Perfect competition defined

Perfect competition is an idealized version of market structure that provides a foundation for understanding how markets work in a capitalist economy. The other market structures can also be understood better when perfect competition is used as a standard of reference. Even so, perfect competition is not ordinarily well understood by the general public. For example, when business people speak of intense competition in the market for a product, they are, in all likelihood, referring to rival suppliers, about whom they have quite a bit of information. However, when economists refer to perfect competition, they are particularly referring to the impersonal nature of this market structure. The impersonality of the market organization is due to the existence of a large number of suppliers of the product—there are so many suppliers in the industry that no firm views another supplier as a competitor. Thus, the competition under perfect competition is impersonal. To understand the nature of competition under the perfectly competitive market form, one should briefly examine some conditions that are necessary before a market structure is considered "perfectly competitive.":

1. Numerous participants. This condition, existence of many buyers and sellers, leads to an important outcome. When there is a large number of buyers or sellers, each individual buyer or seller is so small relative to the entire market that he or she does not have any power to influence the price of the product under consideration. As a result, whether a person is a buyer or a seller, he or she must accept the market price. All buyers and sellers in the market are effectively price takers, not price makers. The market as a whole establishes product prices, and individual buyers or sellers simply decide how much to buy or sell at the given market price. So each seller and purchaser constitutes so small a portion of the market that their decisions have no effect on the price. This requirement rules out trade associations or other collusive arrangements strong enough to af­fect price.

2. Homogeneity of the product sold in the industry, existence of many buyers and sellers, and perfect mobility of resources or factors of production. Homogeneity of product means that the product sold by any one seller in the market is identical to the product sold by any other supplier. The homogeneity of product has an important implication for the market: if products of different sellers are identical, buyers do not care who they buy from, so long as the price is also the same. While this condition of a perfect market sounds extreme, it is, in fact, met in markets for many products. Wheat of a given grade and corn are good examples. Wheat and corn produced by different farmers is essentially the same, and can thus be considered identical. (Different brands of toothpaste are not)The product offered by any seller is identical to that supplied by any other seller. (Example: wheat of a given grade is a homogeneous product; different brands of toothpaste are not.).

3. Freedom of entry and exit. New firms desiring to enter the market face no impediments that the existing firms can avoid. Similarly, if production and sale of the good proves unprofitable, there are no barriers preventing firms from leaving the market.

4. Perfect information. Each firm and each customer is well informed about the available products and their prices. They know whether one supplier is selling at a price lower than another is.

5.. The next condition, perfect mobility of resources, requires that all factors of production (resources used in the production process) can be readily switched from one use to another. Furthermore, it is required that all buyers, sellers, and owners of resources have full knowledge of all relevant technological and economic data. The implication of the this condition is that resources move to the most profitable industry

6. An absence of any collusion (secret agreements) among producers on price, quantities, or quality of goods sold.

No industry in the world (now or in the past) satisfies all these conditions stipulated above fully. Thus, no industry in the world can be considered perfectly competitive in the strictest sense of the term. However, there are token examples of industries that come quite close to being a perfectly competitive market. Some markets for agricultural commodities, while not meeting all three conditions, come reasonably close to being characterized as perfectly competitive markets. The market for wheat, for example, can be considered a reasonable approximation. The wheat market is characterized by an almost homogenous product, and it has a large number of buyers and sellers. It thus satisfies the first two conditions fairly well. However, it is difficult to assert that resources employed in the wheat industry are perfectly mobile.

Our interest in perfect competition is surely not for its descriptive realism. Despite the fact that no industry is truly perfectly competitive, it is still worthwhile to study perfect competition as a market structure. It is under perfect competition that the market mechanism performs best. So, if we want to learn what markets do well, we can put the market's best foot forward by beginning with perfect competition.

As Adam Smith suggested some two centuries ago, perfectly competitive firms use society's scarce resources with maximum efficiency. And as Friedrich Engels (the closest friend of and coauthor with Karl Marx) suggested in the opening quota­tion of this chapter, only (perfect) competition can ensure that the economy turns out just those varieties and relative quantities of the various goods that match the preferences of consumers. So by studying perfect competition, we can learn just what an ideally functioning market system can accomplish. Conclusions derived from the study of the idealized version of perfect competition are often helpful in explaining behavior in the real world.

THE ECONOMICS OF PERFECT COMPETITION.

The study of the idealized version of perfect competition leads to some important conclusions regarding solutions to key economic problems, such as quantity of the relevant product produced, price charged, the mechanism of adjustment in the industry.

As mentioned earlier, under perfect competition, an individual supplier of the product has to take the market price as given. Given this price, the supplier determines how much to produce and sell. The quantity he or she decides to produce is the quantity that maximizes profit for the firm (more technically, where marginal cost of producing the product equals the market price of the product). The total production of all firms in the industry determines the market supply of the product under consideration. This market supply of the product, in conjunction with the total demand for the product by all consumers, determines the market price. Thus, while an individual buyer or seller is a price taker, the collective decisions affect the market price. Since the consumers of the product receive a price that is equal to the cost of production (on the margin), it is argued that consumers are treated fairly under perfect competition.

In addition, the total output produced under perfect competition is larger than, for example, under monopoly. To understand this, we should look at the mechanics of maximizing profit, the guiding force behind a supplier's output decision. In order to maximize profits, a supplier has to look at cost and revenue. Usually, it is assumed that a supplier's marginal cost (the cost of producing an additional unit of the product under consideration) rises ultimately. The producer then, in making the output decision, must compare the cost of producing an additional unit of the product with the revenue the sale of that additional unit (called the marginal revenue) brings to the firm. So long as the marginal revenue from the sale exceeds the marginal cost, there is a gain from producing that additional unit—the unit adds more to revenue (proceeds) than to costs. The supplier will continue producing while the process is profitable (i.e., it increases profits or reduces loss). The firm will stop production where marginal revenue equals marginal cost—this output level maximizes profits (or minimizes loss). In the case of a perfectly competitive firm, the market price for the product is also the marginal revenue. Since the firm is a price taker and supplies an insignificant portion of the total market supply of the product, it can sell as many units of the product as it desires at the going price. We will later show that this is not the case with a monopolist, for example. A monopolist stops production of the product before reaching the point where marginal cost of the product equals the market price of the product.

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