Why is a perfectly competitive firm called a price taker and a monopolist a price maker?

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jimjimjimmy eNotes educator| Certified Educator

A perfectly competitive firm operates within a structure that is defined by five criteria: a) the sale of products that are identical to their competition b) the inability of firms to control market price c) the ownership of a relatively small market share by each firm d) complete transparency regarding products and prices and e) freedom of entry and exit. A perfectly competitive firm would be characterized as a "price taker" due to its inability to influence market price. In a perfectly competitive market, the price of the products are fixed since each firm is producing just enough to stay in business. Therefore, a perfectly competitive firm is essentially given a price at which to sell their products since they have no motivation to sell their products at prices that differ from the "perfect" market demand. 

In contrast, a monopoly firm has full control over the market in which it operates, and as such, this type of firm can manipulate market price purely by changing the price and quantity of their product. A monopoly firm is called a "price maker" because it determines market price and the rate of supply. Under these conditions, there must be roadblocks to entry and exit within the market, imperfect knowledge on behalf of the buyers, and only one producer within the market. Therefore, a monopoly firm's domination is dependent upon the elasticity of the market. The less elastic, the greater degree to which a firm can act as a "price maker" and manipulate market prices. 

pohnpei397 eNotes educator| Certified Educator

The above answer is mostly correct, but I would like to add a little to it to tell you WHY a firm in perfect competition can not influence the market --- WHY it must be a price taker.

The major reason for this is that the product it sells is identical to that of its competitors.  Therefore, it can not, for example, raise its price above that of its competitors and claim that its product is superior.  If it raises its prices above those of its competitors, it will simply be unable to sell any goods.

Take, for example, eggs which, in America at least, are graded by size and quality.  One Grade A egg is essentially identical to another.  Therefore, one egg supplier can not possibly claim its eggs are superior to those of other suppliers.

This is why a firm in perfect competition must be a price taker.

One small quibble with the above answer:

In perfect competition, firms may easily enter the market.  Because of this, firms in this market structure, by definition, make zero economic profit in the long term.  This is why they do not lower prices -- it's not because they have no incentive to do so -- it's because if they do they make negative profit.

krishna-agrawala | Student

In response to assessment of my answer at Post #2 as "mostly correct" by Ponphei in post #3 above, I would like to present my views on some of the issues mentioned in that post.

It is said that when 3 economists discuss an issue they are sure to have between them 4 different views. So Ponphei may be right, but I differ with him on some issues.

Undifferentiated products is one of the condition existing in a perfectly competitive market, but that is not the primary reason for the firm being a price taker. Besides the sameness of the identical products does not determine the quantity sold by a firm. In a perfectly competitive market there are many firms selling identical product, but the quantities they sell is not identical.

The firm is a price taker because of the limited scope of economies of scale available to it. If a firm was able to increase its production to a very high level without reaching the bottom of its marginal cos curve, it will be able to affect market price and quantity in spite of identical product, changing the market structure to monopoly, and therefore will become a price maker instead of a price taker.

On the assertion of Ponphei that firms in perfectly competitive market do not lower price because they are making zero economic profit, is it implied that if a firm is making more than zero economic profit, it will lower its price? If so, why don't monopolistic firms sell at a price so that will give them zero economic profit?

krishna-agrawala | Student

A perfectly competitive firm in the question, I believe refers to a firm operating in a perfectly competitive market. By definition a perfectly competitive market is one in which no single firm has to influence either the equilibrium price of the market or the the total quantity supplied in the market. Thus, a firm operating in a competitive market has no incentive to supply at a price lower than market equilibrium price, as it can sell all it wants to supply at equilibrium. At the same time, the firm cannot sell at price higher than the market price, because it will be able find no buyers at that price, and its sales volume will drop down to zero. Thus, a firm operating in perfectly competitive market has to accept whatever is the market equilibrium price, and therefore it is called a price taker.

In contrast, a monopoly firm is the only supplier in the market and therefore has full control over the market prices and total market supplies. Therefore, a firm operating in a monopoly market fixes its price in such a way that for the quantity demanded by customers at that market price the marginal revenue of the firm is equal to its marginal costs. In this way way it decides the market price as well as the total quantity if a commodity supplied in the market, and therefore it is called a price maker.