Perfect competition

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Perfect competition is an economic model that describes a hypothetical market form in which no producer or consumer has the market power to influence prices. According to the standard economical definition of efficiency (Pareto efficiency), perfect competition would lead to a completely efficient outcome. The analysis of perfectly competitive markets provides the foundation of the theory of supply and demand.

[edit] Requirements

Perfect competition requires that the following five parameters be fulfilled. In such a market, prices would normally move instantaneously to economic equilibrium.

Atomicity

An atomistic market is one in which there are a large number of small producers and consumers on a given market, each so small that its actions have no significant impact on others. Firms are price takers, meaning that the market sets the price that they must choose.

Homogeneity

Goods and services are perfect substitutes; that is, there is no product differentiation.

Perfect and complete information

All firms and consumers know the prices set by all firms (see perfect information and complete information).

Equal access

All firms have access to production technologies, and resources are perfectly mobile.

Free entry

Any firm may enter or exit the market as it wishes (see barriers to entry).

Behavioural assumptions of perfect competition are that:

1. consumers aim to maximize utility
2. producer aim to maximize profits.

[edit] Results

In the short-run, it is possible for an individual firm to make abnormal profit. This situation is shown in this diagram, as the price or average revenue, denoted by P is above the average cost denoted by C .

However, in the long run, abnormal profit cannot be sustained. The arrival of new firms in the market causes the (horizontal) demand curve of each individual firm to shift downward, bringing down at the same time the price, the average revenue and marginal revenue curve. The final outcome is that, in the long run, the firm will make only normal profit (zero economic profit). Its horizontal demand curve will touch its average total cost curve at its lowest point. (See cost curve.)

The model is a description of one type of market structure, most closely approximating only a few markets, such as agriculture. In real-world markets, any of its assumptions may be violated. For example, firms will never have perfect information about each other. Its usefulness as a scientific construct may be judged by the range of market behavior explained by it and as a standard for comparison with other market structures.

In a perfectly competitive market, there will be allocative efficiency and productive efficiency.

• Allocative efficiency occurs when price (P) is equal to marginal cost (MC), at which point the good is available to the consumer at the lowest possible price.
• Productive efficiency occurs when the firm produces at the lowest point on the average cost curve (AC), implying it cannot produce the goods any more cheaply. This would be achieved in perfect competition, since if a firm was not doing it another firm would be able to undercut it by selling products at a lower price.

In contrast to a monopoly or oligopoly, it is impossible for a firm in perfect competition to earn abnormal profit in the long run, which is to say that a firm cannot make any more money than is necessary to cover its economic costs. If a firm is earning abnormal profit in the short term, this will act as a trigger for other firms to enter the market. They will compete with the first firm, driving the market price down until all firms are earning normal profit, it could be said that abnormal profit is 'competed away'. On the other hand, if firms are making a loss, then some firms will leave the industry, reduce the supply and increase the price. Therefore, all firms can only make normal profit in the long run.

It is important to note that perfect competition is a sufficient condition for allocative and productive efficiency, but it is not a necessary condition. Laboratory experiments in which participants have significant price setting power and little to no information about their counterparts consistently produce efficient results given the proper trading institutions (Smith, 1987, p. 245).

[edit] The shutdown point

If the Marginal Revenue curve is equal to the average variable cost curve, the firm will be indifferent between shutting down and continuing to produce.

When a firm is making loss, it will have to decide whether to continue production or not. This decision will, in fact, depend on the different total costs levels and whether the firm is operating in the short run or in the long run.

If the firm is in the short run, and is making a loss whereby:

• Total costs (TC) is greater than total revenue (TR)
• and whereby total revenue is equal to total variable cost (TVC)

it is advisable for the firm to continue production. If it fails to achieve these conditions, it is advise to close down so that the only costs the firm will have to pay will be the fixed costs.

In fact, even if the firm stop producing, it will have to continue to meet the level of fixed costs. Since whether the firm produces or not, it will have to pay fixed costs, it is better for it to continue production in an attempt to decrease total costs and increase total revenue, thus making profits. This can be done by:

• Increasing productivity. The most obvious methods involve automation and computerization which minimize the tasks that must be performed by employees. All else constant, it benefits a business to improve productivity, which over time lowers cost and (hopefully) improves ability to compete and make profit.
• Adopting new methods of production like Just In Time or lean manufacturing in an attempt to reduce costs and wastages.

In the long run, the condition to continue producing requires the price P to be higher than the ATC, i.e. the line representing market price should be above the minimum point of the ATC curve.

If P is equal to ATC, the firm is indifferent between shutting down and continuing to produce. This case is different from the short run shut down case because in long run there's no longer a fixed cost (everything is variable).

[edit] Examples

Some agricultural markets, with numerous suppliers and almost perfectly substitutable products have been suggested as approximations for the perfect-competition model. The extent of its applicability may be dependent on the market in question. Agricultural policies in many countries undermine the requirements for complete Pareto efficiency to apply.

Perhaps the closest thing to a perfectly competitive market would be a large auction of identical goods with all potential buyers and sellers present. By design, a stock exchange resembles this, not as a complete description (for no markets may satisfy all requirments of the model) but as an approximation.

eBay auctions can be often be seen as perfectly competitive. There are very low barriers to entry (anyone can sell a product, provided they have some knowledge of computers and the Internet), many sellers of common products and many potential buyers.

[edit] See also

• Contestable market
• Imperfect competition
• Monopolistic competition
• Workable competition
• Microeconomics
• Bertrand competition
• Cournot competition
• Léon Walras

[edit] References

• Luis M. B. Cabral. Introduction to Industrial Organisation, Massachusetts Institute of Technology Press, 2000, page 84–85.
• John Roberts (1987). "perfectly and imperfectly competitive markets," The New Palgrave: A Dictionary of Economics, v. 3, pp. 837-41.
• Vernon L. Smith (1987). "experimental methods in economics," The New Palgrave: A Dictionary of Economics, v. 2, pp. 241-49.
• George J. Stigler (1987). "competition," The New Palgrave: A Dictionary of Economics, v. 3, pp. 531-46.