Table of Contents
- Perfectly competitive market
- Perfect competition characteristics
- Perfect competition examples
- The reasons for the failure of perfect competition
- Perfect competition graph
- Frequently asked questions
Perfectly competitive market
Perfect competition, also known as a perfectly competitive market or pure competition is a hypothetical market where competition is at its greatest possible level. It comes about when there is a very large number of firms or producers that produce a homogeneous product. An individual firm in perfect competition can only produce a very small amount relative to the total demand of the product of the industry. This is so for an individual firm not to be able to affect the price by changing the supply of its output. Neo-classical economists have argued that perfect competition would produce the best outcome possible for consumers and society.
As it is said to be hypothetical, it emphasizes that is an idealized concept that concept, not reality. The term only highlights the picture of a market in an ideal world. It tentatively emphasizes providing customers with low prices, multiple choices, and high levels of competition. In the perfect market, there are no artificial restrictions. Also, the price of commodities tends to be equal everywhere.
Regarding this, Mrs. Joan stated that “Perfect competition prevails when the demand for the output of each producer is perfectly elastic”. Boulding defined perfect competition as “a large number of buyers and sellers all engaged in the purchase and sale of identically similar commodities, who are in close contact with one another and who buy and sell freely among themselves”.
Perfect competition characteristics
The perfectly competitive market possesses the following characteristics;
- Homogeneous products
- Perfect knowledge
- A large number of buyers and sellers
- Free entry and exit
- Perfect mobility of factors of production
- Absence of price control
- Equal market share
- Buyer-seller independent relationship
- Absence of government regulation
- No transaction costs
Under a perfect market, each firm produces and produces homogeneous products in order for buyers not to have any preference for the product of any individual firm or seller over others. Price will also be uniform everywhere if goods are homogeneous.
Buyers and sellers have no limited reach to information with regard to the market price. In other words, there is perfect knowledge without any information failure or time lags in the flow of information. This implies that information is freely available to all participants, meaning that taking risks is minimal and the role of the entrepreneur is limited. Because of the idea of perfect knowledge on part of the producers and consumers, it is assumed that they are rational in their decisions in order to maximize their self-interest. Consumers look towards maximizing their utility while producers look forward to maximizing their profits. The idea of perfect knowledge facilitates uniformity in prices.
A large number of buyers and sellers
There are so many firms in the market that they are too many to measure, many buyers and sellers. This is because of the absence of barriers to entry into the industry. Because of the large number of firms in the market, it is impossible for an individual firm to influence the price and output of the entire industry. The firms that exist in a perfect market greatly compete among themselves. Firms sell at an equilibrium price where demand is equal to supply. If they do not sell at that price, they will go out of business because many other firms sell the same commodity at a lower price. This makes customers face little costs associated with switching to a substitute good. In essence, the large number of competing firms in the market implies that no firm can raise prices since consumers can switch to cheaper substitutes.
Free entry and exit
Firms can freely enter and exit the industry or market at little or no cost, there are no barriers to entry and exit. If there is the hope of earning a profit, the firm will enter the industry. On the other hand, if there is an expected loss, the firm will leave the business. The free entry and exit to and from the industry includes buyers, sellers, buyers, sellers, and factors of production.
Perfect mobility of factors of production
In the perfect market, goods and factors are perfectly mobile between industries, that is, firms should be able to freely move goods between industries where they can fetch the highest price. The absence of transport costs will help the entire market to maintain price uniformity.
Absence of price control
No individual firm has the power to influence market price or market conditions. In essence, a single firm is a price taker which means that the firm takes its price from the entire industry. A single firm cannot independently increase its price given that it will not sell any goods at all. On the other hand, a producer cannot lower his own price below the market price given that it can sell all its products at the market price. In this case, prices are liable to change freely in response to the forces of demand and supply. The word, price taker means that each market player has accepted the prices which are thoroughly accepted in the market. So they have no sufficient power to set prices. They, therefore, take prices from the whole industry.
Because competing firms cannot compete on price, they have similar market share. This is because a firm that reduces prices will run at a loss since it costs more to make than to sell. This will make such a firm go out of business. Also, a firm cannot increase prices as explained in the point above. This is because there is a high rate of competition to attract customers. So if a firm increases the price, the competition will certainly force it out of business. This, in turn, places a restriction on the ability of a firm to gain market share.
Buyer-seller independent relationship
There exists an independent relationship between buyers and sellers in the perfect market. In other words, there is no attachment between the buyers and sellers in the market. In this case, sellers do not prick and choose the method of accepting a commodity price. From a close view, perfect competition is a pure myth.
Absence of government regulation
There is no need for government regulation in the perfect market except to make the market more competitive. It is as well assumed that externalities are not in place. This implies that there is no external cost or benefit to third parties not involved in the transaction. As there is perfect knowledge regarding the market, there is no need for government involvement in the market mechanism in order to provide regulations into it.
In the perfect market, firms can only make normal profits in the long run though they can make abnormal/supernormal profits in the short run.
No transaction costs
Buyers and sellers in a perfectly competitive market do not get involved in transaction costs in the course of trading goods and services through externalities. The third-party in the transaction does not get commission or benefit from the knowledge transaction.
Perfect competition examples
It is usual to say that perfect competition does not exist in reality, it is just a myth. This statement is true to some extent. For example, perfect competition may have existed in the past centuries when commodities were the major source of economic activity. These commodities include oil, coal, metal, etc. These products were homogeneous and met the conditions of a perfect market. Looking back at the old fashion markets, we would find out that there were many buyers and sellers of the same commodity. For instance, there are many bakers who come into the market to sell bread. This shows a homogeneous product with a large number of buyers and sellers entering and exiting the market.
Though times have changed as we presently live in an economy where firms and producers compete by supplying different products. Customers or buyers are now dependent on brands as a form of obtaining information. In this case, perfect information with regard to the market is not achievable in actual terms because of the number of products we buy. In the previous centuries, it was easier to obtain perfect information because few products were available. Presently, there are millions of products. With this, we can trace a few notable examples that are still in existence presently although they are rare. The perfect competition market examples however include;
- Foreign exchange markets
- Online shopping
In the agricultural market, products are very similar such as potatoes, carrots, and grains. They are all generic with many producers producing them. As the product is homogeneous or identical, it is easy to buy or acquire some land to cultivate it. IT is as well easy to leave the market, that is to stop cultivating the product. So this market shows some signs of perfect competition. It is also important to note that the producers rarely have control over the price of their product as it is the forces of supply and demand that influence the prices. When these producers take their goods to the market, the prices either rise or fall. These producers then have to take the prices as they are, this implies that they are price takers in the market.
Foreign exchange markets
In the foreign exchange market, traders engage in the exchange of currencies. Just as there is only one US Dollar, only one Euro, and only one Great British Pound, the product is homogeneous. In this market also, there are many buyers and sellers. It is furthermore easy to buy some currency and easy to sell it as well. There is an exception in the fact that traders in the foreign exchange market tend not to have perfect information with regard to the market. This in turn will make normal buyers and sellers be at a disadvantage when we compare them to professional traders who do it as a means of livelihood. Despite this exception, it is one of the closest examples of a perfectly competitive market today.
It may be hard for us to see the internet as a distinct market, but it is certain that it is an avenue for many buyers and sellers. We can look at eBay as a typical example. This is exactly what a market connotes even though it is not on a physical level.
The internet gives customers the chance to compare and gather perfect information with regard to a product and its market condition. If we consider a book as an example, there are many buyers and distributors. For instance, we have the Amazon, Waterstones, or Barnes & Noble. There are generally little differences in prices at the same time.
In this instance, however, there are many buyers and sellers that sell similar products. Also, it is easy to enter and exit the market with little or no costs, and without barriers. Even as companies such as Amazon have a strong market share, it is also close to a real-life example of a perfectly competitive market.
The reasons for the failure of perfect competition
The perfect market would have been in place if the conditions highlighted above were simultaneously in place. It is quite unfortunate that it is difficult to establish a very well-organized link in terms of the conditions or points for a perfect market. For a perfectly competitive market, there are always barriers on the way to achieving this aim. So, let us look at the reasons why perfect competition has not been achievable over time.
- Competition between Sellers
- Lack of research and development
- Unbalanced prices
- Changes in demand
- Imperfect information
- Supplier power
- Scarcity issue
Competition between sellers
There are many competing sellers or producers in the market. They do this to show the powers of their company explicitly by enforcing control over a large number of goods and services against other sellers.
Lack of research and development
As the commodities in the market are homogeneous, the entrepreneur will not carry out research and development activities. This research and development is important because it helps in improving the products for a better condition to win the competition against other competitors or the product of other producers.
In a purely competitive market, it is the price mechanism that affects and controls prices. For instance, the main target of every entrepreneur is to maximize profit and this can cause a swift increase in the market price. The buyers are also price takers and they have unstable incomes. This can cause disturbances in the market demand as a failure.
Changes in demand
Talking about consumer behavior and the demand to own goods or services in a wholly competitive market, buyers being free to buy will abnormally affect the demand.
In the real context, the buyers do not always receive perfect and reliable information and knowledge from the realistic market. Promotions and directions that are highly persuasive can affect the decisions of consumers.
The production firms/manufacturers may desire to gain control over the number of goods and services which they provide to the market. This is because they want to show their market power.
Resources such as capital, labor, and raw materials are scarce. This, in turn, can amount to a failure for homogeneous production in the perfectly competitive market.
Perfect competition graph
The perfect competitor’s price line is horizontal and the demand curve is perfectly elastic. By implication, no single firm or producer has influence over the price of a commodity. This is the case because each of the firms contributes a small portion to the total output. For each firm, the price is fixed, that is, they sell at the same price. The price of the commodity is dependent on the total output of the industry as well as the demand for the commodity. In this case, the marginal firms in the industry will be the first to fold up if there is a fall in price.
The perfectly competitive firm produces the most profitable output where its marginal cost is equal to marginal revenue. If the firm produces beyond this point, the marginal cost of production will exceed the marginal revenue thereby causing a decrease in profits.
Short-run and long-run equilibrium in perfect competition
Equilibrium in a perfect market refers to the point where the demands are equal to the market supply. At this point, the price of the firm will be determined. In the short run, it is demand that affects equilibrium. That is, an increase in demand brings about economic profit in the short run. In the long run, the same increase in demand induces entry. Also in this period, both supply and demand for a commodity affect the equilibrium price.
In the short run, a decrease in demand brings about an economic loss, which is negative economic profits. This decrease in demand forces some firms to opt-out of the industry in the long run. In the short run, a firm in the perfect competition receives abnormal/supernormal profits. To explain this better, the firm’s average and marginal costs of production will fall while its output increases. So, it is possible for him to sell at a price that is higher than the marginal cost of production. This amounts to the firm earning abnormal profit. The shaded part in the image below indicates the abnormal profit.
In the long run, the firm’s abnormal profits are wiped off where it is at the equilibrium point and makes normal profits. At the equilibrium point, MC=MR=AC=AR=P=D. The firm, therefore, makes profits where marginal cost is equal to marginal revenue.
Frequently asked questions
What is perfect competition and its features?
Perfect competition, also known as a perfectly competitive market or pure competition is a hypothetical market where competition is at its greatest possible level. It comes about when there is a very large number of firms or producers that produce a homogeneous product.
The perfect market has the following features;
- The products are identical, that is, they are homogeneous.
- Buyers and sellers, that is the players in the market, have perfect information with regard to the present market condition.
- There exists a large number of buyers and sellers in the market such that they are too many to measure.
- In the market, there is free entry and exit, with no barriers.
- There is perfect mobility of factors of production, which means, it is easy to move factors from one industry to another.
- In the perfect market, firms have no control over the prices in the market because they are influenced by the forces of supply and demand. Because of the homogeneity of products, absence of price control, and a large number of competitors, firms tend to have an equal market share.
- There exists an independent relationship between buyers and sellers in the perfect market.
- There is no need for government regulation in the perfect market except to make the market more competitive.
- Firms can only make normal profits in the long run though they can make abnormal/supernormal profits in the short run.
- In the course of a transaction, there are no costs incurred.
What is perfect competition, give an example?
Perfect competition is a market that comes about when there is a very large number of firms or producers that produce a homogeneous product. In this market, there are no barriers to entry and exit. There is no price control because it is the price mechanism that determines the price of products, that is the forces of supply and demand.
Although the perfect competition is said to be a myth, we can still find real-life examples. These examples may not possess all the features of perfect competition, but they can show us the picture of this market.
One of the considerable examples is the agricultural sector where products are very similar such as potatoes, carrots, and grains. As the product is homogeneous or identical, it is easy to buy or acquire some land to cultivate it. It is also easy to leave the market, that is to stop cultivating the product. So this market shows some signs of perfect competition. It is also important to note that the producers rarely have control over the price of their product as it is the forces of supply and demand that influence the prices. When these producers take their goods to the market, the prices either rise or fall. These producers then have to take the prices as they are, this implies that they are price takers in the market.
What are the 5 conditions of perfect competition?
The conditions of a perfect market include;
- The industry has a large number of buyers and sellers in the market.
- All firms produce and sell homogeneous products.
- There is perfect information with regard to the present state of the market. That is, buyers and sellers have all relevant information to make rational decisions.
- A free entry and free exit into and out of the market exist, that is, firms can enter and leave the market without barriers.
- No individual firm has control over price, the price mechanism influences market price.
What is perfect competition in simple words?
In simple words, perfect competition is a market where there is a large number of buyers and sellers selling homogeneous commodities.
Chyou is a published author who focuses on the field of international business. After an established career facilitating mergers and acquisitions for medium to large corporations, Chyou turned to writing to help students better understand international business concepts.