Examples and How It Works

What Is Perfect Competition?

Perfect competition or pure competition is an idealized market condition where many sellers compete to offer the best prices and large sellers have no advantages over smaller ones. Perfect competition rarely occurs in real-world markets but it provides a useful model for explaining how supply and demand affect prices and behavior in a market economy.

There are many buyers and sellers in perfect competition and prices are determined purely by supply and demand. Companies earn just enough profit to stay in business and no more. Other companies would enter the market and drive profits down if they were to earn excess profits.

How Perfect Competition Works

Perfect competition is a benchmark or ideal type to which real-life market structures can be compared. Pure competition is theoretically the opposite of a monopoly in which only a single firm supplies a good or service. That firm can charge whatever price it wants because consumers have no alternatives and it’s difficult for would-be competitors to enter the marketplace.

There are no monopolies in a perfect competition model. This kind of structure has several key characteristics:

• All firms sell an identical product. It’s a commodity or homogeneous.
• All firms are price takers. They can’t influence the market price of their products.
• Market share doesn’t influence prices.
• Buyers have complete or perfect information about the product being sold and the prices charged by each firm in the past, present, and future.
• Capital resources and labor are perfectly mobile.
• Firms can enter or exit the market without cost.

This can be contrasted with the more realistic imperfect competition that exists whenever a hypothetical or real market violates the abstract tenets of neoclassical pure or perfect competition.

All real markets exist outside the plane of the perfect competition model so each can be classified as imperfect. The contemporary theory of imperfect versus perfect competition stems from the Cambridge tradition of post-classical economic thought.

Characteristics of Perfect Competition

A perfectly-competitive market is defined by several factors.

A Large and Homogeneous Market 

A large number of buyers and sellers exist in a perfectly competitive market. The sellers are small firms rather than large corporations that are capable of controlling prices through supply adjustments. They sell products with minimal differences in capabilities, features, and pricing. This ensures that buyers can’t distinguish between products based on physical attributes such as size or color or intangible values such as branding.

A large population of both buyers and sellers ensures that supply and demand remain constant in this market. Buyers can easily substitute products made by one firm for others. 

Perfect Information Availability  

Information about an industry’s ecosystem and competition constitutes a significant advantage. Knowledge about component sourcing and supplier pricing can make or break the market for certain companies.

Information about patents and competitors’ research initiatives can help companies develop competitive strategies and build a moat around their products in certain knowledge and research-intensive industries such as pharmaceuticals and technology,

Absence of Controls

Governments play a vital role in market formation for products by imposing regulations and price controls. They can control the entry and exit of firms into a market by setting up rules to function in it. The pharmaceutical industry must contend with a roster of rules governing the development, production, and sale of drugs.

These rules require big capital investments in the form of employees such as lawyers and quality assurance personnel as well as infrastructure such as machinery to manufacture medicines. The cumulative costs add up and make it extremely expensive for companies to bring a drug to the market.

The technology industry functions with relatively less oversight as compared to its pharma counterpart. Entrepreneurs in this industry can start firms with less capital, making it easy for individuals to start a company in the industry. 

Such controls don’t exist in a perfectly competitive market. The entry and exit of firms are unregulated and this frees them up to spend on labor and capital assets without restrictions and adjust their output in relation to market demands.

Cheap and Efficient Transportation

Cheap and efficient transportation is another characteristic of perfect competition. Companies don’t incur significant costs to transport goods in this type of market. This helps reduce the product’s price and cuts back on delays in transporting goods. 

Theory vs. Reality of Perfect Competition

Real-world competition differs from this ideal primarily because of differentiation in production, marketing, and selling. The owner of a small organic products shop can advertise extensively about the grain fed to the cows that made the manure that fertilized the non-GMO soybeans, thereby setting their product apart from competitors. This is referred to as differentiation.

Homogeneous products and price takers are far from realistic but the global tech and trade transformation is improving information and resource flexibility. The reality is far from this theoretical model but the model is still helpful because of its ability to explain many real-life behaviors.

Barriers to Entry Prohibit Perfect Competition

Many industries also have significant barriers to entry such as high startup costs as seen in the auto manufacturing industry or strict government regulations as seen in the utility industry. These limit the ability of firms to enter and exit such industries. Consumer awareness has increased with the information age but there are still few industries where the buyer remains aware of all available products and prices.

Significant obstacles exist that prevent perfect competition from developing in the economy. The agricultural industry probably comes closest to exhibiting perfect competition because it’s characterized by many small producers with virtually no ability to alter the selling price of their products.

The commercial buyers of agricultural commodities are generally very well-informed and it’s not particularly difficult to enter the marketplace as a producer although agricultural production does involve some barriers to entry.

Advantages and Disadvantages of Perfect Competition

Perfect competition is an idealized framework for a market economy. It provides a convenient model for how an economy works but it’s not always accurate and has significant departures from the real-world economy. The value of a perfect competition framework is only accurate to the extent that it reflects actual conditions.

One notable feature of perfect competition is low profit margins. All consumers have access to the same products so they naturally gravitate toward the lowest prices. Firms can’t set themselves apart by charging a premium for higher-quality products and services. It would be impossible for a company like Apple (AAPL) to exist in a perfectly competitive market because its phones are more expensive than those of its competitors.

Another issue is the absence of innovation. The prospect of greater market share and setting themselves apart from the competition is an incentive for firms to innovate and make better products. No firm possesses a dominant market share in perfect competition, however. The long-term profitability of their operations is zero.

The absence of economies of scale is a disadvantage. Being limited to zero profit margins means that companies will have less cash to invest in expanding their production capabilities. An expansion of production capabilities could potentially bring down costs for consumers and increase business profit margins. The presence of several small firms cannibalizing the market for the same product prevents this, however, and ensures that the average firm size remains small.

Do Firms Profit in Perfect Competition?

Profits may be possible for brief periods in perfectly competitive markets but the market’s dynamics cancel out the effects of positive or negative profits and bring them toward an equilibrium. There’s no information asymmetry in the market so other firms will quickly ramp up their production or reduce their manufacturing costs to achieve parity with the firm that made profits.

The average revenue and marginal revenue for firms in a perfectly competitive market are equal to the product’s price to the buyer. The perfectly competitive market’s equilibrium that had been disrupted earlier will be restored as a result. An adjustment of supply and demand ensures all profits or losses in such markets tend toward zero in the long run.

Perfect Competition vs. Monopoly

The opposite of perfect competition is a monopoly in which a single company controls the supply of a certain product. Consumers can’t go elsewhere if the price is too high in monopoly conditions. They can only decide not to buy the product.

The monopolistic firm can simply set a price point that maximizes its profits rather than setting prices by supply and demand. Some types of firms are considered natural monopolies because there’s a significant first-mover advantage that discourages competitors from entering the market. Other monopolies may be established through government actions or by cartels such as OPEC.

Examples of Perfect Competition 

Perfect competition is a theoretical construct and doesn’t actually exist. As such, it is difficult to find real-life examples of perfect competition but there are variants present in everyday society.

Produce

Consider the situation at a farmer’s market, a place that’s characterized by a large number of small sellers and buyers. There’s typically little difference between products and their prices from one farmer’s market to another. How the produce is grown doesn’t matter unless the market is classified as organic. There’s very little difference in how they’re packaged or branded. It won’t make a difference to the average prices even if one of the farms goes out of business,

Supermarkets

The situation may be relatively similar in the case of two competing supermarkets that stock their aisles from the same set of companies. Again, there’s little to distinguish products from one another between both supermarkets and their pricing remains almost the same.

Another example of perfect competition is the market for unbranded products which features cheaper versions of well-known products.

Knockoffs

Product knockoffs are generally priced similarly and there’s little to set them apart from each other. One product is simply replaced by another if one of the firms manufacturing it goes out of business.

Technology

The development of markets in the technology industry also resembles perfect competition to a certain degree. A proliferation of sites offered similar services during the early days of social media networks. Some examples of such sites are Sixdegrees.com, Blackplanet.com, and Asianave.com. None of them had a dominant market share and the sites were mostly free. They constituted sellers in the market. Consumers of such sites, mainly young people, were the buyers.

The startup costs for companies in this space were minimal. Startups and companies can freely enter and exit these markets. Technologies such as PHP and Java were largely open-source and available to anyone. Capital costs in the form of real estate and infrastructure weren’t necessary. Mark Zuckerberg effectively founded Facebook from his college dorm.

The Bottom Line

Perfect competition describes an imaginary market condition in which all consumers have access to the same products and information. All firms must offer the lowest price possible in this type of economy or they risk being undercut by their competitors. This is just a theoretical model but perfect competition is useful for demonstrating how economic actors behave in a free market.