A market that experiences perfect competition may be referred to as a perfect market by economists. Some economists use perfect competition as a benchmark to which 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 neoclassical economics, perfect competition is a theoretical market structure that produces the best possible economic outcomes for both consumers and society.
- Some economists use perfect competition as a benchmark for the performance of real markets.
- In a perfectly competitive market, so many firms produce the same products that, in the long run, none can attain enough power to influence the industry.
- Economic profit is profit earned above and beyond normal profit.
- There are no economic profits in a perfectly competitive market in the long run because eventually the drivers of profits cease to exist.
What Is a Perfectly Competitive Market?
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, 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, eventually, all of the possible causes of profits are assumed away.
Understanding Normal Profit and Economic Profit
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 means businesses make just enough profit over their total cost so that, effectively, they are being compensated for their opportunity costs. All firms earn normal profit in the long run.
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 explicit 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.
It is important to note this distinction between types of profits when considering the presence of profits in perfect markets.
Perfect Competition and Profits
With perfect competition, the many companies involved earn only enough profit to remain in business. More than that would attract new, competing firms and drive profits downward.
Perfect Markets Achieve Allocative and Productive Efficiency
It has 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. This means that 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 allocative efficiency in the short run. Every 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.
What Type of Profit Do Perfectly Competitive Firms Earn in the Long Run?
All firms in a perfectly competitive market earn normal profit in the long run. Normal profit is revenue minus expenses.
Can a Firm Earn Economic Profits in the Short Run When the Market Is Perfectly Competitive?
Yes, it can. That is the only period of a perfectly competitive market in which economic profits can be earned. Economic profit is that profit earned in addition to normal profit.
In Perfect Competition, When Does Long Run Equilibrium Occur?
Long run equilibrium is reached once opposing economic forces find balance. Short run economic profits attract new competitors and prices fall. Economic loss forces firms out of the industry and prices rise. Marginal revenue equals marginal cost.