Perfect Competition

Thomas Sim PEA2066

Q.
What is 'Perfect Competition'?

A.
Perfect competition (sometimes called pure competition) describes markets such that no participants are large enough to have the market power to set the price of a homogeneous product. Because the conditions for perfect competition are strict, there are few if any perfectly competitive markets. Still, buyers and sellers in some auction-type markets, say for commodities or some financial assets, may approximate the concept. As a Pareto efficient allocation of economic resources, perfect competition serves as a natural benchmark against which to contrast other market structures.

Generally, a perfectly competitive market exists when every participant is a "price taker", and no participant influences the price of the product it buys or sells. 

Its characteristics may include:

  • A large number buyers and sellers – A large number of consumers with the willingness and ability to buy the product at a certain price, and a large number of producers with the willingness and ability to supply the product at a certain price.
  • No barriers of entry and exit – No entry and exit barriers makes it extremely easy to enter or exit a perfectly competitive market.
  • Perfect factor mobility – In the long run factors of production are perfectly mobile, allowing free long term adjustments to changing market conditions.
  • Perfect information - All consumers and producers are assumed to have perfect knowledge of price, utility, quality and production methods of products.
  • Zero transaction costs - Buyers and sellers do not incur costs in making an exchange of goods in a perfectly competitive market.
  • Profit maximization - Firms are assumed to sell where marginal costs meet marginal revenue, where the most profit is generated.
  • Homogenous products - The qualities and characteristics of a market good or service do not vary between different suppliers.
  • Non-increasing returns to scale - The lack of increasing returns to scale (or economies of scale) ensures that there will always be a sufficient number of firms in the industry.
  • Property rights - Well defined property rights determine what may be sold, as well as what rights are conferred on the buyer.
  • Rational buyers - buyers capable of making rational purchases based on information given
  • No externalities - costs or benefits of an activity do not affect third parties

In the short run, it is possible for an individual firm to make an economic profit. This situation is shown in this diagram, as the price or average revenue, denoted by P, is above the average cost denoted by C .

However, in the long run, economic profit cannot be sustained. The arrival of new firms or expansion of existing firms (if returns to scale are constant) in the market causes the (horizontal) demand curve of each individual firm to shift downward, bringing down at the same time the price, the average revenue and marginal revenue curve. The final outcome is that, in the long run, the firm will make only normal profit (zero economic profit). Its horizontal demand curve will touch its average total cost curve at its lowest point. (See cost curve.)

In the short run, perfectly-competitive markets are not productively efficient as output will not occur where marginal cost is equal to average cost (MC=AC). They are allocatively efficient, as output will always occur where marginal cost is equal tomarginal revenue (MC=MR). In the long run, perfectly competitive markets are both allocatively and productively efficient.

In perfect competition, any profit-maximizing producer faces a market price equal to its marginal cost (P=MC). This implies that a factor's price equals the factor's marginal revenue product. It allows for derivation of the supply curve on which the neoclassical approach is based. This is also the reason why "a monopoly does not have a supply curve". The abandonment of price taking creates considerable difficulties for the demonstration of a general equilibrium except under other, very specific conditions such as that of monopolistic competition.

In simple terms, perfect competition has four elements:

  1. There are large number of buyers and sellers.
  2. There are no entry or exit barriers.
  3. There is perfect mobility of the factors, i.e. buyers can easily switch from one seller to the other.
  4. The products are homogeneous.

Source: http://en.wikipedia.org/wiki/Perfect_competition, verbatim on 30 May, 2014.