What Is Perfect Competition?
The term perfect competition refers to a theoretical market structure. Although perfect competition rarely occurs in real-world markets, it provides a useful model for explaining how supply and demand affect prices and behavior in a market economy.
Under perfect competition, there are many buyers and sellers, and prices reflect supply and demand. Companies earn just enough profit to stay in business and no more. If they were to earn excess profits, other companies would enter the market and drive profits down.
- Perfect competition is an ideal type of market structure where all producers and consumers have full and symmetric information and no transaction costs.
- There are a large number of producers and consumers competing with one another in this kind of environment.
- Perfect competition is theoretically the opposite of a monopolistic market.
- Since all real markets exist outside of the plane of the perfect competition model, each can be classified as imperfect.
- The opposite of perfect competition is imperfect competition, which exists when a market violates the abstract tenets of neoclassical pure or perfect competition.
How Perfect Competition Works
Perfect competition is a benchmark or ideal type to which real-life market structures can be compared. Perfect competition is theoretically the opposite of a monopoly, in which only a single firm supplies a good or service and that firm can charge whatever price it wants since consumers have no alternatives and it is difficult for would-be competitors to enter the marketplace.
In a perfect competition model, there are no monopolies. This kind of structure has a number of key characteristics, including:
- All firms sell an identical product (the product is a commodity or homogeneous).
- All firms are price takers (they cannot influence the market price of their products).
- Market share has no influence on prices.
- Buyers have complete or perfect information (in the past, present, and future) about the product being sold and the prices charged by each firm.
- Capital resources and labor are perfectly mobile.
- Firms can enter or exit the market without cost.
This can be contrasted with the more realistic imperfect competition, which exists whenever a market, hypothetical or real, violates the abstract tenets of neoclassical pure or perfect competition.
Since all real markets exist outside of the plane of the perfect competition model, each can be classified as imperfect. The contemporary theory of imperfect versus perfect competition stems from the Cambridge tradition of post-classical economic thought.
Characteristics of Perfect Competition
A perfectly-competitive market is defined by the following factors:
A Large and Homogeneous Market
There are a large number of buyers and sellers in a perfectly competitive market. The sellers are small firms, instead of large corporations capable of controlling prices through supply adjustments. They sell products with minimal differences in capabilities, features, and pricing. This ensures that buyers cannot distinguish between products based on physical attributes, such as size or color, or intangible values, such as branding.
A large population of both buyers and sellers ensures that supply and demand remain constant in this market. As such, buyers can easily substitute products made by one firm for another.
Perfect Information Availability
Information about an industry's ecosystem and competition constitutes a significant advantage. For example, knowledge about component sourcing and supplier pricing can make or break the market for certain companies.
In certain knowledge and research-intensive industries, such as pharmaceuticals and technology, information about patents and research initiatives at competitors can help companies develop competitive strategies and build a moat around their products.
The availability of free and perfect information in a perfectly competitive market ensures that each firm can produce its goods or services at exactly the same rate and with the same production techniques as another one in the market.
Absence of Controls
Governments play a vital role in market formation for products by imposing regulations and price controls. They can control the entry and exit of firms into a market by setting up rules to function in the market. For example, the pharmaceutical industry has to contend with a roster of rules pertaining to the development, production, and sale of drugs.
In turn, these rules require big capital investments in the form of employees, such as lawyers and quality assurance personnel, and infrastructure, such as machinery to manufacture medicines. The cumulative costs add up and make it extremely expensive for companies to bring a drug to the market.
In comparison, the technology industry functions with relatively less oversight as compared to its pharma counterpart. Thus, entrepreneurs in this industry can start firms with less to zero capital, making it easy for individuals to start a company in the industry.
Such controls do not exist in a perfectly competitive market. The entry and exit of firms in such a market are unregulated, and this frees them up to spend on labor and capital assets without restrictions and adjust their output in relation to market demands.
Cheap and Efficient Transportation
Cheap and efficient transportation is another characteristic of perfect competition. In this type of market, companies do not incur significant costs to transport goods. This helps reduce the product’s price and cuts back on delays in transporting goods.
Theory vs. Reality of Perfect Competition
Real-world competition differs from this ideal primarily because of differentiation in production, marketing, and selling. For example, the owner of a small organic products shop can advertise extensively about the grain fed to the cows that made the manure that fertilized the non-GMO soybeans, thereby setting their product apart from competitors. This is what's called differentiation.
The first two criteria (homogeneous products and price takers) are far from realistic. Yet, for the second two criteria (information and mobility) the global tech and trade transformation is improving information and resource flexibility. While the reality is far from this theoretical model, the model is still helpful because of its ability to explain many real-life behaviors.
Companies seek to establish brand value through marketing around their differentiation. As such, they advertise to gain pricing power and market share.
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 utility 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.
Significant obstacles exist that prevent perfect competition from developing in the 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.
Advantages and Disadvantages of Perfect Competition
Perfect competition is an idealized framework for a market economy. While it provides a convenient model for how an economy works, it is not always accurate and has significant departures from the real-world economy. Like with other models, the value of a perfect competition framework is only accurate to the extent that it reflects actual conditions.
One notable feature of perfect competition is low profit margins. Since all consumers have access to the same products, they naturally gravitate towards the lowest prices. Firms cannot set themselves apart by charging a premium for higher-quality products and services. For instance, it would be impossible for a company like Apple (AAPL) to exist in a perfectly competitive market because its phones are more expensive than those of its competitors.
Another is the absence of innovation. The prospect of greater market share and setting themselves apart from the competition is an incentive for firms to innovate and make better products. But no firm possesses a dominant market share in perfect competition, meaning that the long-term profitability of their operations is zero.
Another disadvantage is the absence of economies of scale. Limited to zero profit margins means that companies will have less cash to invest in expanding their production capabilities. An expansion of production capabilities could potentially bring down costs for consumers and increase business profit margins. But the presence of several small firms cannibalizing the market for the same product prevents this and ensures that the average firm size remains small.
Pros and Cons of Perfect Competition
Provides a convenient framework for modeling market activity.
Demonstrates how producers are incentivized to provide lower prices.
The perfect competition model does not always reflect real-world market conditions.
The model does not account for geographical differences or variations between products.
The model does not account for how producers benefit from economies of scale.
Do Firms Profit in Perfect Competition?
Profits may be possible for brief periods in perfectly competitive markets. But the market’s dynamics cancel out the effects of positive or negative profits and bring them toward an equilibrium. Because there is no information asymmetry in the market, other firms will quickly ramp up their production or reduce their manufacturing costs to achieve parity with the firm which made profits.
The average revenue and marginal revenue for firms in a perfectly competitive market are equal to the product’s price to the buyer. As a result, the perfectly competitive market’s equilibrium, which had been disrupted earlier, will be restored. In the long run, an adjustment of supply and demand ensures all profits or losses in such markets tend toward zero.
Perfect Competition vs. Monopoly
The opposite of perfect competition is a monopoly, where a single company controls the supply of a certain product. In monopoly conditions, consumers cannot go elsewhere if the price is too high; they can only decide not to buy the product.
This means that rather than setting prices by supply and demand, the monopolistic firm can simply set a price point that maximizes its profits. Some types of firms are considered natural monopolies because there is a significant first-mover advantage that discourages competitors from entering the market. Other monopolies may be established through government actions, or by cartels, such as OPEC.
Examples of Perfect Competition
As mentioned earlier, perfect competition is a theoretical construct and doesn't actually exist. As such, it is difficult to find real-life examples of perfect competition but there are variants present in everyday society.
Consider the situation at a farmer’s market, a place characterized by a large number of small sellers and buyers. There is typically little differentiation between products and their prices from one farmer’s market to another. How the produce is grown does not matter (unless they are classified as organic) and there is very little difference in how they're packaged or branded. Thus, even if one of the farms producing goods for the market goes out of business, it will not make a difference to average prices.
The situation may also be relatively similar in the case of two competing supermarkets, which stock their aisles from the same set of companies. Again, there is little to distinguish products from one another between both supermarkets and their pricing remains almost the same. Another example of perfect competition is the market for unbranded products, which features cheaper versions of well-known products.
Product knockoffs are generally priced similarly and there is little to differentiate them from one another. If one of the firms manufacturing such a product goes out of business, it is replaced by another one.
The development of new markets in the technology industry also resembles perfect competition to a certain degree. For example, there was a proliferation of sites offering similar services during the early days of social media networks. Some examples of such sites are Sixdegrees.com, Blackplanet.com, and Asianave.com. None of them had a dominant market share and the sites were mostly free. They constituted sellers in the market while consumers of such sites, who were mainly young people, were the buyers.
The startup costs for companies in this space were minimal, meaning that startups and companies can freely enter and exit these markets. Technologies, such as PHP and Java, were largely open-source and available to anyone. Capital costs, in the form of real estate and infrastructure, were not necessary. Remember that Mark Zuckerberg effectively founded Facebook from his college dorm.
What Is Perfect Competition?
In economic theory, perfect competition occurs when all companies sell identical products, market share does not influence price, companies are able to enter or exit without barriers, buyers have perfect or full information, and companies cannot determine prices. In other words, it is a market that is entirely influenced by market forces. It is the opposite of imperfect competition, which is a more accurate reflection of a current market structure.
What Is an Example of Perfect Competition?
Consider a farmers market where each vendor sells the same type of jam. There is little differentiation between each of their products, as they use the same recipe, and they each sell them at an equal price. At the same time, sellers are few and free to participate in the market without any barrier. Buyers, in this case, would be fully knowledgeable of the product’s recipe, and any other information relevant to the good.
What Is the Difference Between Perfect Competition and Imperfect Competition?
While perfect competition is an idealized market structure in which equal and identical products are sold, imperfect competition can be found in monopolies and real-life examples. For instance, imperfect competition involves companies competing for market share, high barriers to entry, and buyers lacking complete information on a product or service. Unlike perfect competition, however, this creates the incentive to innovate and produce better products, in addition to increased profit margins due to the influence of supply and demand.
The Bottom Line
Perfect competition describes an imaginary market condition where all consumers have access to the same products and information. In this type of economy, all firms must offer the lowest price possible or risk being undercut by their competitors. Although this is only a theoretical model, perfect competition is useful for demonstrating how economic actors behave in a free market.