A perfectly competitive market is a hypothetical market where competition is at its highest possible level. Neoclassical economists argued that perfect competition would produce the best possible outcomes for consumers and society. In this article, we tell you what perfect competition is, its characteristics, benefits, and main examples of perfect competition.
What is perfect competition?
Perfect competition is a type of market structure where many companies sell similar products and profits are virtually non-existent due to fierce competition . That said, it’s important to realize that perfect competition is an abstract term used to compare to real-life markets.
Pure or perfect competition is a theoretical market structure in which the following criteria are met:
- All companies sell an identical product.
- All companies accept prices (they cannot influence the market price of their product).
- Market share does not influence prices.
- Buyers have complete or “perfect” information, past, present, and future, about the product being sold and the prices charged by each company.
- The resources for such work are perfectly mobile.
- Firms can enter or exit the market at no cost.
This can be contrasted with the more realistic imperfect competition, which exists whenever a market, hypothetical or real, violates the abstract principles of pure or perfect neoclassical competition.
Since all real markets exist outside the plane of the perfect competition model, each one can be classified as imperfect. The contemporary theory of imperfect versus perfect competition stems from the Cambridge tradition of postclassical economic thought.
Perfect competition characteristics
Below we analyze the main characteristics of perfect competition .
All competitors have a similar market share because the companies cannot compete on price. Since firms produce where Marginal Revenue = Marginal Cost, there is no room to lower prices.
If a company were to cut prices, it would start to make a loss, because it costs more to make than to sell, which means it would go out of business. At the same time, if any company raises prices, there is enough competition to attract customers from that store and drive them out of business. In turn, this restricts a company’s ability to gain market share.
Conditions of equality
Perfect competition is theoretically the opposite of a monopoly , in which only one company supplies a good or service and that company can charge whatever price it wants, as consumers have no alternatives and it is difficult for would-be competitors to enter the market.
Under perfect competition, there are many buyers and sellers, and prices reflect supply and demand. Companies make just enough profit to stay in business and nothing more. If they made excess profits, other companies would enter the market and drive down profits.
A perfectly competitive market has many buyers and sellers. This means that the companies are known as “price takers”. In other words, the firm must sell at the equilibrium price ; this is where the company sells when supply and demand align.
Otherwise they will go out of business as there are many other businesses selling the same good at a lower price. As a result, customers have a low cost of switching to a substitute good.
In perfect competition, competitors sell similar products . This is also known as “homogeneous”, in economic jargon. In simple terms, it means that the products are similar.
Individual companies can be indistinguishable to the average customer. As a result, the ability and willingness to change is easy and free.
Dairy is a notable example. For example, many farmers sell milk to supermarkets, but the product is very similar. In fact, supermarkets change contracts with dairy farmers without customers noticing.
This is where the customer knows that the company is selling the same product at a lower price. As a result, companies are reluctant to raise prices before their competitors.
In addition, customers also know the quality of a product . For example, a company may cut costs to offer a lower-quality product and make more profit. Since customers have perfect information, they will know that the product is inferior. In turn, they will switch to competitors, putting the original company out of business.
No entry or exit barriers
Companies can enter and exit the market at a reduced cost. This can come in the form of financial information, time or information. For example, the oil and gas industry requires a high level of initial investment. As such, this is a barrier to entry for competitors. Under perfect competition, these costs do not exist or are in fact negligible.
Furthermore, firms can easily exit the market under conditions of perfect competition . For example, a company may have a long-term contract . But they cannot exit the market without significant costs.
Companies do not need to spend their time developing a marketing strategy to differentiate their products from their competitors. Therefore, no pricing policies or advertising campaigns are needed to promote sales.
Perfect competition examples
It is often claimed that perfect competition does not exist in the real world. Up to a point, this proposition is correct. For example, perfect competition may have existed in earlier centuries when commodities were the main source of economic activity. In particular, coal, oil, metals, and corn were important parts of the microeconomy . At the same time, they were homogeneous and fulfilled the characteristics.
If we go back centuries to old-fashioned markets, we would find many buyers and many sellers of the same product. For example, there may be many bakers who come to the market to sell loaves of bread. A homogeneous product, with a large number of buyers and sellers who can enter or leave the market.
The time has changed. We now live in an economy where companies compete by offering different products.
Customers now trust brands as a way to get information. ‘Perfect information’ cannot really be achieved due to the number of products we buy.
In earlier times, “perfect information” was easier to obtain because there were so few products available. Yet today there are millions. That said, there are some examples of perfectly competitive markets that still exist today; although they are rare.
In this market, the products are very similar. Carrots, potatoes and cereals are generic and many farmers produce them. As the product is homogeneous, it is easy to buy land and cultivate it. In addition, it is also easy to get out of the market. Therefore, the market has key signs of perfect competition.
Foreign exchange markets
In this market, traders trade currencies. Since there is only one US dollar, one British pound and one euro, the product is homogeneous. Also, there are many sellers and buyers in the market. And it is easy to buy currency and also easy to sell it. That said, there is an exception in that traders may not have “perfect information.”
Normal buyers and sellers can be at a disadvantage compared to professional traders who do it for a living. Even so, it is one of the closest examples of perfect competition that we can find today.
We may not see the Internet as a distinct market. However, the Internet is home to many buyers and sellers. For example, we only need to look at eBay as an example. In fact, this is exactly what a market is, although not on a physical level.
The information economy allows customers to compare and collect perfect information about a product. Think of a specific book: there are many buyers and many distributors. At the same time, there are usually small price differences.
So there are many buyers and sellers selling similar products. In addition, entry and exit are easy with low costs. While companies like Amazon have a strong market share, it’s as close to real-life an example as any.
Differences between perfect competition and imperfect competition
The main points of difference between perfect and imperfect competition in economics are outlined below:
- The competitive market, in which there are a large number of buyers and sellers, and the sellers offer identical products to the buyers; is known as perfect competition. Imperfect competition occurs when one or more conditions of perfect competition are not met.
- Perfect competition is a hypothetical situation, which does not apply in the real world. On the contrary, Imperfect Competition is a situation found in today’s world.
- When it comes to perfect competition, there are many players in the market, but in imperfect competition, there may be few or many players, depending on the type of market structure.
- In perfect competition, sellers produce or supply identical products. On the contrary, in imperfect competition the products offered by sellers can be homogeneous or differentiated.
- If we talk about perfect competition, there are no barriers to the entry and exit of companies, which is the opposite in the case of imperfect competition.
- In perfect competition, firms are assumed to have no influence on the price of a product. Thus, they are price takers, but in imperfect competition, firms are price makers.
Other structures different from perfect competition
There are market structures other than perfect competition that we analyze below.
A monopoly is a company that is the sole provider of a good or service, giving it a tremendous competitive advantage over any other company trying to offer a similar product or service.
Some companies become monopolies through vertical integration. They control the entire supply chain, from production to retail. Others use horizontal integration. They buy competitors until they are the only ones left.
Some, like utilities, enjoy government regulations that give them a market. Governments do this to guarantee the production and supply of electricity because they cannot tolerate disruptions that can come from free market forces.
The term “oligopoly” refers to an industry in which there are only a small number of companies in operation. In an oligopoly, no one company has a large amount of market power. Therefore, no company can raise its prices above the price that would exist in a perfect competition scenario.
In an oligopoly, all the companies have to agree to raise prices and obtain a greater economic profit. Most oligopolies exist in industries where the goods are relatively undifferentiated and generally provide the same benefit to consumers.
The conditions that allow oligopolies to exist include high costs of entry in capital expenditures, legal privilege (license to use wireless spectrum or land for railways), and a platform that gains value with more customers (such as social networks).
History’s oligopolies include steelmakers, oil companies, railroads, tire manufacturers, and wireless service providers. The economic and legal concern is that an oligopoly can lock out new entrants, slow innovation and raise prices, all of which harm consumers.
Firms in an oligopoly set prices, either collectively or under the leadership of one firm, rather than taking prices from the market. Profit margins are therefore higher than they would be in a more competitive market.
The monopolistic competition model describes a common market structure in which firms have many competitors, but each sells a slightly different product.
Many small businesses operate under conditions of monopolistic competition, including independently owned and operated stores and restaurants. In the case of restaurants, each offers something different and has an element of uniqueness, but all are essentially competing for the same customers.
Monopolistically competitive markets have the following characteristics:
- Each company makes independent decisions on price and production, based on its product, its market and its production costs.
- Knowledge is widely spread among participants, but it is unlikely to be perfect. For example, diners can review all available menus at restaurants in a city before making their choice. Once inside the restaurant, they can see the menu again before placing the order. However, they cannot fully appreciate the restaurant or the food until after they have eaten.
- The entrepreneur has a more important role than in companies that are perfectly competitive due to the higher risks associated with decision making.
- There is freedom to enter or exit the market, as there are no major barriers to entry or exit.
Monopsony is a market condition that is heavily influenced by a single buyer. It is the opposite of monopoly: a market condition with only one seller. In monopsony, the buyer exercises majority control over the purchase of a good or service, which gives him more power during negotiations.
Monopsonies are common in the labor market in situations where only one company is responsible for providing a large number of jobs. Labor market monopsonies tend to be disadvantageous for workers, as firms are able to negotiate lower wages due to their market power.
An oligopsony is a market in which there are few buyers but many providers. This makes it a buyer’s market. In an oligopsony, the few buyers are often large and powerful. Consequently, buyers exert considerable influence over sellers. In fact, in some cases, if prices drop, providers have no choice but to comply.
An oligopsony contrasts with an oligopoly, which is a market with few suppliers and many buyers. In an oligopoly, providers control the market and ultimately prices.
An oligopsony is a form of imperfect competition. Oligopolies, monopolies, and duopolies are also forms of imperfect competition.
Perfect competition benefits
The operation of the perfect competition market produces benefits for sellers and buyers that we see below.
The first and foremost advantage of perfect competition is that the possibilities of exploitation by the consumer are very low in the case of this type of market structure because, in perfect competition, sellers do not have any monopoly pricing power. and, therefore, they cannot influence the price of the product or charge more than the normal price of the consumers.
Another advantage of perfect competition is that the consumer gets a standardized product regardless of where the product is purchased, for example, if a consumer lives in city A and travels to city B and needs a soap that normally has perfect competition, then the consumer does not have to worry about the quality of the product because the product will remain the same whether the consumer buys it in city A or city B.
Perfect competition is a consumer-oriented market, which implies that the consumer is king in the case of this type of market structure and the sellers cannot upset the consumer because the consumer will quickly switch from one seller to another if he is not satisfied with the seller’s product or services.
Another advantage of perfect competition is that it has very little or no advertising expense because the products are homogeneous and if the company maintains the price as decided by market forces, sales will be made automatically without the company incurring much expense. of advertising.
Perfect competition: is it possible?
Real-world competition differs from this ideal primarily by differentiation in production, marketing, and sales. For example, in agriculture, the owner of a small organic produce store can talk at length about the grain that is fed to the cows that make the manure that fertilizes non-GMO soybeans, that’s differentiation. Through marketing, companies seek to establish brand equity around their differentiation and advertise to gain pricing power and market share.
Therefore, the first two criteria, homogeneous products and price takers, are far from being realistic. However, for the second two criteria, information and mobility , the global technological and commercial transformation is improving the flexibility of information and resources. Although the reality is far from this theoretical model, the model is still useful due to its ability to explain many behaviors in real life.
Barriers to entry prohibit perfect competition. Many industries also have significant barriers to entry, such as high start-up costs or strict government regulations, that limit the ability of companies to enter and exit those industries. And while consumer awareness has increased with the information age, there are still few industries where the shopper is aware of all available products and prices.
There are significant obstacles that prevent 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 who have virtually no ability to alter the selling price of their products. Commercial buyers of agricultural products are generally very well educated, and although agricultural production does involve some barriers to entry, it is not particularly difficult to enter the market as a producer.
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