Perfect Competition

Perfect competition in economics refers to condition in market in an ideal situation. In this situation price for all goods and services are decided by market on basis of competition and no external intervention takes place. Characteristics of perfect competition  are given below:

Perfect Competition

  • It is one extreme of the market structure spectrum
  • Characteristics:
    • Large number of firms
    • Products are homogenous (identical) – consumer has no reason to express a preference for any firm
    • Freedom of entry and exit into and out of the industry
    • Firms are price takers – have no control over the price they charge for their product
    • Each producer supplies a very small proportion of total industry output
    • Consumers and producers have perfect knowledge about the market
  • Diagrammatic representation

Perfect Competition 1

  • The MC is the cost of producing additional (marginal) units of output. It falls at first (due to the law of diminishing returns) then rises as output rises.
  • The average cost curve is the standard ‘U’ – shaped curve. MC cuts the AC curve at its lowest point because of the mathematical relationship between marginal and average values.
  • The industry price is determined by the demand and supply of the industry as a whole. The firm is a very small supplier within the industry and has no control over price. They will sell each extra unit for the same price. Price therefore = MR and AR
  • Given the assumption of profit maximisation, the firm produces at an output where MC = MR (Q1). This output level is a fraction of the total industry supply.
  • At this output the firm is making normal profit. This is a long run equilibrium position.

Perfect Competition 2

  • Now assume a firm makes some form of modification to its product or gains some form of cost advantage (say a new production method).
  • Average and Marginal costs could be expected to be lower but price, in the short run, remains the same.
  • The lower AC and MC would imply that the firm is now earning abnormal profit (AR>AC) represented by the coloured area.
  • Because the model assumes perfect knowledge, the firm gains the advantage for only a short time before others copy the idea or are attracted to the industry by the existence of abnormal profit. If new firms enter the industry, supply will increase, price will fall and the firm will be left making normal profit once again.

 

  • Example:

Though perfect competition is an extreme and is not realized in reality, a very near example of perfect competition would be the fish market and the vegetable/fruit market who sell at the same place. This is because –

1) There are large number of buyers and sellers.

2) There are no entry or exit barriers.

3) There is perfect mobility of the factors, i.e buyers can easily switch from one seller to the other.

4) The products are homogenous