In neoclassical economics, perfect competition is a theoretical market structure that produces the best possible economic outcomes for both consumers and society. A market that experiences perfect competition may be referred to as a "perfect" market by economists that subscribe to this school of thought. So, some economists use perfect competition as a benchmark to compare the performance of real markets. While some industries may exhibit certain characteristics of perfect competition, very few industries can be described as perfectly competitive because it is an abstract, theoretical model. In addition to perfect competition, the other types of market structures (all with varying degrees of competition) are monopoly, monopolistic competition, and oligopoly.

Key Takeaways

  • In neoclassical economics, perfect competition is a theoretical market structure that produces the best possible economic outcomes for both consumers and society.
  • In a perfectly competitive market, there are so many firms producing the same products that, in the long-run, none of the firms can attain enough power to influence the industry.
  • In the long-run, all of the possible causes of economic profits are eventually assumed away in the model of perfect competition.

In a perfectly competitive market, firms can only experience profits or losses in the short-run. In the long-run, profits and losses are eliminated because an infinite number of firms are producing infinitely-divisible, homogeneous products. Firms experience no barriers to entry, and all consumers have perfect information. There are so many firms producing the same products that none of the firms can attain enough power in the long-run to influence the industry. Thus, in the long-run, all of the possible causes of profits are eventually assumed away in the model of perfect competition.

Perfect Markets Achieve Allocative and Productive Efficiency

It has also been theoretically demonstrated that a perfectly competitive market will reach an equilibrium in which the quantity supplied for every product or service is equal to the quantity demanded at the current price.

Allocative efficiency and productive efficiency are both characteristics of perfect competition. Allocative efficiency refers to an optimal distribution of goods and services to consumers in an economy. Productive efficiency refers to a firm or a market that is operating at maximum capacity; it can no longer produce additional amounts of a good without lowering the production level of another product. In a perfectly competitive market, every firm is considered to have achieved both allocational and operational efficiency.

In the theoretical model of perfect competition, a firm will achieve allocational efficiency in the short-run. In the short-run, any producer faces a market price that is equal to its marginal cost of production.

In the short-run, perfect markets are not necessarily productively efficient. But in the long-run, productive efficiency is achieved as new firms enter the market. Increased competition reduces price and cost to the minimum of the long-run average costs. At this point, price equals both the marginal cost and the average total cost for each good.

Distinction Between Normal Profits and Economic Profits

Economists and accountants make a distinction between normal profits and economic profits. Normal profit is defined as revenue less explicit and implicit expenses. Normal profit allows for businesses to make just enough profit over their total cost so that, effectively, they are being compensated for their opportunity costs.

An economic profit is anything earned in addition to normal profits. Sometimes economists refer to economic profit as "super-normal profit." While there may be economic profits earned in the short-run, there can be no explicitly economic profits in the long-run of a perfectly competitive industry.

Economic profits in the short-run will attract competitor firms, and prices will inevitably fall. Similarly, economic losses will cause firms to exit the market, and prices will rise. These phenomena will continue until long-run equilibrium is reached.

However, all firms earn normal profits in the long-run. It is important to note this distinction between types of profits when considering the presence of profits in perfect markets.