Perfect competition
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Perfect competition is a model in economic theory. It describes a hypothetical market form in which no producer or consumer has the market power to influence prices in the market. This would lead to an outcome which is efficient, according to the standard definition in economics (Pareto efficiency). The analysis of perfectly competitive markets provides the foundation of the theory of supply and demand.
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Assumptions of perfect competition
Perfect competition requires five parameters to be fulfilled:
- Atomicity -- there are a large number of small producers and consumers on a given market, each so small that its actions have no significant impact on others, firms are price takers.
- Homogeneity -- that goods and services are perfect substitutes.
- Perfect and complete information -- all firms and consumers know the prices set by all firms.
- Equal access -- all firms have access to production technologies, and resources (including information) are perfectly mobile.
- Free entry -- any firm may enter or exit the market as it wishes (see Barriers to entry).
In such a market, the price would move instantaneously to equilibrium.
Results of a Perfectly Competitive Market
This model is in most cases only a distant approximation of real markets, with the possible exception of certain large street markets. In general, few, if any of the conditions listed above will apply in real markets. For example, firms will never have perfect information about each other, and there will always be some transaction costs. In a perfectly competitive market, there will be both allocative and productive efficiency. Productive efficiency occurs when the firm produces at the lowest point on the average total cost curve, implying it cannot produce the goods for any cheaper. This is shown on the diagram - the horizontal demand curve touches the ATC (average total cost) curve at the lowest point. This would be achieved in perfect competition, as if any firm was not doing this another firm would be able to undercut it by selling products at a lower price. Allocative efficiency occurs when price is equal to marginal cost, as the good is available to the consumer at the lowest possible price. This is also achieved in perfect competition.
In contrast to a monopoly or oligopoly, it is impossible for a firm in perfect competition to earn abnormal profit in the long run, that is to say that a firm cannot make any more money than is necessary to cover its costs. If a firm is earning abnormal profit in the short term, this will act as a trigger for other firms to enter the market. They will compete with the first firm, driving the market price down until all firms are earning normal profit.
Examples of Perfect Competition
Some say that agriculture, with a large amount of suppliers, relatively inelastic demand, and almost perfectly substitutable product is an approximation to the perfect competition model. This may be/have been true in some places and times, but in modern economies it is not. For example, in the global agriculture market, agricultural subsidies are provided to US and European (via the CAP) farmers whose products are exported (dumped) at prices below the cost of production. Any form of government intervention such as subsidies warps the market, meaning that perfect competition does not occur. Buying a farm (of even renting one, together with equipment) is a rather substantial barrier to entry!
Perhaps the closest thing to a perfectly competitive market would be a street market with many small stalls selling identical smallholding-sourced food produce. As perfect competition is a theoretical absolute, there are no examples of a perfectly competitive market.
See also
Reference
- Luis M. B. Cabral: Introduction to Industrial Organisation, Massachusetts Institute of Technology Press, 2000, page 84-85.
