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What is Perfect Competition:
An ideal market structure characterized by a large number of small firms, identical products sold by all firms, freedom of entry into and exit out of the industry, and perfect knowledge of prices and technology. This is one of four basic market structures. The other three are monopoly, oligopoly, and monopolistic competition. Perfect competition is an idealized market structure that is not observed in the real world. While unrealistic, it does provide an excellent benchmark that can be used to analyze real world market structures. In particular, perfect competition efficiently allocates resources.Perfect competition a market structure characterized by a large number of firms so small relative to the overall size of the market, such that no single firm can affect the market price or quantity exchanged. Perfectly competitive firms are price takers. They set a production level based on the price determined in the market. If the market price changes, then the firm re-evaluates its production decision. This means that the short-run marginal cost curve of the firm is its short-run supply curve.
Characteristics
The four characteristics of perfect competition are: (1) large number of small firms, (2) identical products, (3) perfect resource mobility, and (4) perfect knowledge.- Large Number of Small Firms: A perfectly competitive industry contains a large number of small firms, each of which is relatively small compared to the overall size of the market. This ensures that no single firm can exert market control over price or quantity. If one firm decides to double its output or stop producing entirely, the market is unaffected. The price does not change and there is not discernible change in the quantity exchanged in the market.
- Identical Products: Each firm in a perfectly competitive market sells an identical product, what is often termed "homogeneous goods." The essential feature of this characteristic is not so much that the goods themselves are exactly, perfectly the same, but that buyers are unable to discern any difference. In particular, buyers cannot tell which firm produces a given product. There are no brand names or distinguishing features that differentiate products.
- Perfect Resource Mobility: Perfectly competitive firms are free to enter and exit an industry. They are not restricted by government rules and regulations, start-up cost, or other barriers to entry. While some firms incur high start-up cost or need government permits to enter an industry, this is not the case for perfectly competitive firms. Likewise, a perfectly competitive firm is not prevented from leaving an industry as is the case for government-regulated public utilities.
- Perfect Knowledge: In perfect competition, buyers are completely aware of sellers' prices, such that one firm cannot sell its good at a higher price than other firms. Each seller also has complete information about the prices charged by other sellers so they do not inadvertently charge less than the going market price. Perfect knowledge also extends to technology. All perfectly competitive firms have access to the same production techniques. No firm can produce its good faster, better, or cheaper because of special knowledge of information.
Demand and Revenue
| Demand Curve, Perfect Competition |
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Each firm in a perfectly competitive market is a price taker and can sell all of the output that it wants at the going market price, in this case $2.50. A firm is able to do this because it is a relatively small part of the market and its output is identical to that of every other firm. As a price taker, the firm has no ability to charge a higher price and no reason to charge a lower one.
Because it can sell all of the output it wants at the going market price, it has no reason to charge less. If it tries to charge more than the going market price, then buyers can simply buy output from any of the large number of perfect substitutes produced by other firms.
Because the price facing a perfectly competitive firm is unrelated to the quantity of output produced and sold, this price is also equal to the marginal revenue and average revenue generated by the firm. If a firm is able to sell any quantity of output for $2.50 each, then the average revenue, revenue per unit sold, is also $2.50. Moreover, each additional unit of output sold, marginal revenue, generates an extra $2.50.
Short-Run Production
| Short-Run Production, Perfect Competition |
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The short-run production decision for perfect competition can be illustrated using the exhibit to the right. The top panel indicates the two sides of the profit decision--revenue and cost. The straight green line is total revenue. Because price is constant, the total revenue curve is a straight line. The curved red line is total cost. The shape of the total cost curve is based on increasing then decreasing marginal returns. The difference between total revenue and total cost is profit, which is illustrated by the lower panel as the brown line.
A firm maximizes profit by selecting the quantity of output that generates the greatest gap between the total revenue line and the total cost line in the upper panel, or at the peak of the profit curve in the lower panel. In this example, the profit maximizing output quantity is 7. Any other level of production generates less profit.
Supply and Marginal Cost
A key implication obtained from the short-run analysis of perfection competition is positive relation between price and the quantity of output supplied. In particular, the supply curve for a perfectly competitive firm is positively sloped.This relation is generated for two reasons:
- First, a perfectly competitive firm produces the quantity of output that equates price and marginal cost.
- Second, the marginal cost curve, guided by the law of diminishing marginal returns, is positively sloped.
This conclusion, however, only applies to perfect competition. Firms operating in market structures that do not equate price and marginal cost, but rather equate marginal revenue and marginal cost. As such, the marginal cost curve is not the supply curve for the firm.
Long-Run Production
In the long run, with all inputs variable, a perfectly competitive industry reaches equilibrium at the output that achieves the minimum efficient scale, that is, the minimum of the long run average cost curve. This is achieved through a two-fold adjustment process.- The first of the folds is entry and exit of firms into and out of the industry. This ensures that firms earn zero economic profit and that price is equal to average cost.
- The second of the folds is the pursuit of profit maximization by each firm in the industry. This ensures that firms produce the quantity of output that equates price (and marginal revenue) with short-run and long-run marginal cost.
This condition means that the market price (which is also equal to a firm's average revenue and marginal revenue) is equal to marginal cost (both short run and long run) and average cost (both short run and long run). With price equal to marginal cost, each firm is maximizing profit and has no reason to adjust the quantity of output or factory size. With price equal to average cost, each firm in the industry earns only a normal profit. Economic profit is zero and there are no economic losses, meaning no firm is inclined to enter or exit the industry.
P = AR = MR = MC = LRMC = ATC = LRAC
A Benchmark of Efficiency
Perfect competition is an idealized market structure that achieves an efficient allocation of resources. Although unrealistic, the characteristics of perfect competition ensure efficiency. In fact, a primary purpose of perfect competition is to illustrate perfection, to illustrate the best of all possible resource allocation worlds, and to provide a benchmark for comparison with real world market structures that inevitably fall short of this perfection.Efficiency is achieved with perfect competition because the price is equal to marginal cost. Price indicates the value of the good produced and thus the satisfaction a generated from production. Marginal cost indicates the opportunity cost of goods not produced and thus the satisfaction lost from foregone production.
Because the satisfaction obtained (price) is equal to satisfaction foregone (marginal cost) overall satisfaction cannot be increased by increasing or decreasing production. If price and marginal cost are not equal, then satisfaction can be increased by changing production.
The Other Three Market Structures
| Market Structure Continuum |
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- Monopoly: To the far right of the market structure continuum is monopoly, characterized by a single competitor and extensive market control. Monopoly contains a single seller of a unique product with no close substitutes. The demand for monopoly output is THE market demand.
- Oligopoly: In the middle of the market structure continuum, residing closer to monopoly, is oligopoly, characterized by a small number of relatively large competitors, each with substantial market control. A substantial number of real world markets fit the characteristics of oligopoly.
- Monopolistic Competition: Also in the middle of the market structure continuum, but residing closer to perfect competition, is monopolistic competition, characterized by a large number of relatively small competitors, each with a modest degree of market control. A substantial number of real world markets fit the characteristics of monopolistic competition.
The four key characteristics of perfect competition are: (1) a large number of small firms, (2) identical products sold by all firms, (3) perfect resource mobility or the freedom of entry into and exit out of the industry, and (4) perfect knowledge of prices and technology.These four characteristics mean that a given perfectly competitive firm is unable to exert any control whatsoever over the market. The large number of small firms, all producing identical products, means that a large (very, very large) number of perfect substitutes exists for the output produced by any given firm.
This makes the demand curve for a perfectly competitive firm's output perfectly elastic. Freedom of entry into and exit out of the industry means that capital and other resources are perfectly mobile and that it is not possible to erect barriers to entry. Perfect knowledge means that all firms operate on the same footing, that buyers know about all possible perfect substitutes for a given good and that firms actually do produce identical products.
Large Number of Small Firms
A perfectly competitive market or industry contains a large number of small firms, each of which is relatively small compared to the overall size of the market. This ensures that no single firm can exert market control over price or quantity. If one firm decides to double its output or stop producing entirely, the market is unaffected. The price does not change and there is no discernible change in the quantity exchanged.How many firms are needed in a perfectly competitive industry, such that each is so small it has absolute no market control? There is no actual number that answers this question. This is due partly to the fact that perfect competition is an idealized market structure that does not exist in the real world. It is also partly due to the notion that the number of firms is not as important as the result... that no firm has market control.
Here are two extreme examples that will help illuminate this notion. Example 1 is Phil's home grown zucchinis. Phil is one among gadzillions (a really large number) of people who grow zucchinis in their backyard gardens. Phil has no control over the zucchini market because the total zucchini market contains gadzillions of zucchini producers, each producing only a handful of zucchinis. Should Phil decide to produce more zucchinis, fewer zucchinis, or none at all, the zucchini market and especially the zucchini price are unaffected. Zucchini buyers continue buying zucchinis from the remaining gadzillions of zucchini producers as if nothing changed. As far as the market is concerned, nothing has changed.
Example 2 is the innovative folks at Quadra DG Computer Works, which produces the Quadra 400 Data RAM Cartridges (a memory storage cartridge used in the Quadra 400 Data RAM Computer Storage System). In this hypothetical economic world, Quadra DG Computer Works is only one of threes companies that produce computer storage products. Because it holds a market share of 33 percent, Quadra DG has a substantial degree of market control. Should Quadra DG decide to produce more or fewer Quadra 400 Data RAM Cartridges, or stop producing them altogether, then the computer storage market takes notice. The price and quantity exchanged are likely to change.
Identical Goods / Homogenous Goods
Each firm in a perfectly competitive market sells an identical product, which is also commonly termed "homogeneous goods." The essential feature of this characteristic is not so much that the goods themselves are exactly, perfectly the same, but that buyers are unable to discern any difference. In particular, buyers cannot tell which firm produces a given product. There are no brand names or distinguishing features that differentiate products by firm.This characteristic means that every perfectly competitive firm produces a good that is a perfect substitute for the output of every other firm in the market. As such, no firm can charge a different price than that received by other firms. If they should try to charge a higher price, then buyers would immediately switch to other goods that are perfect substitutes.
Once again, Phil the zucchini grower offers an example. Phil's zucchinis are no different than Becky's zucchinis, which are no different than Dan's zucchinis, which are no different than Alicia's zucchinis, which are no different than any of the other zucchinis produced by any of the other gadzillions of zucchini growers. They look the same. They taste the same. And most important, they satisfy the same zucchini need.
In contrast, the Quadra 400 Data RAM Cartridges used in the Quadra 400 Data RAM Computer Storage System are unique. First of all, Quadra 400 Data RAM Cartridges only work in the Quadra 400 Data RAM Computer Storage System. Second of all, Quadra 400 Data RAM Computer Storage System only uses Quadra 400 Data RAM Cartridges. Third of all, the brand name of Quadra DG Computer Works is printed on each cartridge, signifying whatever quality notion (good or bad) that buyers have for this product. To most buyers, Quadra 400 Data RAM Cartridges are NOT identical to OmniRam computer storage cartridges or MegaMem computer storage cartridges. Each works with a different system, have different uses, and have different quality connotations.
Perfect Resource Mobility
Perfectly competitive firms are free to enter and exit an industry. They are not restricted by government rules and regulations, start-up cost, or other barriers to entry. While some firms incur high start-up cost or need government permits to enter an industry, this is not the case for perfectly competitive firms. Likewise, a perfectly competitive firm is not prevented from leaving an industry as is the case for government-regulated public utilities.Perfectly competitive firms can acquire whatever labor, capital, and other resources that they need without delay and without restrictions. There is no racial, ethnic, or sexual discrimination.
For example, if Phil wants to leave the zucchini industry and entry the kumquat industry, he can do that without restriction. Likewise if Becky is a kumquat producer who wants to entry the zucchini industry, she can do so without restraint. Phil and Becky are not faced with up-front investment cost nor brand-name recognition that might prevent them from entering a perfectly competitive industry. When they enter an industry they can instantly compete on equal ground with existing firms.
By comparison, when Quadra DG Computer Works entered the market it needed to build several expensive factories, spend millions of advertising dollars to achieve brand name recognition, and obtain several government patents to produce its Quadra 400 Data RAM Cartridges. Additionally, because Quadra 400 Data RAM Cartridges are used in top secret military projects, Quadra DG Computer Works is not allowed to STOP producing Quadra 400 Data RAM Cartridges without authorization from the Secretary of Defense and an act of Congress.
Perfect Knowledge
In perfect competition, buyers are completely aware of sellers' prices, such that one firm cannot sell its good at a higher price than other firms. Each seller also has complete information about the prices charged by other sellers so they do not inadvertently charge less than the going market price. Perfect knowledge also extends to technology. All perfectly competitive firms have access to the same production techniques. No firm can produce its output faster, better, or cheaper because of special knowledge of information.Phil, for example, has all of the information needed to grow zucchinis. This is the same information possessed by Becky, Dan, Alicia, and the other gadzillions of zucchini producers. Phil also knows that the going price of zucchinis is 50 cents. All of the zucchini buyers know that the going price is fifty cents.
In contrast, Quadra DG Computer Works has several patents on the production of Quadra 400 Data RAM Cartridges that are not available to its competition (OmniRam and MegaMem). Quadra DG also has a secret formula that it uses for production locked away in the company safe.
PERFECT COMPETITION, AmosWEB
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