First, let's review what economic factors must be present in an industry with perfect competition.

5 Requirements of Perfect Competition

  • 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.

Because these five requirements rarely exist together in any one industry, perfect competition is rarely (if ever) observed in the real world. For example, most products have some degree of differentiation. Even with a product as simple as bottled water, for example, producers vary in the method of purification, product size, brand identity, etc. Commodities such as raw agricultural products, although they can still differ in terms of quality, come closest to being identical, or having zero differentiation. When a product does come to have zero differentiation, its industry is usually concentrated into a small number of large firms, or an oligopoly.

Barriers to Entry Prohibit Perfect Competition

Many industries also have significant barriers to entry, such as high startup costs (as seen in the auto manufacturing industry) or strict government regulations (as seen in the utilities industry), which limit the ability of firms to enter and exit such industries. And although consumer awareness has increased with the information age, there are still few industries where the buyer remains aware of all available products and prices.

As you can see, there are significant obstacles preventing perfect competition from appearing in today's economy. The agricultural industry probably comes closest to exhibiting perfect competition because it is characterized by many small producers with virtually no ability to alter the selling price of their products. The commercial buyers of agricultural commodities are generally very well-informed and, although agricultural production involves some barriers to entry, it is not particularly difficult to enter the marketplace as a producer.

Economists' Thoughts on Perfect Competition

No economist believes perfect competition is representative of the real world. Very few believe perfect competition is ever achievable. The real debate among economists is whether perfect competition should be considered a theoretical benchmark for real markets. Neoclassical economists argue that perfect competition can be useful, and most of their analysis stems from its principles. Many other smaller schools of thought disagree.

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

Nobel laureate F.A. Hayek argued that perfect competition had no claim to be called "competition." He pointed out that the model removed all competitive activities and reduced all buyers and sellers to mindless price-takers.

Joseph Schumpeter 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.

(For related reading, see: Economic Basics: Competition, Monopoly and Oligopoly.)

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