Necessary Conditions (or the Assumptions) for a Competitive Market

Microeconomics is focused primarily on creating mathematical models intended to represent logical decision-making by consumers and producers. Every model is a simplification of the actual patterns or relationships that occur in the actual process of making a decision. For the most part, microeconomic models are not intended to represent actual psychological processes of decision-making, rather they are constructed primarily to represent a logical process of decision-making, which can be tracked.

Since these models are simplified and emphasize logic (rather than complex, contrdictory emotions) we begin by identifying a set of Assumptions (or Necessary Conditions) that limit the range of behaviors and outcomes that the models represent. Since we want the model to be as useful as possible in representing decision-making we want to make as few assumptions as possible. Thus, every assumption we make in order to construct a model is a necessary condition (i.e. a requirement) to logically draw conclusions from the model. If we remove any one of the assumptions then the model will generate different results.

You can think of economic model building as writing a set of computer software commands to make a video game character behave in a logical and predictable manner in order to achieve a specific goal. We do not want the character to behave erratically. Additionally, we want the character to pursue and achieve a specific goal. Consequently, we want to limit the character’s behavior to a set of logical and specific decisions. We are not going to allow the character an unlimited number of options. Thus, we will identify a specific set of necessary conditions that we must include in order to get the character to behave as desired. Some of these assumptions are necessary in order to get our character to behave the way we want. These are called behavioral assumptions. Other assumptions have to be made in order for the programming language (i.e. mathematics) to work. These are the mathematical assumptions.

Even if our character behaves perfectly and achieves its goals its behavior will not represent what actual people in a real situations would do, since people are more complex and make decisions based upon contradictory emotions, as well as logic. Similarly, the assumptions or necessary conditions that we make for our microeconomic models allow our models to illustrate a logical solution a limited problem, but do not represent what people actually decide to do.

The basic model of a Competitive Market makes the following assumptions.

Behavioral Assumptions

1.   Economic Rationality. We assume that every decisionmaker in every model is economically rational. Recall that a person is economically rational if the person does two things:

i. Utility Maximization: the person must seek to maximize their net benefit from each decision, and;

ii. Preference Ordering: the person must be able to prioritize, or rank their preferences over the various choices provided.

2.   Unlimited Number of Small Firms. There is no market concentration, no monopoly, no oligopoly. We assume there are always enough competitors in the market to ensure that no firm or group of firms can gain dominate the market.

3.   No Market Power. We assume all producers are price takers and that no firm or group of firms can influence the market price of any good.

4.   No barriers to entry nor exit. We assume there are no barriers for competitive firms to enter into a market of profits can be made, nor are there any barriers forcing firms to remain in a market if the firms are experiencing loses.

5.   Perfect Information. No lying, fraud, industry, or proprietary secrets. All consumers and producers have the same complete set of information in order to ensure that all decision makers make decisions based upon an accurate assessment of MC = MU.

Mathematical  Assumptions

6.   Standardized products. No specialized, unique, labeled, trade-marked products.

7.   Infinitely divisible product units.

8.  Instantaneous and costless adjustments.

If any of these assumptions do not exist in an actual market, then the market is not competitive and we cannot conclude that the market will generate any of the benefits that a competitive market is supposed to generate (i.e. efficiency, consumer sovereignty, social optimality, uniqueness).