12/03/2022
✓✓ What is Perfect Competition
Perfect Competition is a type of market structure where many firms sell similar products and profits are virtually non-existent due to fierce competition. With that said, it is important to realise that perfect competition is an abstract term used to compare against real life markets.
Although perfect competition is based on a number of assumptions, that in reality, rarely exist – there are some close examples. With that said, there are a number of key characteristics of perfect markets that identify them as such. Let us look at them below
✓✓ 5 Characteristics of Perfect Competition
Perfect competition has 5 key characteristics:
Many Competing Firms
Similar Products Sold
Equal Market Share
Buyers have full information
Ease of Entry and Exit
When these characteristics are seen in the market, we can consider it perfectly competitive. Let us look at them in more detail below.
1. Many Competing Firms
A perfectly competitive market has many buyers and sellers. This means that firms are known as ‘price takers’. In other words, the firm must sell at the ‘equilibrium’ price – this is where the firm sells when supply and demand align. If not, they will go out of business, as there are many other firms that sell the same good at a lower price. As a result, customers have little cost of switching to a substitute good.
The number of competitors in the market means that each company is prevented from raising prices. If they do, then they will be forced out of the market as consumers are able to switch to cheaper alternatives
2. Similar Products Sold
In perfect competition, competitors sell similar products. This is otherwise known as ‘homogenous’ – in economic jargon. In simple terms, it means the products are similar.
Individual businesses may be indistinguishable to the average customer. As a result, the ability and willingness to switch is easy and costless.
Dairy is a notable example. For instance, many farmers sell milk to supermarkets, but the product is very similar. In fact, supermarkets change contracts with dairy producers without customers even noticing
3. Equal Market Share
Competitors all have a similar market share because firms are unable to compete on price. As firms produce where Marginal Revenue = Marginal Cost, there is no room to reduce prices.
If a firm was to reduce prices, it would start making a loss – because it costs more to make than sell, meaning it would go out of business. At the same time, if any firm increases prices, there is enough competition to attract customers from that store and put them out of business. In turn, this puts a restriction on a firms ability to gain market share.
4. Buyers have full information
In economic jargon, we call this ‘Perfect Information’. This is where the customer knows that the business down the road sells the same product at a lower price. As a result, businesses are reluctant to raise prices ahead of a competitor.
Furthermore, customers are also aware of the quality of a product. For instance, one firm may reduce costs to provide a lower quality product and make more profit. Since customers have perfect information, they will know the product is inferior. In turn, they will switch to competitors – putting the original firm out of business
5. Ease of Entry and Exit
Firms can enter and exit the market with little cost. This can come in the form of financial, time, or information. For instance, the oil and gas industry requires a high level of up-front investment. As such, this is a barrier to entry for competitors. Under perfect competition, these costs do not exist or are in fact insignificant.
Additionally, firms are able to exit the market with ease under perfect competition. For example, a firm may have a long-term contract. But they are unable to leave the market without significant costs.
