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Perfect competition is a model of a market structure where allocative and productive efficiency are achieved (long run). A number of assumptions are made:

1. Many small firms (no monopoly power)
2. Many individual buyers (no monopsony power)
3. No barriers to entry or exit
4. Homogenous products (no product differentiation)
5. Perfect knowledge (no asymmetric information)
6. No externalities

Contents 1 Perfect competition graphically 2 Short run 3 Long run 4 Evaluation of perfect competition 5 Comments

Perfect competition graphically

In perfect competition, firms are price takers. If they charged a price other than the market price they would either:

• Lose their customers due to selling at a higher price than competitors
• Go out of business because they are selling below cost

Therefore the firm's demand curve is horizontal and equal to the market price.

Short run

If the market price is set above or below the costs of the firm, the firm may make profits or losses. The firm produces at the output solution point (MR = MC). If the costs are lower than this, the firm makes a profit. Allocative efficiency is achieved because AR=MC. Productive efficiency is not achieved because AC does not equal MC at the output solution point.

The reverse is also true: a firm which has costs higher than the market price will make a loss. Again, allocative efficiency is achieved. Productive efficiency is not.

Long run

If firms in the short run are making profits, there are incentives for new firms to enter the market. This will increase market supply, causing market price to drop and the profit of incumbent firms to be eroded. This can occur because there are no barriers to entry. The price will drop to the point where productive efficiency is achieved.

This is long run equilibrium with no tendency to change.

• Productive efficiency is achieved: AC = MC.
• Allocative efficiency is achieved: MC = AR

Evaluation of perfect competition

Perfect competition is merely a theoretical ideal. However, the model can still be useful even if it's not realistic.

• It provides a measure against which other market structures can be compared
• Economic analysis can be used to investigate the effects of relaxing assumptions (e.g. allowing for product differentiation or asymmetric information)

The model of perfect competition is most applicable in markets such as

• Some agricultural markets
  • Many buyers and sellers
  • Low barriers to entry
  • Mostly homogenous products
  • The firms demand curve is almost horizontal (e.g. a firm's PED for sweetcorn was estimated to be -31353). This means sellers are unable to price at anything other than the market price.
• Currency markets
  • Homogenous product
  • Good knowledge in the market
  • Very low transaction costs

Even these markets do not fit the model perfectly. Think of the impact of big supermarket monopsony power and transaction costs in agricultural markets, and the possible barriers to entry in trading currency.

Comments