Key Terms
Perfect Competition: A market structure in which the following six criteria are met:
1) Homogenous product
2) All firms are price takers
3) All firms have small market share
4) Perfect information
5) No entry barriers
6) Large Number of buyers/sellers
Homogenous: All products are the same irrespective of price.
Price Taker: A firm that has to accept the price ruling in the market.
1) Homogenous product
2) All firms are price takers
3) All firms have small market share
4) Perfect information
5) No entry barriers
6) Large Number of buyers/sellers
Homogenous: All products are the same irrespective of price.
Price Taker: A firm that has to accept the price ruling in the market.
Theory
What is Perfect Competition?
A perfectly competitive market is a hypothetical market where competition is at its greatest possible level. A market must exhibit the following characteristics to be considered perfectly competitive.
1) Homogenous product
Completely identical goods that are not branded
2) All firms are price takers
A firm cannot influence the market price, it takes its price from the whole industry. If a single firm increases its price it won't sell any goods and no rational producer will sell below the market price.
3) All firms have small market share
There are many firms in the market that all have the equal minimum market share
4) Perfect information
Perfect information means that there are no time lags in the flow of information, knowledge is freely available.
5) No entry or exit barriers
No barriers to entry or exit means that firms can join or leave the market at will.
6) Large Number of buyers/sellers
Given that there are no entry barriers there are many firms in the market.
Examples of Perfect Competition
In the agriculture market anyone can grow vegetables, all products are the same, all firms have a small market share and follow the market price.
FOREX (Foreign Exchange Market)
Anyone can trade on the FOREX market, there are large numbers of buyers and sellers each with a small market share.
Diagram
If firms are making abnormal profits in the short run, there is incentive for new firms to enter industry. This causes an outward shift in market supply = forcing down price. Increase in supply reduces price until price = long run average cost. There is now no further incentive for movement into and out of industry. Long-run equilibrium established.
Advantages of Perfect Competition
1) Efficiency
Allocative Efficiency: Equilibrium will occur where P = MC, hence allocative efficiency arises.
X-efficiency: All points on the average cost curve are said to be X-efficient.
Productive Efficiency: In the long run equilibrium will occur at output where MC = ATC, which is productive efficiency.
2) Non-price Competition
In perfect competition non-price competition may arise in order to win sales and protect market share. This leads to spill over benefits for consumers e.g. Delivery services.
3) Equity Considerations
It might be considered fair that in perfectly competitive market structures, consumers pay a price that reflects the costs of producing goods.
2) Non-price Competition
In perfect competition non-price competition may arise in order to win sales and protect market share. This leads to spill over benefits for consumers e.g. Delivery services.
3) Equity Considerations
It might be considered fair that in perfectly competitive market structures, consumers pay a price that reflects the costs of producing goods.
Disadvantages of Perfect Competition
1) Inefficiency
Dyanmic efficiency involves innovation to improve the quality of a product and lower costs of production. Firms in a perfectly competitive market are unlikely to be dynamically efficient because there is a lack of supernormal profit meaning no investment in R+D.
Even in the short-run with perfect knowledge there is no incentive to develop new technology because it would be shared with other companies.
2) No economies of scale
Economies of scale can only be exploited by firms who make enough profit to be able to expand the operations of the firm. Since firms in perfect competition only make normal profit, it is unlikely that they will be able to exploit internal economies of scale.
However although a firm in perfect competition may not be able to exploit internal economies of scale it maybe able to benefit from external economies of scale, caused by an expansion of the industry rather than the firm.
3) Homogenous product gives consumers little choice
Although the consumer has the maximum choice of firms and of products to choose from, each firm is supplying an identical good at the same price. In this sense there is no choice at all in perfect competition.
Dyanmic efficiency involves innovation to improve the quality of a product and lower costs of production. Firms in a perfectly competitive market are unlikely to be dynamically efficient because there is a lack of supernormal profit meaning no investment in R+D.
Even in the short-run with perfect knowledge there is no incentive to develop new technology because it would be shared with other companies.
2) No economies of scale
Economies of scale can only be exploited by firms who make enough profit to be able to expand the operations of the firm. Since firms in perfect competition only make normal profit, it is unlikely that they will be able to exploit internal economies of scale.
However although a firm in perfect competition may not be able to exploit internal economies of scale it maybe able to benefit from external economies of scale, caused by an expansion of the industry rather than the firm.
3) Homogenous product gives consumers little choice
Although the consumer has the maximum choice of firms and of products to choose from, each firm is supplying an identical good at the same price. In this sense there is no choice at all in perfect competition.