Perfect competition is a market structure where many firms offer a homogeneous product. Because there is freedom of entry and exit and perfect information, firms will make normal profits and prices will be kept low by competitive pressures.
Features of perfect competition
- Many firms.
- Freedom of entry and exit; this will require low sunk costs.
- All firms produce an identical or homogeneous product.
- All firms are price takers, therefore the firm’s demand curve is perfectly elastic.
- There is perfect information and knowledge.
Diagram for perfect competition
- The industry price is determined by the interaction of Supply and Demand, leading to a price of Pe.
- The individual firm will maximise output where MR = MC at Q1
- In the long run firms will make normal profits.
What happens if supernormal profits are made?
If supernormal profits are made new firms will be attracted into the industry causing prices to fall. If firms are making a loss then firms will leave the industry causing price to rise
The features of perfect competition are very rare in the real world. However perfect competition is as important economic model to compare other models. It is often argued that competitive markets have many benefits which stem from this theoretical model.
Changes in long run equilibrium
1. The effect of an increase in demand for the industry.
If there is an increase in demand there will be an increase in price Therefore the demand curve and hence AR will shift upwards. This will cause firms to make supernormal profits.
This will attract new firms into the market causing price to fall back to the equilibrium of Pe
2. An increase in firms costs
The AC curve will increase therefore AR< AC
Firms will now start making a loss and therefore firms will go out of business. This will cause supply to fall causing prices to increase.
Efficiency of perfect competition
- Firms will be allocatively efficient P=MC
- Firms will be productively efficient. Lowest point on AC curve
- Firms have to remain efficient otherwise they will go out of business.
- Firms are unlikely to be dynamically efficient because they have no profits to invest in research and development.
- If there are high fixed costs, firms will not benefit from efficiencies of scale
- see more: efficiency of perfect competition
Examples of perfect competition
In the real world, it is hard to find examples of industries which fit all the criteria of ‘perfect knowledge’ and ‘perfect information’. However, some industries are close.
- Foreign exchange markets. Here currency is all homogeneous. Also, traders will have access to many different buyers and sellers. There will be good information about relative prices. When buying currency it is easy to compare prices
- Agricultural markets. In some cases, there are several farmers selling identical products to the market, and many buyers. At the market, it is easy to compare prices. Therefore, agricultural markets often get close to perfect competition.
- Internet related industries. The internet has made many markets closer to perfect competition because the internet has made it very easy to compare prices, quickly and efficiently (perfect information). Also, the internet has made barriers to entry lower. For example, selling a popular good on the internet through a service like e-bay is close to perfect competition. It is easy to compare the prices of books and buy from the cheapest. The internet has enabled the price of many books to fall in price so that firms selling books on the internet are only making normal profits.