A perfectly competitive market is a hypothetical market where competition is at its greatest possible level. Neo-classical economists argued that perfect competition would produce the best possible outcomes for consumers, and society.
Perfectly competitive markets exhibit the following characteristics:
- There is perfect knowledge, with no information failure or time lags in the flow of information. Knowledge is freely available to all participants, which means that risk-taking is minimal and the role of the entrepreneur is limited.
- Given that producers and consumers have perfect knowledge, it is assumed that they make rational decisions to maximise their self interest – consumers look to maximise their utility, and producers look to maximise their profits.
- There are no barriers to entry into or exit out of the market.
- Firms produce homogeneous, identical, units of output that are not branded.
- Each unit of input, such as units of labour, are also homogeneous.
- No single firm can influence the market price, or market conditions. The single firm is said to be a price taker, taking its price from the whole industry. The single firm will not increase its price independently given that it will not sell any goods at all. Neither will the rational producer lower price below the market price given that it can sell all it produces at the market price.
- There are very many firms in the market – too many to measure. This is a result of having no barreirs to entry.
- There is no need for government regulation, except to make markets more competitive.
- There are assumed to be no externalities, that is no external costs or benefits to third parties not invlolved in the transaction.
- Firms can only make normal profits in the long run, although they can make abnormal (super-normal) profits in the short run.
The firm as price taker
The single firm takes its price from the industry, and is, consequently, referred to as a price taker. The industry is composed of all firms in the industry and the market price is where market demand is equal to market supply. Each single firm must charge this price and cannot diverge from it.
Equilibrium in perfect competition
In the short run
Under perfect competition, firms can make super-normal profits or losses.
However, in the long run firms are attracted into the industry if the incumbent firms are making supernormal profits. This is because there are no barriers to entry and because there is perfect knowledge. The effect of this entry into the industry is to shift the industry supply curve to the right, which drives down price until the point where all super-normal profits are exhausted. If firms are making losses, they will leave the market as there are no exit barriers, and this will shift the industry supply to the left, which raises price and enables those left in the market to derive normal profits.
In the long run
The super-normal profit derived by the firm in the short run acts as an incentive for new firms to enter the market, which increases industry supply and market price falls for all firms until only normal profit is made.
It can be argued that perfect competition will yield the following benefits:
- Because there is perfect knowledge, there is no information failure and knowledge is shared evenly between all participants.
- There are no barriers to entry, so existing firms cannot derive any monopoly power.
- Only normal profits made, so producers just cover their opportunity cost.
- There is no need to spend money on advertising, because there is perfect knowledge and firms can sell all they can produce. In addition, selling unbranded goods makes it hard to construct an effective advertising campaign.
- There is maximum possible:
- There is maximum allocative and productive efficiency:
Equilibrium will occur where P = MC, hence allocative efficiency.
In the long run equilibrium will occur at output where MC = ATC, which is productive efficiency.
- There is also maximum choice for consumers.
How realistic is the model?
Very few markets or industries in the real world are perfectly competitive. For example, how homogeneous is the output of real firms, given that even the smallest of firms working in manufacturing or services try to differentiate their product.
The assumption that producers and consumers act rationally is questioned by behavioural economists, who have become increasingly influential over the last decade. Numerous experiments have demonstrated that decision making often falls well short of what could be described as perfectly rational. Decision making can be biased and subject to rule of thumb ‘guidance’ when consumers and producers are faced with complex situations.
Although unrealistic, it is still a useful model in two respects. Firstly, many primary and commodity markets, such as coffee and tea, exhibit many of the characteristics of perfect competition, such as the number of individual producers that exist, and their inability to influence market price. Secondly, for other markets in manufacturing and services, the model is a useful yardstick by which economists and regulators can evaluate levels of competition that exist in real markets.