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How does the perfect competition model break down when one of the six assumptions is lost?

So the perfectly competitive market model has six specific requirements:

  1. Perfect information.
  2. Sellers are price takers.
  3. Homogeneous product.
  4. Many buyers and sellers
  5. No barriers to entry/exit.
  6. Firms are profit maximizers.

Wikipedia indicate that there are potentially other requirements as well, but there are the six that I learned from Mankiw. Now, I know that there are alternative models to perfect competition (such as monopolistic, and so forth) but the idea of “perfect” competition breaks down when one of these isn’t present.

What happens to the model (that perfect X) when one of these six factors isn’t available? Do one of the lines become kinked? Does the X become a K? What kind of role does each play in keeping the X, well, an X?

Answer 15

I’m not sure what you mean by lines being “kinked”. To address the overarching question here, at a high level, relaxing each of those assumptions gives you a different market structure:

  1. Relax perfect information? Now we have things like adverse selection/moral hazard (models of imperfect information)
  2. Relax price-taking? We get monopoly (this is related to [4])
  3. Relax homogeneity? We get non-price competition; extra features, brand loyalty, etc. (monopolistic competition)

  4. Relax many buyers and sellers? Now we get things like monopsony and monopoly (respectively) 4.a (From Ryan in comments) If you relax the “many sellers” assumption and end up with some number of sellers greater than 1, you can end up with very interesting competitive situations:

    In one case (Bertrand competition), you end up with a price/per-firm quantity identical to perfect competition.

    In another (Cournot competition), you end up with two firms, each sharing a portion of demand and acting like a monopoly on their portion

    In another (Stackelberg competition), the outcome is similar to Cournot, but you have some path dependency because it depends on which firm sets their price first (Stackelberg leader).

  5. Add barriers to entry/exit? Now we can get things like natural monopoly

Regarding 6: if we relax the assumption about profit (or utility, if you’re working with the rational consumer model), I don’t really know what happens. I suspect you would be left with an economic model that could literally be used to predict any sort of behavior (you lose the nice, falsifiability of the standard rational agent models).

Answer 144

Sticky-price “New-Keynsian” macroeconomic models explicitly aim to relax the price-taking assumption on the part of firms. Without going into too many details (i.e. abstracting away from the formation of the demand curve these firms face), one result is essentially something you would expect. Compared with the version of the model in which everyone is a price-taker, firms optimally add a “markup” to the prices that they ask. (This markup becomes one of the “dials” that researchers can turn to try to get the model to help explain business cycles. Not entirely an answer to your question, but thought I’d throw it in there :)

Check out Wikipedia for sticky-price macro models to learn mode about “stepping away from perfect competition” in the macroeconomic realm. Greg Mankiw, who writes a popular econ blog, is a big proponent of these types of models.

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