
price—one that is determined in the marketplace—your customers will take

their business elsewhere. In addition, you know that the number of lightbulbs
that you sell will have little or no effect on the wholesale price of bulbs. You are
a price taker.
The assumption of price taking applies to consumers as well as firms. In a perfectly competitive market, each consumer buys such a small proportion of total
industry output that he or she has no impact on the market price, and therefore
takes the price as given.
Another way of stating the price-taking assumption is that there are many
independent firms and independent consumers in the market, all of whom
believe—correctly—that their decisions will not affect prices.
PRODUCT HOMOGENEITY Price-taking behavior typically occurs in markets
where firms produce identical, or nearly identical, products. When the products
of all of the firms in a market are perfectly substitutable with one another—that is,
when they are homogeneous—no firm can raise the price of its product above the
price of other firms without losing most or all of its business. Most agricultural
products are homogeneous: Because product quality is relatively similar among
farms in a given region, for example, buyers of corn do not ask which individual
farm grew the product. Oil, gasoline, and raw materials such as copper, iron,
lumber, cotton, and sheet steel are also fairly homogeneous. Economists refer to
such homogeneous products as commodities.
In contrast, when products are heterogeneous, each firm has the opportunity to raise its price above that of its competitors without losing all of its sales.
Premium ice creams such as Häagen-Dazs, for example, can be sold at higher
prices because Häagen-Dazs has different ingredients and is perceived by many
consumers to be a higher-quality product.
The assumption of product homogeneity is important because it ensures that
there is a single market price, consistent with supply–demand analysis.
FREE ENTRY AND EXIT This third assumption, free entry (or exit), means
that there are no special costs that make it difficult for a new firm either to enter