Perfect
Competition is a type of market structure where many firms sell similar
products and profits are virtually non-existent due to fierce competition. With
that said, it is important to realize that perfect competition is an abstract
term used to compare against real life markets.
Perfect competition has 5 key characteristics:
· Many Competing Firms
· Similar Products Sold
· Equal Market Share
· Buyers have full information
· Ease of Entry and Exit
When these
characteristics are seen in the market, we can consider it perfectly
competitive. Let us look at them in more detail below.
1.
Many Competing Firms
A perfectly competitive
market has many buyers and sellers. This means that firms are known as ‘price
takers’. In other words, the firm must sell at the ‘equilibrium’ price – this
is where the firm sells when supply and demand align. If not, they will go out
of business, as there are many other firms that sell the same good at a lower
price. As a result, customers have little cost of switching to a substitute
good.
The number of
competitors in the market means that each company is prevented from raising
prices. If they do, then they will be forced out of the market as consumers are
able to switch to cheaper alternatives.
2.
Similar Products Sold
In perfect competition,
competitors sell similar products. This is otherwise known as ‘homogenous’ – in
economic jargon. In simple terms, it means the products are similar.
Individual businesses
may be indistinguishable to the average customer. As a result, the ability and
willingness to switch is easy and costless.
Dairy is a notable
example. For instance, many farmers sell milk to supermarkets, but the product
is very similar. In fact, supermarkets change contracts with dairy producers
without customers even noticing.
3.
Equal Market Share
Competitors all have a
similar market share because firms are unable to compete on price. As firms
produce where Marginal Revenue = Marginal Cost, there is no room to reduce
prices.
If a firm was to reduce
prices, it would start making a loss – because it costs more to make than sell,
meaning it would go out of business. At the same time, if any firm increases
prices, there is enough competition to attract customers from that store and
put them out of business. In turn, this puts a restriction on a firm’s ability
to gain market share.
4.
Buyers have full information
In economic jargon, we
call this ‘Perfect Information’. This is where the customer knows that the
business down the road sells the same product at a lower price. As a result,
businesses are reluctant to raise prices ahead of a competitor.
Furthermore, customers
are also aware of the quality of a product. For instance, one firm may reduce
costs to provide a lower quality product and make more profit. Since customers
have perfect information, they will know the product is inferior. In turn, they
will switch to competitors – putting the original firm out of business.
5.
Ease of Entry and Exit
Firms can enter and
exit the market with little cost. This can come in the form of financial, time,
or information. For instance, the oil and gas industry requires a high level of
up-front investment. As such, this is a barrier to entry for competitors. Under
perfect competition, these costs do not exist or are in fact insignificant.
Additionally, firms are
able to exit the market with ease under perfect competition. For example, a
firm may have a long-term contract. But they are unable to leave the market
without significant costs.