Perfect competition is a theoretical market structure in which competition is at its greatest possible level. Some markets, such as stock exchanges and commodity markets, approximate perfect competition. But a true state of perfect competition in a market is not attainable in real life. In theory, if perfect competition existed, resources would be allocated in the most efficient way possible. As a concept, though, perfect competition is useful because it functions as a standard to measure the efficiency and effectiveness of real world markets.
A perfectly competitive market contains these 5 elements:
1) All firms sell an identical product; 2) All firms are price takers - they cannot control the market price of their product because price is determined by supply and demand; 3) All firms have a relatively small market share; there are no monopolies; 4) Buyers have complete information about the product being sold and the prices charged by each firm; and 5) The industry is characterized by low barriers or no barriers to enter and exit an industry.
As an example of a perfectly competitive market, imagine a group of fishermen who all sell the same type of rainbow trout at a local market.
Each stand at the market sells each rainbow trout at $1.00. This is just enough for each fisherman to pay for his costs and have enough money to live on. Now assume all the fishermen get together and agree to raise the price of each fish to $1.50 so they can make more money. This strategy only works for a short period of time due to the very low to non-existent barriers of entry to the fishing business. (The up-front investment in becoming a fisherman is relatively low). New fishermen know that they can make money selling each fish for $1.00. These new fishermen can easily set up their own stands at the local market and start selling rainbow trout for less than the $1.50 collusion price. Very shortly, because of perfect competition, fish prices at every stand return to $1.00, as their product won’t sell at the inflated price.
In This Series
InvestingImperfect competition appears in several different forms. Markets are evaluated by how they compare to, and try to approach, perfect competition.
InsightsMonopolistic competition exists in industries that have many firms offering similar products or services: for example, restaurants, supermarkets and clothing stores.
TradingAvoid the perfection trap and make peace with the market’s high levels of systematic noise.
InvestingGoogle has partnered with non-profits to use a big data approach to solve the illegal fishing problem.
TechBlockchain, the technology underlying bitcoin, has infinite uses--including stopping illegal fishing and even stopping human rights abuses.
InvestingA competitive advantage is an advantage a firm has over its competitors.
InvestingDeciding whether it's possible to attain above-average returns requires an understanding of EMH.