Question

A single firm in a perfectly competitive market is relatively small compared to the rest of the market. What does this mean? How "small" is "small"?

Short answer

In a perfectly competitive market, a firm being relatively small means that it has a negligible impact on the overall market price and output. This implies that the firm cannot influence the market price and must act as a price taker. The degree of "smallness" is determined by the firm's market share, which measures its contribution to the total market output compared to the overall market. Being small in a perfectly competitive market means that the firm must focus on minimizing costs and producing efficiently to earn a profit in the long run.

Step-by-step solution

Understanding Perfect Competition

In a perfectly competitive market, there are a large number of buyers and sellers, each trading identical products. This means that no individual buyer or seller has the ability to influence market price. Since each firm is a price taker, they can sell as much as they want at the prevailing market price without affecting it. In this context, when we say that a firm is relatively small, we mean that it has a negligible impact on the overall market price and output.

Defining "Small" in a Perfectly Competitive Market

To determine how "small" is "small," we have to consider the overall size of the market and the number of firms competing in it. A firm would be considered small if its individual contribution to total market output, or its market share, is very low compared to the overall market. For example, let's say the total market output is 100,000 units, and there are 1,000 identical firms producing 100 units each. In this case, each firm has a market share of only 0.1% (100 units divided by 100,000 units), so we can consider them to be relatively small.

Effects of Being a Small Firm in a Perfectly Competitive Market

In a perfectly competitive market, being small means that the firm has no control over the market price and cannot influence it. As a price taker, the small firm can sell as much output as it wants at the market price, and its decisions will not affect the price or output of other firms in the market. This means that the small firm must focus on minimizing its costs and producing efficiently to earn a profit in the long run.

Characteristics of a Perfectly Competitive Market

To better understand the notion of a small firm in a perfectly competitive market, it's important to remember the key characteristics of such a market: 1. Large number of buyers and sellers: This ensures that no single firm can influence the market price. 2. Homogeneous or identical products: All firms in the market sell products that are identical, ensuring that buyers have no preference for any specific firm. 3. Free entry and exit: New firms can enter the market, and existing firms can leave the market without significant cost implications. This ensures that any economic profits or losses are short-lived and lead to long-run equilibrium. 4. Perfect information: Buyers and sellers have complete knowledge of the market, preventing any advantages from asymmetric information. A firm being small in such a market is crucial for the competition to be perfect, as it ensures that no single firm can manipulate the price or sway the market in its favor.