In neoclassical economics, perfect competition is a theoretical market structure in which six economic factors must be met. Neoclassical economists claim that perfect competition would produce the best possible economic outcomes for both consumers and society.

These criteria must be met in order for a market to be considered perfectly competitive: all firms sell an identical product; all firms are price-takers; all firms have a relatively small market share; buyers know the nature of the product being sold and the prices charged by each firm; the industry is characterized by freedom of entry and exit. All real markets exist outside of the perfect competition model because it is an abstract, theoretical model.

Key Takeaways

  • Neoclassical economists claim that perfect competition–a theoretical market structure–would produce the best possible economic outcomes for both consumers and society.
  • All real markets exist outside of the perfect competition model because it is an abstract, theoretical model.
  • Significant obstacles prevent perfect competition from actually emerging in the real economy.

Barriers to Entry Prohibit Perfect Competition

One characteristic of a market that experiences perfect competition is that all firms sell an identical product. In reality, most products have some degree of differentiation. Even with a product as seemingly simple as bottled water, producers will vary in their given method of purification, product size, and brand identity.

Commodities–such as raw agricultural products–come closest in terms of firms offering identical products, although products can still differ in terms of their quality. In a market when products are close to identical, like the commodities market, the industry tends to become concentrated into a small number of large firms, a type of market structure called an oligopoly.

Another characteristic of an industry that experiences perfect competition is that it is characterized by the freedom of entry and exit. In the real world, however, many industries have significant barriers to entry. High startup costs or strict government regulations may limit the ability of firms to enter and exit industries. High startup costs are characteristic of the automobile manufacturing industry. In the utilities industry, there are strict government regulations.

And while consumer awareness has increased in the information age as more consumers seek out and research information online, there are still few industries where the buyer remains aware of all available products and prices.

Significant obstacles prevent perfect competition from actually emerging in the real economy. At times, the agricultural industry comes close to exhibiting characteristics of a perfectly competitive market. In the agricultural industry, there are many small producers with virtually no ability to alter the selling price of their products. The commercial buyers of agricultural commodities are also generally very well-informed. Finally, although agricultural production involves some barriers to entry, it is not particularly difficult to enter the marketplace as a producer.

Economists' Critique of Perfect Competition

While neoclassical economists believe that perfect competition creates a perfect market structure, with the best possible economic outcomes for both consumers and society, in general, they do not claim that this model is representative of the real world. As such, it is debated whether or not perfect competition should be used as a theoretical benchmark for real economic markets. Neoclassical economists argue that perfect competition can be useful, and most of their analysis stems from its principles. Many other smaller schools of economic thought disagree that perfect competition is a useful model and question whether or not–if it could be executed in real economic markets–if it would provide positive economic outcomes for consumers and businesses.

Some economists are highly critical of the neoclassical school's reliance on perfect competition. Critics of perfect competition can be broadly separated into two groups. The first group believes the assumptions built into the model are so unrealistic that the model cannot produce any meaningful insights. The second group argues that perfect competition is not even a desirable theoretical outcome.

For example, the Austrian economist and winner of the Nobel Prize for Economics in 1974, Friedrich Hayek, argued that perfect competition had no claim to be called "competition." In his critique of perfect competition, Hayek claimed that the model removes all competitive activities and reduces all buyers and sellers to mindless price-takers. Hayek's contributions to the field of economics were informed by the Austrian school of economics.

The Czech economist Joseph Schumpeter, also part of the Austrian school of economics, noted that research, development, and innovation are undertaken by firms that experience economic profits, rendering perfect competition less efficient than imperfect competition in the long run.