EFA (21): Perfect competition

One of the first things that students of economics learn about is perfect competition. This is the subject of the 21st item in our Economics for Amateurs (EFA) series. You can find the series here each Monday.

The word "perfect" makes it sound as though the competition is either very good or very tough — as, for example, between two rivals in a particular market (such as Microsoft and Google).

But this is not what economists mean by the term "perfect competition". Instead, they define a perfectly competitive market as one in which none of the firms (or consumers) believe that their decisions will have an impact on the market price. In other words, they are "pricetakers".

This is not the case in markets in which one firm is the only seller (a "monopolist") or in which there are a few dominant firms ("oligopolists"). In such cases, the firms clearly have an influence on price.

This is also not the case in markets where there is only one buyer (a "monopsonist") or a small number of buyers who can influence market prices through their purchasing decisions.

In a perfectly competitive market, there are a large number of sellers (and buyers). And because each of them is small in relation to the size of the market, they have to take the market price as given when making their production and purchaseing decisions.

A typical example is a food market, in which there are typically numerous sellers of (more or less) identical fruit and vegetables. If one seller tries to charge more than all the others, he will lose all his business.

This illustrates another condition for perfect competition: the various seller must be offering a nearly uniform product, which is not the case for many real-life competing products.

Other conditions are that consumers have perfect knowledge about the products being sold, and that there is free entry of firms into the market. Concerning this latter point, even if the existing firms decided to collude to increase prices, other sellers could enter the market and push prices down again.

In reality, of course, very few markets are perfectly competitive. But the theoretical model is still a useful one. For more about the implications of perfectly competitive markets for firms' production deciisons, see here.