Contents
What are the characteristics of perfect competition?
Perfectly competitive markets have several key properties:
- No barriers to entry and exit.
- Many small firms.
- Firms are price takers.
- No product differentiation – all products are exactly the same.
- Perfect information for buyers and sellers.
Examples of markets are closer to perfect competition include some aspects of online marketplaces, foreign exchange (forex) markets and global agricultural markets.
Case study: online marketplaces
Consider online marketplaces. This includes companies like eBay, Etsy and Amazon. Each platform features millions of sellers.
In 2023, Etsy reached over 9 million sellers, while eBay had 18.1 million sellers.
For a given product, there could be hundreds of different sellers. Particularly where the same product is being sold by different sellers, we could see a market structure approaching perfect competition.
However there is still some differentiation even among these sellers. Sellers for the same good could differ on reliability, whether the good is new or used, their brand or reviews.
Other product categories may be different. Looking at a broader category, such as a computer, you’ll find several different alternatives, each with different features. When thinking like this products, online marketplaces may better resemble monopolistic competition.
You may even find some submarkets on online marketplaces with only a few key sellers.
It is hard to find an example of a perfectly competitive market in practice. Some differentiation or barrier to entry is likely to exist.
If no perfectly competitive markets exist, why is perfect competition useful?
One way to view perfect competition is as a benchmark. Perfect competition is a reference point for judging how competitive markets are. The further a market from perfect competition, the less “competitive” it is.
Is a perfectly competitive market a good thing?
Diagrammatic analysis of perfect competition
Perfect competition in the short run
Firms are price takers in perfect competition. Hence the level of output that an individual firm sets does not influence the market price.
So the price is fixed from the point of view of the firms at p, which means their average and marginal revenues are also constant (horizontal).
The cost curves are the standard cost curves.
The firm produces where marginal revenue equals marginal cost to maximise profit. This occurs at quantity q.
This shows that in the short run, the perfectly competitive firm can make supernormal profit. The supernormal profit here is the output level q, multiplied by the profit per unit (p-c).
This can be shown as the rectangle with area q(p-c).
Note it is also possible for firms to make a supernormal loss in the short run. This occur if the price line AR=MR=p lies below the ATC curve.
Perfect competition in the long run
The absence of barriers to entry in perfect competition means firms can enter the market over time.
In particular, firms may observe supernormal profits being made in the short run and decide to enter the market.
Firm entry shifts the industry supply curve right from S to S1. This lowers the equilibrium price from p to p1.
The lower price p1 is the new market price for price taking firms. So for a firm, their average revenue and marginal revenue are now lower.
This process of firm entry, supply shifting right and the price falling continues until there is zero supernormal profit.
At this point, there is no further incentive for firms to enter the market. So in the long run, firms in perfect competition make normal profits only.
What are the benefits and drawbacks of perfect competition?
The benefits of perfect competition
Perfectly competitive markets satisfy allocative efficiency. The level of output maximises social welfare (in this case, by setting the price equal to marginal cost).
Note however that the free market does not take into account externalities. Externalities can cause a welfare loss and hence allocative inefficiency, even in perfectly competitive markets.
Perfect competition leads to productive efficiency in the long run. This means firms are producing at the minimum point of their average cost curve.
X efficiency also exists in a perfectly competitive market. Firms not operating on their lowest cost curve would be undercut and forced out of the market in the long run by firms that do operate on their lowest cost curve.
The drawbacks of perfect competition.
However in the long run there is dynamic inefficiency. Firms make zero supernormal profits and so cannot invest to lower their costs over time.
Products are exactly the same in perfect competition – there is no product differentiation. This lack of variety may be undesirable for consumers, some of whom may prefer a slight variation or customised version of the product.
Perfect information and no entry barriers can reduce incentives to innovate. If a firm comes up with a more efficient method of production, it knows that other firms can simply copy the innovation without having to pay the research and development costs. This could leave average costs higher than under a less competitive market.
Firms are small in perfectly competitive markets. As a result, firms cannot exploit economies of scale.
Note a lot of the arguments above focussed on the long run only. What happens if we consider the short run? In the short run, supernormal profits are possible and the firm may not be productively efficient.
The extent of economies of scale in an industry also matters. Some industries would have limited economies of scale or instead, would have significant diseconomies of scale. Such industries may be well suited to having many small firms as in perfect competition.
Practice question in the style of Edexcel Economics A on perfect competition
This is an essay question written in the style of Edexcel Economics A.
First there is a short extract, followed by the question.
Extract: Some financial markets such as foreign exchange or stock markets involve the buying and selling of standardised financial assets. Between 70% and 90% of traders lose money and small traders cannot influence the market price for stocks. However, some institutional traders may have more information or faster technology than solo traders, and herd behaviour can make prices deviate from fundamentals.
Question: Evaluate the view that financial markets are perfectly competitive. (15 marks)
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