perfect competition


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Related to perfect competition: Monopolistic competition, oligopoly

Perfect competition

An idealized market environment in which every market participant is too small to affect the market price by acting on its own.
Perfect competitionclick for a larger image
Fig. 140 Perfect competition. See entry. (a) Short-run equilibrium. (b)Long-run equilibrium.

perfect competition

or

atomistic competition

A type of MARKET STRUCTURE characterised by:
  1. many firms and buyers: that is, a large number of independently acting firms and buyers, each firm and buyer being sufficiently small to be unable to influence the price of the product transacted;
  2. homogeneous products: that is, the products offered by the competing firms are identical, not only in physical attributes but are also regarded as identical by buyers, who have no preference between the products of various producers;
  3. free market entry and exit: that is, there are no BARRIERS TO ENTRY (hindrances to the entry of new firms) or impediments to the exit of existing sellers
  4. perfect knowledge of the market by buyers and sellers.

In a perfectly competitive market, individual sellers have no control over the price at which they sell, the price being determined by aggregate market demand and supply conditions. Each firm produces such a small fraction of total industry output that an increase or decrease in its own output will have no perceptible influence upon total supply and, hence, price. Further, given the infinite cross ELASTICITY OF DEMAND between the homogeneous outputs of the competing sellers, no seller can increase his price above the ruling market price without losing all his custom. Thus, the demand curve facing the firm will be a horizontal straight line at the ruling market price. In consequence, marginal revenue (MR) equals average revenue (AR). The competitive firm is a price taker, accepting price as something completely outside its control, and will simply adjust its output independently to the most profitable level at that price; that is, the firm will continue to produce additional units of output so long as price (= MR = AR) exceeds marginal cost. When these are equated, the firm will maximize profits. Fig. 140 (a) shows the short-run competitive-equilibrium position for a ‘representative’ firm and the industry.

The individual supply schedules (MCs) of x’ number of identical firms are summed horizontally to obtain the industry supply curve (SS). Given industry demand (DD), the short-run equilibrium price and output are Pe and Qe. Taking the equilibrium price as given, the competitive firm establishes its profit-maximizing output at the level Qf (P = MC) and, in this case, realizes ABOVE-NORMAL PROFITS (Pfxyz).

The long-run equilibrium position can also be ascertained. It is deduced, from the assumptions of profit maximization, perfect knowledge and free entry and exit, that, unless the returns to the productive resources employed in the industry are at a level that could be derived from alternative uses elsewhere in the economy, there will be resources entering or leaving this industry. In general, outputs will be adjusted to demand until market output is extended (or reduced) and price reduced (or increased) to the point where the average cost of supplying that output is just equal to the price at which that output sells.

If, as in the example above, established sellers are earning above-normal profits, then new resources will be attracted into the industry, thereby increasing total market supply and reducing market price. This process will continue until the excess profits have been competed away. Fig. 140 shows the long-run competitive equilibrium position for the ‘representative’ firm and the industry. Given an unchanged industry demand (DD), the long-run equilibrium price and output for the industry are P1e and Q1e. Given the equilibrium price, the firm establishes its profit-maximizing output at the point Q1f, where P = MC at the point of minimum long-run average cost.

Static market theory shows perfect competition to result in a more efficient MARKET PERFORMANCE than other forms of market organization (see especially the comparison with MONOPOLY). Specifically, market output is optimized at a level equal to minimum supply costs; consumers are charged a price just equal to minimum supply costs, with suppliers receiving a NORMAL PROFIT return. The conclusion of competitive optimality, however, rests on a number of assumptions, some of which are highly questionable, in particular the assumption that cost structures are identical for small perfectly competitive firms and large oligopolistic and monopoly suppliers (see OLIGOPOLY, ECONOMIES OF SCALE), while, given its static framework, it ignores important dynamic influences, such as TECHNOLOGICAL PROGRESS. See also MONOPOLISTIC COMPETITION.

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