This section of the Cambridge IGCSE Economics (0455) syllabus requires students to understand the effects of having a high number of firms in a market on the following variables: price, quality, choice, and profit.

Note: the theory of perfect and imperfect competition and diagrams are not required.

A competitive market (often referred to as perfect competition) is characterised by an industry in which many firms compete, all with relatively low market share. This means there is an immense degree of competition in the market. For example, small fruits and vegetable market stall owners compete in highly competitive markets.

The main characteristics of firms operating in competitive markets are outlined below. These characteristics, or features, have a direct impact on price, quality, choice, and profit.

• There are many buyers and sellers in the industry. No individual firm is large enough to have significant market power to influence the market supply or demand (see Unit 2.6). It also means that any change in the level of output of a single firm has no impact on the market equilibrium output or price, i.e., firms in highly competitive markets cannot influence the market supply of a good or service. This results in firms all charging the same, or very similar, prices. It also means that consumers have plenty of choice as to which firm they buy from.
• In highly competitive markets, firms produce or sell a homogeneous product. This means the products are identical, rather than differentiated. For example, bananas or carrots sold in fruit and vegetable markets are more or less the same, irrespective of which market vendor sells these. The existence of a large number of firms in the market means that customers can simply switch between the substitute products of the competing firms.
• It is also assumed that buyers and sellers have perfect knowledge of prices. As firms are price takers, they are aware of the price charged by competitors in the industry. Similarly, as consumers purchase homogenous products, they are also aware of the market price.
• There are very few, if any, barriers to entry. This means there is freedom of entry into the market. This will happen if the market experiences higher levels of demand and/or lower market supply (and hence higher profits), which attracts new firms to enter the industry. The opposite is true if there is lower demand and/or higher supply.
• All firms are price takers. This means the firm's price is determined by the market forces of demand and supply. This is because no individual firm is large enough to be able to influence the market equilibrium price or output. This can limit the profits of any individual firm operating in highly competitive markets. Being a price taker also means that any seller who sets a higher price will have no demand whilst any vendor who lowers their price will make a loss (or lower profit margin). In fact, there is no advantage in reducing price because the firm can sell its entire output at the (higher) market equilibrium price.
• In theory, there is an incentive for firms operating in highly competitive markets to compete on quality so as to attract more customers. However, in reality, as firms produce homogenous goods, the quality is the same.
• The intensity of competition also means that each firm can only earn a relatively low level of profit and minimal market share in the long run.

Healthy competition ensures that consumers get the right goods and services at the right prices at the right time.  Competitive markets also ensure higher output and lower (more competitive) prices, unlike in monopoly markets where a single firm dominates the industry. Firms in these markets also have the incentive to remain efficient in their production so as to remain competitive in the industry. This means firms in competitive markets will use of the least-cost method of production to ensure prices are competitive.

Overall, highly competitive markets tends to benefit consumers in terms of price, quality, and choice. This is because competition gives firms a greater incentive to reduce prices, improve quality, and offer customers more choice. However, the existence of competition in the market tends to limit the amount of profit that firms can earn.

Note: the economic theory of competitive markets (perfect competition) in an extreme, hypothetical model. In reality, most markets are imperfectly competitive in nature. For example, most firms in most markets will have some degree of product differentiation, such as branding and quality.

To test your understanding of this topic in the Cambridge IGCSE syllabus (Competitive markets), have a go at answering the following true or false quiz.