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How would you feel living in a world where all products are homogenous? In a world where neither you as a buyer nor the firm as a seller has the ability to influence the market price?
This type of market can’t be found in the real world but is one of economics’ most essential market structures. It’s called the perfect competition. Although it is theoretical and doesn’t have real-world applications, it provides an important framework for analysing how efficient resource allocation happens in an economy. In this explanation, you’ll learn everything you need to know about perfect competition.
Perfect competition is a theoretical market structure that doesn’t really occur in the real world. The theory of perfect competition suggests that many firms sell identical products. In this ideal and perfect market structure, none of the parties involved in the market can influence the price. That is to say, buyers and sellers can’t change the prices; instead, the market equilibrium sets the prices. Other firms are free to enter and leave this market whenever they want. Firms also disclose complete information about their products, and buyers are fully aware of everything related to the product they are buying.
Perfect competition doesn’t exist in the real world as it is very hard to find a market that simultaneously meets all the conditions for it. However, perfect competition’s theoretical underlying provides handy tools to judge firms’ behaviour in terms of how efficient their allocation of resources is. In perfect competition, resources are allocated in such a way that it benefits the entire society’s welfare.
The characteristics of perfect competition are:
A perfectly competitive market structure is characterised by having many firms supplying in the market. This lowers their market share and the ability to influence the market price. If one firm decides to increase its prices, customers will simply buy from another supplier.
In perfect competition, firms are faced with a perfectly elastic demand curve, which means that even a slight change in the price of a good would lead to a fall of demand into zero. Because of that, firms have no other choice but to take the price given by the market equilibrium.
Another important characteristic of perfect competition is that the products are identical. Yes, all the products sold in the market are identical regardless of the supplier. In the real world, you would find this in agriculture, where every farmer sells apples. How different could apples be from one another?
There are no barriers to entering or leaving the market in perfect competition. Sellers can choose to enter the market at any given point. This means that they will not face the predatory price practices that prevent them from entering the market.
Perfect competition requires sellers to disclose all the information about their products. This way, buyers have perfect information on what type of good or service they are buying.
Profit maximisation in perfect competition is different in the short and in the long run. Let’s see each scenario.
The perfect competition theory suggests that the firm can sell whatever quantity they want at the equilibrium market price. The price equilibrium is also the point where the perfectly elastic demand curve occurs— meaning that there is an infinite demand for the good at that price. If the price increases, there would be zero demand for the product. That’s why the firm is a price taker and can’t influence the market price on its own. This applies to all firms participating in the marketplace.
Figure 1. Profit maximisation in the short run, StudySmarter Originals
Figure 1 illustrates how firms maximise their profit in the short run in perfect competition. The price is set in diagram 2, where the market demand and supply meet, creating what is known as the equilibrium price.
As you can see in diagram 1 of Figure 1, as individual firms are faced with the perfectly elastic demand, the point at which market equilibrium price occurs also provides the demand curve, the curve for marginal revenue and the average revenue of the firm.
In perfect competition, firms will maximise their profits where the marginal cost equals the marginal revenue for the product, MR=MC. This is when firms no longer have the incentive to increase production as adding an extra input would add to the firm’s cost. On the other hand, the firm could produce more and gain more revenue if its marginal revenue is higher than its marginal cost. Hence a firm maximises profit only at the point where MC=MR. This is also the point where the firm chooses the optimal quantity to produce so it can generate abnormal profits (well, at least in the short run, as in perfect competition).
The perfect competition theory suggests that although firms can’t leave or enter the market in the short run, they can do so in the long run. Additionally, there are no barriers to entering or leaving the market in the long run. This provides other dynamics to the way firms maximise profits in the long run. One of the main incentives the firms have to enter the market is that they see other firms making abnormal profits. This then leads new firms to join the market in the short run, and, eventually, to erode abnormal profits until everyone only makes normal profits.
Figure 2. Profit maximisation in the long run, StudySmarter Originals
Figure 2 shows what happens when new firms enter the market. As new firms enter, they provide additional products, shifting the market supply to the right, as seen in diagram 2 of Figure 2. The shift in supply translates into lower equilibrium prices. When prices drop from P to P', firms start experiencing losses as the new price is smaller than the individual firm’s average total cost.
Many firms will not be able to sustain the costs, which leads them to leave the market shifting the market supply curve from S’ to S’’. The new S’’ curve brings the market price up to the point where it is equal to the lowest point in the ATC curve and equal to MC. This erodes the abnormal profits and leads to firms making only normal profits in the long run, where there’s no incentive for other firms to join the market anymore.
Although perfect competition doesn’t occur in the real world, there are a couple of industries where you can find market structures close to what a perfect competition would look like.
Think about it. In agriculture, you have many farmers producing many identical products, like apples or strawberries. Regardless of what the farmers do, they can’t differentiate apples. Additionally, as there are many sellers and many buyers of apples, none of them can influence the market price. Instead, it is determined by the point where equilibrium occurs.
The only factors that can affect the price of apples are external factors such as the weather, for instance. If the weather becomes unsuitable for growing apples, it will influence the production of apples, which will shift the market supply to the left. As a result, prices increase, and the quantity demanded drops.
However, you should note that the price changed because external factors acted upon the market. Neither sellers nor buyers influenced the price.
You could also think of the foreign exchange market as a close example of perfect competition. If you’re trading the US dollar, there’s only one type of US dollar, so the product is homogenous. Moreover, there are many buyers and sellers who are incapable of influencing the market price on their own. The price is determined by supply and demand in the market.
Although the foreign exchange market meets most of the requirements for perfect competition, not all buyers and sellers have perfect information when trading currencies.
There are many advantages that perfect competition provides. One of the main advantages is that it enables resources to be allocated efficiently in an economy. That happens because the equilibrium is set where the demand and supply meet. At this point, there’s no consumer or producer surplus loss, and economic welfare is maximised. Moreover, perfect competition prevents large companies from engaging in unfair practices that keep new firms out of the market. This provides an incentive for others to join the market.
One of the leading and most important disadvantages is that products are identical. Could you imagine living in a world where everyone is wearing the same blue shirt? It would be kind of boring, right? Another major disadvantage of perfect competition is that firms only make normal profits in the long run. This prevents firms from investing in research and development, which leads to less innovation. Although perfect competition can be pretty helpful in some aspects, there would be huge tradeoffs of perfect competition in the real world.
Perfect competition is a theoretical market structure that doesn't occur in the real world. The theory of perfect competition suggests that many firms sell identical products. In this ideal and perfect market structure, none of the parties involved in the market can influence the prices.
Both buyers and sellers are price takers in perfect competition.
Perfect competition doesn't occur in the real world. However, there are examples of industries close to perfect competition such as agriculture and foreign market exchange.
Characteristics of perfect competition include a large number of producers, firms are price takers, identical products, freedom of entry or exit, perfect information.
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