Perfect Competition

What It Means

Perfect competition, also known as pure competition, is a theoretical concept describing a type of market structure (a market is any place or system in which buyers and sellers come together) in which no seller or buyer has more power than another. Perfect competition in an industry would exist if no seller or buyer had the power to alter prices by acting alone.

There are several key characteristics of perfect competition. For one, all businesses engaged in perfect competition must produce the same product or service. In addition, perfect competition requires the participation of a large number of companies, so that all the businesses involved will have a relatively small share of the same market; as a result, no single company will have the advantage of selling to a significantly larger number of customers than any of the others. Companies operating in a state of perfect competition must be “price-takers”—that is, they must be able to change their rates of production and sales without being forced to raise or lower prices on their goods. At the same time, perfect competition would give companies the power of free entry and exit; in other words, companies would have the ability to enter the market (in the hope of earning a profit) or leave the market (in the event their business was not profitable) without incurring the high costs traditionally associated with market entry and exit. Perfect competition makes it possible for consumers to have all the information they will need (for example, what products are being sold and how much they cost) to make intelligent purchases. Under these conditions, economists argue, no seller or buyer would have the power to alter prices by acting alone.

Sellers and buyers in any market have competing desires that take the form of the forces of supply and demand, respectively. When prices are high, sellers naturally want to supply more of a good and increase their profits, but those same high prices make buyers, who want to maximize their own economic well-being, naturally less likely to buy that good. These opposing desires should balance one another out to determine what is known as an equilibrium price.

This would strictly be the case, however, only under conditions of perfect competition. When a large number of equally powerful sellers are competing with one another to attract buyers, a seller who attempts to inflate his profits by charging higher than the equilibrium price will lose his customers to rivals able to charge a lower price. Prices under conditions of perfect competition tend toward a level that is as low as possible while still allowing companies to pay their operating costs and remain in business. By forcing companies to minimize their costs, perfect competition thus also encourages businesses to produce the maximum feasible amount of any product in the most efficient way.

In reality, however, perfect competition has probably never existed, or only very rarely. Companies often gain competitive advantages over their rivals and are able to influence prices. In some instances, a company is able to take over a particular marketplace, eliminating competition and assuming control over prices, production, and so on; this form of market dominance is known as a monopoly. An oligopoly is similar to a monopoly, in the respect that the market is dominated by a small group, although an oligopoly always involves the participation of at least two separate companies. Some industries also engage in something called monopolistic competition. While the structure of monopolistic competition is similar to that of perfect competition, businesses engaging in monopolistic competition offer slightly different products than their competitors, thereby creating a greater sense of consumer choice; as a result, businesses have greater freedom to raise prices if they perceive a high consumer demand for their particular products. Nevertheless, the idea of perfect competition underlies many basic economic theories, such as the concepts of supply and demand, and it is often seen as the ideal condition of any market system. It is a theoretical simplification that allows economists to speculate about the nature of markets, and it provides a standard against which the competition in actual, real-life markets may be judged.

When Did It Begin

Early economists such as Adam Smith and David Ricardo put forward the notion that we now call perfect competition, seeing it as the ideal toward which an economic system should aspire. During the late eighteenth and early nineteenth centuries, when these and other so-called classical economists were writing, government intervention, especially in matters of international trade, was overtly restricting the workings of supply and demand. If the government refrained from tampering with the economy, if buyers and sellers were knowledgeable about the markets in which they participated, and if those markets allowed buyers and sellers to interact freely, early economists believed, then no seller or buyer acting alone should be able to affect the price system.

The practical limitations to this early model of perfect competition were plainly evident by the mid-nineteenth century, as large businesses and combinations of businesses, pursuing profits without any government interference, were able to dominate their industries and structure markets for their own benefit. Trade unions (organizations of workers that were able to appeal more effectively for improved working conditions than individual employees could bring about on their own) also arose during this time, further complicating any hopes that perfect competition might naturally occur. In the late nineteenth and early twentieth century governments began acting to restrain businesses that monopolized their industries and took advantage of workers and consumers, partly in an attempt to bring about greater competition in the economy.

Despite the clear evidence that markets in reality were far from perfectly competitive, mainstream economists in the nineteenth and twentieth centuries continued to base most of their theories on ideas of how markets behaved under conditions of perfect competition. The idea maintained its theoretical power partly because it was easier to theorize about markets under conditions of perfect competition than about markets which were imperfect, messy, and unpredictable. But economists continue to study and teach theories about perfectly competitive markets because, despite the fact that these theories rest on a simplified idea of competition, they are able to illuminate many complex economic issues.

More Detailed Information

A perfectly competitive market is one in which no seller or buyer has the ability to affect prices. For this to be the case, the market would have to have several characteristics. In a perfectly competitive market all firms would have to sell an identical product, or products so similar that buyers considered them interchangeable. In reality most companies that compete against one another sell products that are comparable but that have distinct characteristics. For example, in the American sneaker industry, buyers are not choosing between identical products when they buy similarly priced Adidas versus Nike shoes. Some consumers like Adidas shoes, perhaps because they believe them to be of higher quality, perhaps merely because they like the logo or the brand image transmitted by Adidas’ advertising campaigns, while others buy Nikes for these or any number of other reasons. Adidas and Nike can exploit these differences in their products and brands to gain market share and raise prices relative to one another, without consumers automatically rushing to buy the other company’s shoes.

Additionally, a perfectly competitive market would be characterized by a large number of sellers, none of which controls a large share of the market. This would mean that no single company could affect prices by, for instance, cutting or increasing its production. A company that controls a majority or a substantial share of the market can force prices higher by cutting production (since this would result in a situation in which there is more demand for the product than supply) or can force prices lower by increasing production (so that supply outpaces demand). In a perfectly competitive market, by contrast, a company could triple its output or periodically produce nothing at all, without price or the market’s overall volume of transactions being affected.

Conditions of perfect competition would also require that there be complete freedom for companies to enter the industry. If a company in a perfectly competitive market raised prices above the equilibrium level in the hope of inflating its profits, new companies could immediately enter the market and sell the same product at the equilibrium price, forcing the first company either to lower its prices or go out of business. In reality there are often numerous barriers restricting the entry of new companies into markets. For example, a new sneaker company that wanted to compete with Nike or Adidas would have to invest a great deal of money in advertising and marketing in order to build awareness of its brand to rival that of its established competitors. The size and experience of established companies also gives them the ability to buy raw materials and other resources more cheaply than a company that is just launching, making it harder for a start-up company to compete.

Perfect competition also presupposes that every buyer and seller knows the price of every seller’s product, so that no seller can get away with charging more than another seller. It also requires that all companies have the same knowledge of and access to technology and any other techniques for improving production. If only one among a dozen sneaker companies discovered a new form of sewing machine that could stitch leather twice as fast at half the cost of the others’ machines, it would be able to cut its costs dramatically and gain market share by selling its shoes more cheaply than the others.

There has probably never been a perfectly competitive market. The industry that comes the closest to meeting the requirements of perfect competition in the United States is the agricultural industry. There are, for instance, thousands of wheat farmers selling a nearly identical product, and none of them control a large portion of the overall market for wheat. Wheat farmers have no power to set the price for their product; they must sell their crop for whatever price the market offers them.

Recent Trends

As a company grows it can take advantage of what economists call economies of scale: as the ability to cut costs increases, the larger one’s output becomes. For example, imagine a sneaker company, Go!, that sells X pairs of shoes each month. At this level of sales it pays price Y for each pair’s worth of raw leather that it buys from its supplier. Once Go! begins selling 10X sneakers, however, its supplier might give it a better deal on each unit of leather, since the supplier’s own costs decrease if it can sell a large portion of inventory at once, with minimal money spent on delivery, storage, and marketing. If Go! can buy leather for 1/2X, it will develop an enormous advantage over competitors who cannot sell 10X sneakers. Go! will naturally press this advantage until it gains as much market share as possible.

Economists have long understood that the phenomenon of economies of scale tends to result in industries dominated by one or a handful of gigantic companies. Nevertheless, until roughly the 1970s, most economists still based most of their theories on perfectly competitive markets. Beginning at around that time, however, a number of economists began pioneering ways of studying the messier phenomenon of imperfect competition. Instead of trying to arrive at a simple, general theory for how imperfect competition worked (which was impossible given the complex and irregular nature of imperfect competition), economists instead focused on explaining many different ways it has been observed to work. The exploration of how imperfectly competitive markets function is ongoing today, even as the old models of perfectly competitive markets continue to offer many useful theoretical simplifications.