What is perfect competition?
Pure or perfect competition is a theoretical market structure in which the following criteria are met:
- All companies sell an identical product (the product is a “product” or “homogeneous”).
- All companies are price takers (they cannot influence the market price of their product).
- Market share has no influence on prices.
- Buyers have complete or “perfect” information – past, present and future – on the product sold and the prices charged by each company.
- The resources for such work are perfectly mobile.
- Companies can enter or exit the market at no cost.
This can be contrasted with the more realistic imperfect competition, which exists whenever a market, hypothetical or real, violates the abstract principles of pure or perfect neoclassical competition.
Since all real markets exist outside of the perfect competition model plan, each can be classified as imperfect. The contemporary theory of imperfect competition versus perfect competition stems from the Cambridge tradition of post-classical economic thought.
[Important: in reality, perfect competition does not exist, but highly competitive and liquid markets for like commodities, such as oil or wheat, are the closest real-world examples.]
How Perfect Competition Works
Perfect competition is a benchmark, or “ideal type,” to which actual market structures can be compared. Perfect competition is theoretically the opposite of a monopoly, in which only one company provides a good or service and that company can charge the price of its choice because consumers have no alternative and it is difficult to potential competitors to enter the market.
In perfect competition, there are many buyers and sellers, and prices reflect supply and demand. Companies earn just enough profits to stay in business and no more. If they were to make excess profits, other companies would enter the market and lower profits.
A large and homogeneous market
There are many buyers and sellers in a perfectly competitive market. Sellers are small businesses, rather than large companies capable of controlling prices through supply adjustments. They sell products with minimal differences in capacity, functionality and price. This ensures that buyers cannot distinguish products based on physical attributes, such as size or color, or intangible values, such as the brand.
A large population of buyers and sellers guarantees that supply and demand remain constant in this market. As such, buyers can easily replace products made by one company with another.
Perfect availability of information
Information about the ecosystem and competition in an industry is a significant advantage. For example, knowing the supply of components and supplier prices can make or break the market for some companies. In some knowledge-intensive and research-intensive industries, such as pharmaceuticals and technology, patent information and research initiatives from competitors can help companies develop competitive strategies and build a divide around them. products.
In a perfectly competitive market, however, these gaps do not exist. The information is also and freely accessible to all market players. This ensures that each company can produce its goods or services at exactly the same pace and with the same production techniques as another on the market.
Lack of controls
Governments play a vital role in shaping the product market by imposing price regulation and control. They can control the entry and exit of businesses in a market by establishing rules for operating in the market. For example, the pharmaceutical industry faces a list of rules regarding the research, production and sale of drugs.
In turn, these rules require large capital investments in the form of employees, such as lawyers and quality assurance staff, and infrastructure, such as machinery for making medicines. The cumulative costs add up and make it extremely expensive for companies to put a drug on the market.
In comparison, the tech industry operates with relatively less surveillance than its pharmaceutical counterpart. Thus, entrepreneurs in this industry can start businesses with less than zero capital, which allows individuals to easily start a business in the industry.
Such controls do not exist in a perfectly competitive market. The entry and exit of companies in such a market is not regulated, which frees them to spend on labor and fixed assets without restrictions and adjust their production according to market demands.
Inexpensive and efficient transportation
Another characteristic of perfect competition is cheap and efficient transport. In this type of market, companies do not incur significant costs for the transport of goods. This reduces the price of the product and reduces delays in the transportation of goods.
Key points to remember
- Perfect competition is an ideal type of market structure where all producers and consumers have complete and symmetrical information, with no transaction costs, where there are a large number of producers and consumers who compete.
- Perfect competition is theoretically the opposite of a monopoly market.
- Since all real markets exist outside of the perfect competition model plan, each can be classified as imperfect.
Examples of perfect competition
As mentioned earlier, perfect competition is a theoretical construction and does not exist in reality. As such, it is difficult to find concrete examples of perfect competition, but there are variations in everyday society.
Consider the situation in a farmers market, a place characterized by a large number of small sellers and buyers. In general, there is little difference between products and their prices from one market to another. The origin of the products does not matter (unless they are classified as organic) in such cases and there is very little difference in the packaging or the brand of the products. So even if one of the farms producing goods for the market ceases to operate, it will not make a difference from average prices.
The situation can also be relatively similar in the case of two competing supermarkets, which stock their aisles from the same set of businesses. Again, there is not much to distinguish the products from each other between the two supermarkets and their price remains almost the same. Another example of perfect competition is the unbranded product market, which offers cheaper versions of well-known products.
Product imitations are generally priced the same way and there are few differences between them. If one of the companies manufacturing such a product ceases operations, it is replaced by another.
The development of new markets in the technology industry also resembles to some extent perfect competition. For example, there was a proliferation of sites offering similar services at the start of social networks. Some examples of such sites are Sixdegrees.com, Blackplanet.com and Asianave.com. None of them had a dominant market share and the sites were mostly free. They were sellers in the market while the consumers of these sites, who were mainly young, were the buyers.
The start-up costs for businesses in this space were minimal, which means that startups and businesses can freely enter and exit these markets. Technologies, such as PHP and Java, were widely open-source and accessible to everyone. Capital expenditure, in the form of real estate and infrastructure, was unnecessary. (Facebook [FB] Mark Zuckerberg started the business from his university dorm.)
What are the disadvantages of perfect competition models?
Perfect competition establishes an ideal framework for establishing a market. But this market is defective and has some drawbacks. The first is the lack of innovation. The prospect of a larger market share and stand out from the competition encourages companies to innovate and make better products. But no company has a dominant market share in perfect competition.
Profit margins are also set by demand and supply. Companies cannot stand out by charging a premium for their products and services.
For example, it would be impossible for a company like Apple Inc. (AAPL) to exist in a perfectly competitive market because its phones are more expensive than their competitors. The second disadvantage of perfect competition is the lack of economies of scale. Profit margins limited to zero mean that companies will have less cash to invest in order to expand their production capacities.
An expansion of production capacity could potentially lower costs for consumers and increase the company’s profit margins. But the presence of several small companies cannibalizing the market for the same product prevents such an occurrence and ensures that the average size of the companies engaged in the market remains small.
Are companies making a profit in a perfectly competitive market?
The short answer to this question is no. Profits may be possible for short periods in perfectly competitive markets. But market dynamics cancel out the effects of positive or negative profits and bring them back to equilibrium. Because there is no information asymmetry on the market, other companies will quickly increase their production or reduce their manufacturing costs to reach parity with the company that made the profits.
Average and marginal business income in a perfectly competitive market are equal to the price of the product for the buyer. As a result, the perfectly competitive market balance, which had previously been disrupted, will be restored. In the long run, adjusting supply and demand ensures that all profits or losses in these markets tend to zero.
Does perfect competition exist in the real world?
Competition in the real world differs from this ideal mainly due to the differentiation of production, marketing and sales. For example, in agriculture, the owner of a small organic store can talk at length about the grain given to the cows that made the manure that fertilized the non-GMO soybeans – that’s differentiation. Through marketing, companies seek to establish “brand value” around their differentiation and to advertise to gain pricing and market share power.
Thus, the first two criteria – homogeneous products and price takers – are far from realistic. Yet for the other two criteria – information and mobility – the global transformation of technology and commerce improves the flexibility of information and resources. Although reality is far from this theoretical model, the model is still useful because of its ability to explain many real behaviors.
Barriers to entry prevent perfect competition
Many industries also have significant barriers to entry, such as high start-up costs (such as in the automotive industry) or strict government regulations (such as in the utility industry), which limit the capacity of companies to enter and exit these industries. And although consumer awareness has increased with the information age, there are still few industries where the buyer remains aware of all the products and prices available.
As you can see, there are significant barriers preventing perfect competition from appearing in today’s economy. The agricultural industry is probably the closest to perfect competition, because it is characterized by many small producers who have practically no possibility of changing the selling price of their products. Commercial buyers of agricultural products are generally very knowledgeable and, although agricultural production poses certain barriers to entry, it is not particularly difficult to enter the market as a producer.