Perfect Competition

Perfect Competition:

Definition:

  • Perfect competition is a market structure where a large number of small firms are competing against each other.
  • In a perfect competition, each firm is so small compared to the overall market that it has zero market power to set the price, and thus is a price taker.
  • All firms sell identical products and consumers have perfect and complete information about the products.
  • There are no barriers to entry, meaning any new firm can enter or exit the market at will.

Characteristics:

  • Large Number of Buyers and Sellers: The market has many buyers and sellers where no single buyer or seller has influence over market price.
  • Homogeneous Product: All firms in the market produce identical goods or services.
  • Freedom of Entry and Exit: New firms can enter the market and old firms can exit freely without any legal, financial, or technological barriers.
  • Perfect Knowledge: Both buyers and sellers have perfect knowledge about the market, that is, the buyers know the prices of goods in the market and the sellers know the methods of production and availability of resources.

Short Run and Long Run Equilibrium:

  • In the short run, firms can make supernormal profits or losses. However, due to the absence of barriers to entry and exit, in the long run, firms in perfect competition will only make normal profits.
  • The long run equilibrium in perfect competition occurs when price equals marginal cost and average cost, that is, when P=MC=AC.

Efficiency:

  • Allocative Efficiency: This occurs when the price equals marginal cost, or P=MC. This means that resources are allocated where consumers get most satisfaction.
  • Productive Efficiency: This is achieved when firms produce at the lowest cost per unit, where price equals the minimum of average cost (P=AC). In this case, the firms are operating on the bottom point of their average cost curve.

Disadvantages:

  • Since perfect competition results in normal profits in long run, this market structure may lack the incentive for technological innovation and improvement in quality, which often comes with the potential for supernormal profits.
  • Lack of variety : As all firms produce identical products in the perfectly competitive market, it may results in a lack of diversity for consumers.
  • Unrealistic assumptions: Many assumptions of perfect competition like standardized products, perfect knowledge and no barriers to entry and exit are unrealistic in real world scenario.

Examples and Real-world implications:

  • While it is hard to find real-world examples of perfect competition due to its stringent assumptions, the agricultural sector comes closest to this market structure.
  • Understanding perfect competition helps economists to understand and predict how resources are allocated in industries that approximate to perfect competition, and provides a benchmark against which to measure the efficiency of real-world markets.