SummaryEven though perfect competition is hard to come by, it’s a good starting point to understand market structures. A deep understanding of how competitive markets work and are formed is the cornerstone to understand why it’s so hard to reach them. In this first Learning Path on perfect competition, we start by analysing firms’ cost structure, before analysing their interaction in the market.
- Perfect competition
Industry and market:
Perfect competition or competitive markets -also referred to as pure, or free competition-, expresses the idea of the combination of a wide range of firms, which freely enter or leave the market and which considers prices as information, since each bidder only provides a relative small share of the good to the market and thus do not exert a noticeable influence on it. Therefore, perfect competitors cannot influence the levels of market clearing prices. Also, buyers are numerous and disperse, which also means that they cannot influence prices.
This market model is based on a set of assumptions, each of them representing a necessary but insufficient condition to ensure perfect competition. These assumptions are:
-Homogeneous product: all firms offer the same goods, with the same characteristics and quality as the others, without any variations.
-Large number of agents: there should be a sufficient quantity of buyers and sellers, so that no action from a single agent will affect the market structure or its prices.
-No entry or exit barriers: there has to be free entry and exit of agents in the market. This assumption is of special interest for firms, which must be able to enter or leave the market freely.
-Price flexibility: price adjustments to changes happen as fast as possible. Usually, price changes are assumed instantaneous.
-Free and perfect information: all agents have perfect knowledge of products and their prices, and everything else related to them, as well as free access to this information.
-Perfect factor mobility: all factors should be able to change so adjustments processes can be carried out with the greatest efficiency.
-No government intervention: markets should be left alone as government intervention would only lead to imbalances in perfectly competitive markets.
Perfect competition markets are almost impossible to find in the real word as all markets have some type of imperfection. This is the reason they are mostly considered only theoretically. However, its study helps understand real world markets and their phenomena.
It must be noted that the theory of contestable markets, developed by William J. Baumol in his “Contestable Markets: An Uprising in the Theory of Industry Structure”, 1982, that perfect competition prices and output can be reached with just a few of these assumptions. Furthermore, Bertrand’s duopoly model determines that oligopolistic markets can reach the same prices as in perfect competition as long as oligopolists compete by changing their prices, instead of the quantity offered.