Perfect Competition

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In economic theory, perfect competition (sometimes called pure competition)
describes markets such that no participants are large enough to have the market
power to set the price of a homogeneous product. Because the conditions for
perfect competition are strict, there are few if any perfectly competitive
markets. Still, buyers and sellers in some auction-type markets, say for
commodities or some financial assets, may approximate the concept. As a
Pareto efficient allocation of economic resources, perfect competition serves as
a natural benchmark against which to contrast other market structures.

Basic structural characteristics

Generally, a perfectly competitive market exists when every participant is a

"price taker", and no participant influences the price of the product it buys or
sells. Specific characteristics may include:

A large number buyers and sellers

A large number of consumers with the willingness and ability to buy the product
at a certain price, and a large number of producers with the willingness and
ability to supply the product at a certain price.

No barriers of entry and exit

No entry and exit barriers makes it extremely easy to enter or exit a perfectly
competitive market.

Perfect factor mobility

In the long run factors of production are perfectly mobile, allowing free long
term adjustments to changing market conditions.

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Perfect information

All consumers and producers are assumed to have perfect knowledge of price,
utility, quality and production methods of products.

Zero transaction costs

Buyers and sellers do not incur costs in making an exchange of goods in a

perfectly competitive market.

Profit maximization

Firms are assumed to sell where marginal costs meet marginal revenue, where
the most profit is generated.

Homogeneous products

The products are perfect substitutes for each other;i.e.-the qualities and
characteristics of a market good or service do not vary between different
suppliers.

Non-increasing returns to scale

The lack of increasing returns to scale (or economies of scale) ensures that there
will always be a sufficient number of firms in the industry.

Property rights

Well defined property rights determine what may be sold, as well as what rights
are conferred on the buyer.

Rational buyers

Buyers are capable of making rational purchases based on information given.

No externalities

Costs or benefits of an activity do not affect third parties.

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In the short run, perfectly competitive markets are not productively efficient as
output will not occur where marginal cost is equal to average cost (MC = AC).
They are allocatively efficient, as output will always occur where marginal cost
is equal to marginal revenue (MC = MR). In the long run, perfectly competitive
markets are both allocatively and productively efficient.

In perfect competition, any profit-maximizing producer faces a market price

equal to its marginal cost (P = MC). This implies that a factor's price equals the
factor's marginal revenue product. It allows for derivation of the supply curve
on which the neoclassical approach is based. This is also the reason why "a
monopoly does not have a supply curve". The abandonment of price taking
creates considerable difficulties for the demonstration of a general equilibrium
except under other, very specific conditions such as that of monopolistic
competition.

Approaches and conditions

In neoclassical economics there have been two strands of looking at what

perfect competition is. The first emphasis is on the inability of any one agent to
affect prices. Usually justified by the fact that any one firm or consumer is so
small relative to the whole market that their presence or absence leaves the
equilibrium price very nearly unaffected. This assumption of negligible impact
of each agent on the equilibrium price has been formalized by Aumann (1964)
by postulating a continuum of infinitesimal agents. The difference between
Aumann's approach and that found in undergraduate textbooks is that in the
first, agents have the power to choose their own prices but do not individually

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affect the market price, while in the second it is simply assumed that agents treat
prices as parameters. Both approaches lead to the same result.

The second view of perfect competition conceives of it in terms of agents taking

advantage of and hence, eliminating profitable exchange opportunities. The
faster this arbitrage takes place, the more competitive a market. The implication
is that the more competitive a market is under this definition, the faster the
average market price will adjust so as to equate supply and demand (and also
equate price to marginal costs). In this view, "perfect" competition means that
this adjustment takes place instantaneously. This is usually modeled via the use
of the Walrasian auctioneer (see article for more information). The widespread
recourse to the auctioneer tale appears to have favored an interpretation of
perfect competition as meaning price taking always, i.e. also at non-equilibrium
prices; but this is rejected e.g. by Arrow (1959) or Mas-Colell et al.

Steve Keen notes, following George Stigler, that if firms do not react
strategically to one another, the slope of the demand curve that a firm faces is
the same as the slope of the market demand curve. Hence, if firms are to
produce at a level that equates marginal cost and marginal revenue, the model of
perfect competition must include at least an infinite number of firms, each
producing an output quantity of zero. As noted above, an influential model of
perfect competition in neoclassical economics assumes that the number of
buyers and sellers are both of the power of the continuum, that is, an infinity
even larger than the number of natural numbers. K. Vela Velupillai quotes
Maury Osborne as noting the inapplicability of such models to actual economies
since money and the commodities sold each have a smallest positive unit.

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Thus nowadays the dominant intuitive idea of the conditions justifying price
taking and thus rendering a market perfectly competitive is an amalgam of
several different notions, not all present, nor given equal weight, in all
treatments. Besides product homogeneity and absence of collusion, the notion
more generally associated with perfect competition is the negligibility of the
size of agents, which makes them believe that they can sell as much of the good
as they wish at the equilibrium price but nothing at a higher price (in particular,
firms are described as each one of them facing a horizontal demand curve).
However, also widely accepted as part of the notion of perfectly competitive
market are perfect information about price distribution and very quick
adjustments (whose joint operation establish the law of one price), to the point
sometimes of identifying perfect competition with an essentially instantaneous
reaching of equilibrium between supply and demand. Finally, the idea of free
entry with free access to technology is also often listed as a characteristic of
perfectly competitive markets, probably owing to a difficulty with abandoning
completely the older conception of free competition. In recent decades it has
been rediscovered that free entry can be a foundation of absence of market
power, alternative to negligibility of agents.

Free entry also makes it easier to justify the absence of collusion: any collusion
by existing firms can be undermined by entry of new firms. The necessarily
long-period nature of the analysis (entry requires time!) also allows a
reconciliation of the horizontal demand curve facing each firm according to the
theory, with the feeling of businessmen that "contrary to economic theory, sales
are by no means unlimited at the current market price". Sraffian economists see
the assumption of free entry and exit as characteristic of the theory of free
competition in Classical economics, an approach that is not expressed in terms
of schedules of supply and demand.

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