Perfect competition

'Perfect' competition is a theoretical 'best case' type of market structure which, although not found in reality, provides a useful staring point in the analysis of market structures.

Characteristics

Firms operating under conditions of perfect competition face the following characteristics:

  1. Knowledge is ‘complete’ - producers and consumers have access to complete market knowledge
  2. There are no barriers to entry or exit
  3. There are infinite numbers of competitive firms
  4. Products are identical ('homogeneous')
  5. Firms are price takers, taking their price from the industry
  6. Super-normal profits are available in the short run, but not long run
  7. Firms are allocatively efficient in both the short and long run, but only productively efficient in the long run, and:
  8. Welfare is maximised
Perfect competition

In the diagram we can see that, in the short run, the single firm can gain super-normal profits (at P,K,L,P1).

However, this acts as an incentive for new firms to enter the market in anticipation of also making super-normal profits.

Given that there are no barriers to entry, and with perfect knowledge, firms can enter. As they enter, the industry supply curve shifts to the right, pushing down the industry price.

The effect of this is to reduce the super-normal profits available for each firm. Entry comes to an end when only normal profits are available to the 'marginal' firm.

Video on perfect competition

Firms operating under conditions of ‘perfect competition’ take their price from the whole market [or industry]. In the short run, super-normal profits are possible, at price P. However, super-normal profits (at P,K,L,P1) encourage new entrants, shifting industry supply [S to S1], and pushing down price, to P1.

Eventually, super-normal profits are eroded, and new firms stop entering.


Check your knowledge

Perfect competition

Try a quiz on perfect competition.

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Monopolistic competition

What is monopolistic competition?

Monopolistic competition
Oligopoly

What are the disadvantages of oligopoly?

Oligopoly
Game theory

How does game theory explain oligopoly?

Game theory


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