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.
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[edit] Requirements
Perfect competition requires that the following five parameters be fulfilled. In such a market, prices would normally move instantaneously to 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 (including information) are perfectly mobile.
- Free entry
- Any firm may enter or exit the market as it wishes (see barriers to entry).
[edit] Results
The model is in most cases only a distant approximation of real markets, with the possible exception of certain large street markets. In general, few, if any of the conditions listed above will apply in real markets. For example, firms will never have perfect information about each other, and there will always be some transaction costs. In a perfectly competitive market, there will be both 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 [citation needed] given the proper trading institutions.
[edit] The shutdown point
In a perfectly competitive market, the firm is a price taker; that is, the firm accepts the current market price P and it has no control over the price. The condition to continue producing requires the price P to be higher than the AVC, i.e. the line representing market price should be above the minimum point of the AVC curve. If P is equal to AVC, the firm is indifferent between shutting down and continuing to produce. However if P is less than AVC, the firm should shut down completely, because then it is incurring some variable costs over and above its fixed cost.
[edit] Examples
Some have suggested that agriculture, with numerous suppliers, and almost perfectly substitutable products, is an approximation to the perfect competition model. This may have been true in some places at certain times, but in modern economies the assertion is hard to prove due to the complex nature of political policies and wealth distribution.
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 closely approximates this, though there is no way to guarantee atomicity (or even approach it). As perfect competition is a theoretical absolute, there are no real-world examples of a perfectly competitive market.
[edit] See also
[edit] Reference
- Luis M. B. Cabral. Introduction to Industrial Organisation, Massachusetts Institute of Technology Press, 2000, page 84–85.
