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Encyclopedia > Perfect competition

Perfect competition is an economic model that describes a hypothetical market form in which no producer or consumer has the market power to influence prices. According to the standard economical definition of efficiency (Pareto efficiency), perfect competition would lead to a completely efficient outcome. The analysis of perfectly competitive markets provides the foundation of the theory of supply and demand. In microeconomics, the main criteria by which one can distinguish between different market forms are: the number and size of producers and consumers in the market, the type of goods and services being traded, and the degree to which information can flow freely. ... In economics, market power is the ability of a firm to alter the market price of a good or service. ... In economics and business, the price is the assigned numerical monetary value of a good, service or asset. ... Pareto efficiency, or Pareto optimality, is an important notion in neoclassical economics with broad applications in game theory, engineering and the social sciences. ... The supply and demand model describes how prices vary as a result of a balance between product availability at each price (supply) and the desires of those with purchasing power at each price (demand). ...

Contents

Requirements

Perfect competition requires that the following six conditions be fulfilled. In such a market, prices would normally move instantaneously to economic equilibrium.

Atomicity
An atomistic market is one in which there are a large number of small producers and consumers on a given market, each so small that its actions have no significant impact on others. Firms are price takers, meaning that the market sets the price that they must choose.
Homogeneity
Goods and services are perfect substitutes; that is, there is no product differentiation. (All firms sell an identical product)
Perfect and complete information
All firms and consumers know the prices set by all firms (see perfect information and complete information).
Equal access
All firms have access to production technologies, and resources are perfectly mobile.
Free entry
Any firm may enter or exit the market as it wishes (see barriers to entry).
Individual buyers and sellers act independently
The market is such that there is no scope for groups of buyers and/or sellers to come together with a view to changing the market price (collusion and cartels are not possible under this market structure)

Behavioral assumptions of perfect competition are that: There are very few or no other articles that link to this one. ... In economics, market power (sometimes called monopoly power) is a market failure which occurs when one or more of the participants has the ability to influence the price or other outcomes in some general or specialized market. ... Perfect information is a term used in economics and game theory to describe a state of complete knowledge about the actions of other players that is instantaneously updated as new information arises. ... Complete information is a term used in economics and game theory to describe an economic situation or game in which knowledge about other market participants or players is available to all participants. ... In economics and especially in the theory of competition, barriers to entry are obstacles in the path of a firm which wants to enter a given market. ...

  1. Consumers aim to maximize utility
  2. Producers aim to maximize profits.

To be exhaustive, note that some economists[1] do not agree with this presentation of the model of perfect competition. Many reasons are advanced, but one of the main is that it focuses on unnecessary conditions (atomicity, perfect information...) while it does not allow an answer to the question : "If agents are price-takers, who sets the prices ?" Indeed, in this model, as firms and consumers can not set the prices, it can't be—as it is often said (e.g. below)—that it is the firms who fix them. So, actually, there is a need for a benevolent agent who proposes prices to firms and consumers and fixes the ones at which exchange will occur. They also think that the argument that a global entity called "the market" could fix the prices, when its constituents (producers and consumers) can not is greatly disturbing[2]. Above other criticism, there is also the lack of emphasis on the fact that no uncertainty about future prices or incomes, no transport cost, and no indivisibility can be integrated in this model.


Results

In the short-run, it is possible for an individual firm to make abnormal profit. This situation is shown in this diagram, as the price or average revenue, denoted by P is above the average cost denoted by C .
In the short-run, it is possible for an individual firm to make abnormal profit. This situation is shown in this diagram, as the price or average revenue, denoted by P is above the average cost denoted by C .
However, in the long run, abnormal profit cannot be sustained. The arrival of new firms in the market causes the (horizontal) demand curve of each individual firm to shift downward, bringing down at the same time the price, the average revenue and marginal revenue curve. The final outcome is that, in the long run, the firm will make only normal profit (zero economic profit). Its horizontal demand curve will touch its average total cost curve at its lowest point. (See cost curve.)
However, in the long run, abnormal profit cannot be sustained. The arrival of new firms in the market causes the (horizontal) demand curve of each individual firm to shift downward, bringing down at the same time the price, the average revenue and marginal revenue curve. The final outcome is that, in the long run, the firm will make only normal profit (zero economic profit). Its horizontal demand curve will touch its average total cost curve at its lowest point. (See cost curve.)

The model is a description of one type of market structure, most closely approximating only a few markets, such as agriculture. In real-world markets, any of its assumptions may be violated. For example, firms will never have perfect information about each other. Its usefulness as a scientific construct may be judged by the range of market behavior explained by it and as a standard for comparison with other market structures. Image File history File links No higher resolution available. ... Image File history File links No higher resolution available. ... Image File history File links Perfect competition. ... Image File history File links Perfect competition. ... A cost curve is a graph of the costs of production as a function of total quantity produced. ... An explanation is a statement which points to causes, context, and consequences of some object, process, state of affairs, etc. ...


In a perfectly competitive market, there will be allocative efficiency and productive efficiency. Allocative efficiency is the market condition whereby resources are allocated in a way that maximizes the net benefit attained through their use. ... Productive efficiency is when the economy is working on its production possibility frontier (PPF). ...

  • Allocative efficiency occurs when price (P) is equal to marginal cost (MC), at which point the good is available to the consumer at the lowest possible price.
  • Productive efficiency occurs when the firm produces at the lowest point on the average cost curve (AC), implying it cannot produce the goods any more cheaply. This would be achieved in perfect competition, since if a firm was not doing it another firm would be able to undercut it by selling products at a lower price.

In contrast to a monopoly or oligopoly, it is impossible for a firm in perfect competition to earn abnormal profit in the long run, which is to say that a firm cannot make any more money than is necessary to cover its economic costs. If a firm is earning abnormal profit in the short term, this will act as a trigger for other firms to enter the market. They will compete with the first firm, driving the market price down until all firms are earning normal profit, it could be said that abnormal profit is 'competed away'. On the other hand, if firms are making a loss, then some firms will leave the industry, reduce the supply and increase the price. Therefore, all firms can only make normal profit in the long run. In economics and finance, marginal cost is the change in total cost that arises when the quantity produced changes by one unit. ... This article is about the economic term. ... This article does not cite any references or sources. ... Supernormal Profit, also referred to as abnormal profit or pure profit, is an economic term of profit exceeding the normal profit. ... In accounting terms, accounting profit is the total revenue minus costs properly chargeable against the goods sold (Ref. ...


It is important to note that perfect competition is a sufficient condition for allocative and productive efficiency, but it is not a necessary condition. Laboratory experiments in which participants have significant price setting power and little or no information about their counterparts consistently produce efficient results given the proper trading institutions (Smith, 1987, p. 245).


The shutdown point

The shutdown point is a point where firms stop producing temporarily.



When a firm is making a loss, it will have to decide whether to continue production or not. This decision will, in fact, depend on the different total costs levels and whether the firm is operating in the short run or in the long run.


If the firm is in the short run, and is making a loss whereby:

  • Total costs (TC) is greater than total revenue (TR)
  • and whereby total revenue is equal to total variable cost (TVC)

it is advisable for the firm to continue production. If it fails to achieve these conditions, it is advised to close down so that the only costs the firm will have to pay will be the fixed costs. Fixed costs are un-expired assets or expenses whose total does not change in proportion to the activity of a business, within the relevant time period or scale of production. ...


Even if the firm stop producing, it will have to continue to meet the level of fixed costs. Since whether the firm produces or not, it will have to pay fixed costs, it is better for it to continue production in an attempt to decrease total costs and increase total revenue, thus making profits. This can be done by:

  • Increasing productivity. The most obvious methods involve automation and computerization which minimize the tasks that must be performed by employees. All else constant, it benefits a business to improve productivity, which over time lowers cost and (hopefully) improves ability to compete and make profit.
  • Adopting new methods of production like Just In Time or lean manufacturing in an attempt to reduce costs and wastages.

In the long run, the condition to continue producing requires the price P to be higher than the ATC, i.e. the line representing market price should be above the minimum point of the ATC curve. Just In Time (JIT) is an inventory strategy implemented to improve the return on investment of a business by reducing in-process inventory and its associated costs. ... Lean manufacturing is the production of goods using less of everything compared to mass production: less human effort, less manufacturing space, less investment in tools, and less engineering time to develop a new product. ...


If P is equal to ATC, the firm is indifferent between shutting down and continuing to produce. This case is different from the short run shut down case because in long run there's no longer a fixed cost (everything is variable).


Examples

Some agricultural markets, with numerous suppliers and almost perfectly substitutable products have been suggested as approximations for the perfect-competition model. The extent of its applicability may be dependent on the market in question. Agricultural policies in many countries undermine the requirements for complete Pareto efficiency to apply.


Perhaps the closest thing to a perfectly competitive market would be a large auction of identical goods with all potential buyers and sellers present. By design, a stock exchange resembles this, not as a complete description (for no markets may satisfy all requirements of the model) but as an approximation. The flaw in considering the stock exchange as an example of Perfect Competition is the fact that large institutional investors (e.g. investment banks) may solely influence the market price. This, of course, violates the condition that "no one seller can influence market price".


eBay auctions can be often be seen as perfectly competitive. There are very low barriers to entry (anyone can sell a product, provided they have some knowledge of computers and the Internet), many sellers of common products and many potential buyers. In economics and especially in the theory of competition, barriers to entry are obstacles in the path of a firm which wants to enter a given market. ... The tower of a personal computer. ...


In the eBay market competitive advertising does not occur, because the products are homogeneous and this would be redundant. However, generic advertising (advertising which benefits the industry as a whole and does not mention any brand names) may occur.


References

  1. ^ One of the most famous is Bernard Guerrien, economics and mathematics teacher in Paris Panthéon-Sorbonne, also people regrouped in the movement post-autistic economics
  2. ^ "The Arrow-Debreu model has nothing to do with competition and markets: it is a model of a “highly centralized” economy, with a benevolent auctioneer doing a lot of things, and with stupid price-taker agents", Guerrien, see [1]

  Results from FactBites:
 
Platonic Competition - Mises Institute (5050 words)
The doctrine of "pure and perfect competition" is a central element both in contemporary economic theory and in the practice of the Anti-Trust Division of the Department of Justice.
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Price competition is not the self-sacrificial chiseling of prices to "marginal cost" or their day by day, minute by minute adjustment to the requirements of "rationing scarce capacity." It is the setting of prices perhaps only once a year — by the most efficient, lowest-cost producers, motivated by their own self-interest.
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Perfect competition is an idealized version of market structure that provides a foundation for understanding how markets work in a capitalist economy.
To understand the nature of competition under the perfectly competitive market form, one should briefly examine the three conditions that are necessary before a market structure is considered "perfectly competitive." These are: homogeneity of the product sold in the industry, existence of many buyers and sellers, and perfect mobility of resources or factors of production.
Perfect competition is considered desirable for society for at least two reasons.
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