13 Perfect Competition

The Policy Question
Should the Government Allow Oil Companies to Merge Retail Gas Stations?

In the late 1990s and early 2000s, there were a number of mergers of big oil companies in the United States: Exxon acquired Mobil, BP Amoco acquired ARCO, Chevron acquired Texaco, and Phillips merged with Conoco. This led to massive consolidation in the oil business. In response, US government regulators required the sell-off of some refineries to maintain competitiveness in regional refined gas markets. For the most part, however, the same regulators were unconcerned about the reduction in competition in the retail gas market. In this chapter, we will explore perfectly competitive markets and, in so doing, will be able to better understand why regulators were relatively unconcerned about concentration in the retail gas industry.

Exploring the Policy Question

1. Why were retail gas stations not considered a main concern of regulators?
2. Does the merger of major oil companies necessarily lead to higher gas prices? Why or why not?

13.1 Conditions for Perfect Competition

Learning Objective 13.1: Describe the characteristics of a perfectly competitive market.

In perfectly competitive markets, firms and consumers are all price takers: their supply and purchasing decisions have no impact on the market price. This means that the market is so big and any one individual seller or buyer is such a small part of the overall market, their individual decisions are inconsequential to the market as a whole. It is worth mentioning here at the start that this is a very strong assumption, and thus this is considered an almost purely theoretical extreme, along with monopolies at the other extreme. We can and will describe markets that come pretty close to the assumptions underlying perfect completion, but most markets will lie somewhere in between purely competitive and monopolistic. It is important to study these extremes to better understand the full range of markets and their outcomes.

Before we describe in detail perfectly competitive markets, let’s consider how we categorize market structure, the competitive environments in which firms and consumers interact. There are three main metrics by which we measure a market’s structure:

1. The number of firms.
2. More firms mean more competition and more places to which consumers can turn to purchase a good.
3. The similarity of goods.
4. The more similar the goods sold in the market are, the more easily consumers can switch firms, and the more competitive the market is.
5. The barriers to entry.
6. The more difficult it is to enter a market for a new firm, the less competitive it is.

The first is relatively straightforward; more firms mean more competition in the sense that it is hard to charge more for a product that consumers can find easily from other sellers. The second is a little subtler because products can be differentiated by something as simple as a brand or more tangible aspects like colors, features, and other characteristics. Finally, the third can be barriers of law like patents or technology, even if not covered by legal patent protection, or more natural barriers like a very high cost of starting up a firm that is not justified by the expected revenue.

We will study four market types in more detail where these metrics will be discussed further, but for now, they are described along the three metrics in table 13.1.

With this categorization in place, we can turn to the definition of perfect competition. Perfect competition is a market with many firms, an identical product, and no barriers to entry. Let’s take these three metrics one by one.

Many Firms

Having many firms means that from the perspective of one individual firm, there is no way to raise or lower the market price for a good. This is because the individual firm’s output is such a small part of the overall market that it does not make a difference in terms of price. Firms are, therefore, price takers, meaning that their decision is simply how much to sell at the market price. If they try to sell for a higher price, no one will buy from them, and they could sell for a lower price, but if they did so, they would only be hurting themselves because it would not affect their quantity sold. Thus from an individual firm’s perspective, they face a horizontal demand curve. We assume they can sell as much as they want but only at the market price. This is an extreme assumption, as mentioned before, but there are some markets that resemble this description. Take the market for corn in the United States. The annual US corn crop is roughly twelve billion bushels, and there are roughly 315,000 corn farms in the country. Thus average output per farm is about thirty-eight thousand bushels annually, or about 0.000003 percent of the total supply of corn in the United States. If one farmer of average corn acreage decided to withhold output, there would not likely be any effect on the market price. It is also true that consumers are price takers as well, meaning no one consumer has a large enough impact to affect prices.

Identical Goods

The existence of identical goods means there is nothing to distinguish one firm’s goods from another. To use the corn example, once all the corn is dumped into the grain elevator, there is absolutely no way to tell from which farm a particular kernel of corn came. This means there is no way for one seller to differentiate their output to try to sell it at a different price on the premise that it is different. Contrast this to the automotive market, where the products are heterogeneous. Cars manufactured by Audi are very different than cars manufactured by Kia. An Audi A6 is very different than a Kia Optima in many substantive ways. Even when there is very little substance that is different, branding can be used to differentiate. Take, for example, polo shirts from Lacoste and Ralph Lauren. The shirt might be almost identical in terms of style, fabric, color, and so on, but by branding them with a logo—a crocodile or polo player—the manufacturers are able to differentiate them in the minds of consumers.

Barriers to Entry

It is very easy for firms to start and stop selling in this market. For example, if a farmer decides to plant corn instead of soybeans, there is nothing preventing them from doing so. Likewise, a farmer who wishes to plant soybeans instead of corn faces no barriers. In general, free entry and exit mean that there are no legal barriers to entry, like needing a special permit only given to a limited number of firms, and no major cost obstacles, like needing to invest millions of dollars in a manufacturing plant, as a new car manufacturer would. This ensures that firms remain price takers even when demand increases. If there is suddenly more demand for corn, perhaps from ethanol producers, farmers can quickly adjust their crops so existing growers do not have an opportunity to raise prices. Free exit is important as well because if firms know they cannot exit easily, they might be reluctant to enter in the first place.

There are two other implicit assumptions worth mentioning here. The first is that we assume that buyers and sellers have full information, meaning that they know the prices charged by every firm. This is important because without it, a firm could possibly charge an uninformed consumer more, and this violates the price-taker condition. The second is that there are negligible transaction costs, meaning it is easy for customers to switch sellers and vice versa. This is also important to ensure price taking, for if transactions costs were high, customers might accept higher prices from existing suppliers to avoid the cost of initiating a new transaction with another supplier at a lower price.

Take a moment and think about the policy example, retail gas, and how well it matches our definition of a perfectly competitive market.

• Are there many sellers?
• Is the product identical?
• Are there barriers to entry?

Your answers to these questions will be the basis of our evaluation of the policy stance the federal government took in assessing the oil company mergers.

In chapter 9, we studied profit maximization for a price-taking firm. We now know in what type of market we find price-taking firms: perfectly competitive markets. In the three other market types we will consider, firms will all have some control over the price of the goods they sell. It is worth taking a moment to review the principles of profit maximization for price-taking firms.

We now know clearly what leads a firm’s demand curve to be horizontal and thus the same as the marginal revenue curve: the fact that the firm is in a perfectly competitive market and has no influence on prices.

13.2 Perfect Competition and Efficiency

Learning Objective 13.2: Explain how perfectly competitive markets lead to Pareto-efficient outcomes.

In chapter 10.4, we studied the concepts of consumer and producer surplus and defined Pareto efficiency. We saw how prices adjust to conditions of excess supply and excess demand until a price that equates to supply and demand is reached. What this means is that the market ensures that everyone who values the good more than or equal to the marginal cost of producing it will find a seller willing to sell the good and that all opportunities for consumer and producer surplus will be exploited. This is how we know that total surplus is maximized.

In a perfectly competitive market, neither consumers nor producers have any influence over prices in the market, leaving them free to adjust to supply and demand excesses. Because of this, there is no deadweight loss, total surplus is maximized, and the outcome of the market is Pareto efficient. Prices in competitive markets act as demand and supply signals that are independent of institutional control and ensure that in the end, there are no mutually beneficial trades that do not happen. By mutually beneficial, we mean that buyers and sellers wish to engage in them because they will both be made better off.

It is in this sense that “free” markets are considered efficient. By “free,” we mean that prices freely adjust—there are no institutional or competitive controls that prevent prices from adjusting to equilibrate the market until the efficient outcome is achieved. By efficient, we mean Pareto efficient—there is no deadweight loss. With this chapter, we understand the conditions that must hold for a market to achieve the efficient outcome. There must be many buyers and sellers, the good must be homogenous, there must be free entry and exit, and there must be complete information about the good and prices on the part of buyers and no transactions costs. If this sounds like a lot, it is. In later chapters, we will examine the effects of other market structures and when assumptions like complete information fail to hold.

13.3 Policy Example
Should the Government Allow Oil Companies to Merge Retail Gas Stations?

Learning Objective 13.3: Use the perfectly competitive market model to evaluate the decision to allow the consolidation of retail gas stations under fewer brands.

We are now well equipped to address our policy example. What we need to do is evaluate the retail gas market using the description of a perfectly competitive market to try to decide how closely it resembles a perfectly competitive market. We then need to determine if the market looks like a competitive one pre-merger and if that would change significantly after the merger.

Number of Firms

Overall, there are many retail gas stations in the United States—more than 150,000 in 2012. But the United States is too big a geographical area to use for our purposes. For most consumers of retail gas, a reasonable example of a market is the metropolitan area in which they live if they live in urban areas or perhaps a ten-mile radius for rural residents. The number of major branded gas stations was reduced from ten to five with the mergers, but there are also a number of independent or non-name brand gas stations in most retail markets. Post-merger, most communities affected by the merger, those that had stations that represented each of the company brands that merged, still had more than one competing station. But how many competing stations is enough? We will study this question in more detail in chapter 19.

Identical Goods

Retail gas is essentially identical, but major brands do a lot of advertising to try to convince customers that their brand is better. How successful they are at this strategy is beyond our analysis here, but one clue to this is how much more the major branded stations charge over independent stations. However, in this case, the question is how much major brands are able to charge. Casual observation suggests that the answer is not very much. Major branded stations located close to each other almost always charge prices very close to each other, suggesting that though consumers consider their gas higher quality than that of the independent brands, they consider all major branded gas essentially identical.

Free Entry and Exit of Firms

The market for retail gas is fairly open but with some particular aspects. The first is that retail gas requires buried tanks, which often require special permitting. There may also be more zoning restrictions than for other businesses in some areas. But in general, there are few restrictions that prevent new stations to open and existing stations to close.

Retail gas is also one of the most transparent markets in terms of pricing. Most stations prominently display their prices on signs seen easily from the roadway, so the assumption about full information is more apt here than for most retail markets. There are also few transactions costs. There is virtually no cost to purchasing from one station or switching to another. The major gas brands try to create some frictions by establishing loyalty programs or credit card tie-ins that qualify customers for lower prices, but the extent of these programs is clearly limited based on the price matching that most stations do that are located close together.

It appears, then, that the retail gas market is fairly close to a competitive market, if not quite perfect, and that it remains fairly competitive even after the string of mergers. To fully answer the question of whether total surplus is reduced by the merger, we would need to look more closely at real-world price data, but on the face of it, the mergers of retail gas station brands appear relatively benign.