First, let's review what economic factors must be present in an industry with perfect competition.
5 Requirements of Perfect Competition
1. All firms sell an identical product.
2. All firms are price-takers.
3. All firms have a relatively small market share.
4. Buyers know the nature of the product being sold and the prices charged by each firm.
5. The industry is characterized by freedom of entry and exit.
These five requirements rarely exist together in any one industry. As a result, perfect competition is rarely (if ever) observed in the real world. For example, most products have some degree of differentiation. Even with a product as simple as bottled water, for example, producers vary in the method of purification, product size, brand identity, etc. Commodities such as raw agricultural products, although they can still differ in terms of quality, come closest to being identical, or having zero differentiation. When a product does come to have zero differentiation, its industry is usually consolidated into a small number of large firms, or an oligopoly.
Barriers to Entry Prohibit Perfect Competition
Many industries also have significant barriers to entry, such as high startup costs (as seen in the auto manufacturing industry) or strict government regulations (as seen in the utilities industry), which limit the ability of firms to enter and exit such industries. And although consumer awareness has increased with the information age, there are still few industries where the buyer remains aware of all available products and prices.
As you can see, there are significant obstacles preventing perfect competition from appearing in today's economy. The agricultural industry probably comes closest to exhibiting perfect competition because it is characterized by many small producers with virtually no ability to alter the selling price of their products. The commercial buyers of agricultural commodities are generally very well-informed and, although agricultural production involves some barriers to entry, it is not particularly difficult to enter the marketplace as a producer.
Economists' Thoughts on Perfect Competition
No economist believes perfect competition is representative of the real world. Very few believe perfect competition is ever achievable. The real debate among economists is whether perfect competition should be considered a theoretical benchmark for real markets. Neoclassical economists argue that perfect competition can be useful, and most of their analysis stems from its principles. Many other smaller schools of thought disagree.
Many economists are highly critical of the neoclassical reliance on perfect competition. These arguments can be broadly separated into two groups. The first group believes the assumptions built into the model are so unrealistic it cannot produce any meaningful insights. The second group argues that perfect competition is not even a desirable theoretical outcome.
Nobel laureate F.A. Hayek argued that perfect competition had no claim to be called "competition." He pointed out that the model removed all competitive activities and reduced all buyers and sellers to mindless price-takers.
Joseph Schumpeter noted that research, development and innovation are undertaken by firms that experience economic profits, rendering perfect competition less efficient than imperfect competition in the long run.
(For related reading, see: Economic Basics: Competition, Monopoly and Oligopoly.)
Perfect competition is an imaginary construct (i.e. a set of false assumptions) used primarily in mainstream, neo-classical economic discourse to explain competition and monopoly in the economy. Firms under perfect competition are assumed to operate in a market defined by the following characteristics:
- a homogeneous product available in infinitely divisible units
- an infinite number of buyers and sellers
- the absence of any barriers to entry
- and with each firm having access to perfect information.
Under such conditions firms' demand curves would be perfectly elastic meaning that they could bring any supply to the market without affecting price. Furthermore for a profit-maximizing firm operating in a perfectly competitive market price would be equal to marginal cost. Firms who are able to sell products at a price above marginal cost (i.e. firms with downward sloping demand curves) are assumed to operate under conditions of imperfect competition and thus possess market power.
Criticisms of perfect competition
Many economists have been highly critical to the concept of perfect competition, suggesting that the assumptions associated with the model do not correspond at all to the actual characteristics of real markets and when the assumptions are dropped the model does not provide any useful conclusions about market behavior. For example it is pointed out that in reality there is no such thing as a perfectly elastic demand curve as all firms face a downward sloping demand curve and thus possess some "market power". Furthermore, the model of perfect competition has often been used as the benchmark for anti-trust policy, where policy makers maintain that it is the job of government to promote perfect competition. Thus policy makers misuse the model as a normative benchmark in deciding what anti-trust actions should be taken against firms.
Perfect competition vs. actual competition
Main article: Competition
"Pure and perfect competition" is completely unlike anything one normally means by the term "competition." Normally, one thinks of competition as denoting a rivalry among producers, in which each producer strives to match or exceed the performance of other producers. This is not what "pure and perfect competition" means. Indeed, the existence of rivalry, of competition as it is normally understood, is incompatible with "pure and perfect competition." Consider the following passage in a widely used economics textbook by Professor Richard Leftwich:
"By way of contrast, intense rivalry may exist between two automobile agencies or between two filling stations in the same city. One seller's actions influence the market of the other; consequently, pure competition does not exist in this case."
F.A. Hayek argues that the theory of perfect competition has little claim to be called "competition" at all, and that its conclusions are of little use as guides to policy. None of the devices adopted in ordinary life for what is normally understood as competition would still be open to a seller in a market in which so-called "perfect competition" prevails.
Advertising, undercutting, and improving ("differentiating") the goods or services produced are all excluded by definition — "perfect" competition means indeed the absence of all competitive activities.
Especially remarkable in this connection is the explicit and complete exclusion from the theory of perfect competition of all personal relationships existing between the parties. In actual life the fact that our inadequate knowledge of the available commodities or services is made up for by our experience with the persons or firms supplying them — that competition is in a large measure competition for reputation or good will — is one of the most important facts which enables us to solve our daily problems.
No products of two producers are ever exactly alike, even if it were only because, as they leave his plant, they must be at different places. These differences are part of the facts which create our economic problem, and it is little help to answer it on the assumption that they are absent.
That in conditions of real life the position even of any two producers is hardly ever the same is due to facts which the theory of perfect competition eliminates by its concentration on a long-term equilibrium which in an ever-changing world can never be reached. At any given moment the equipment of a particular firm is always largely determined by historical accident, and the problem is that it should make the best use of the given equipment (including the acquired capacities of the members of its staff) and not what it should do if it were given unlimited time to adjust itself to constant conditions.
Competition is the more important the more complex or "imperfect" are the objective conditions in which it has to operate. Indeed, far from competition being beneficial only when it is "perfect," Hayek argue that the need for competition is nowhere greater than in fields in which the nature of the commodities or services makes it impossible that it ever should create a perfect market in the theoretical sense.
The economic problem is a problem of making the best use of what resources we have, and not one of what we should do if the situation were different from what it actually is. There is no sense in talking of a use of resources "as if" a perfect market existed, if this means that the resources would have to be different from what they are, or in discussing what somebody with perfect knowledge would do if our task must be to make the best use of the knowledge the existing people have.
- Austrian Economics, Neoclassical Economics, Marketing, and Finance (pdf) by Walter Block, William Barnett II, and Stuart Woord, 2002
- Perfect Competition and the Transformation of Economics a review by John B. Egger
- Perfect Competition and the Transformation of Economics a review by David Gordon, 1997
- The Austrian Theory of Efficiency and the Role of Government (pdf) by Roy E. Cordato
- Perfect Competition: “Gobble”-degook by Joseph Salerno
- A Note on the Canard of "Asymmetric information" As a source of market failure (pdf) by Thomas DiLorenzo, 2011
- "The Implications of an Imperfect World" by Jonathan M. Finegold Catalan, July 2011
- Perfect competition at Wikipedia
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- ↑ 1.01.11.2Peter Klein"Fundamentals of Economic Analysis: A Causal-Realist Approach", 2007, Lecture 7 Competition and Monopoly.
- ↑ 2.02.1George Reisman. "Platonic Competition", 2005.
- ↑Richard H. Leftwich and Ross D. Eckert, "The Price System and Resource Allocation", 9th ed., The Dryden Press, Chicago, 1985, p. 41. Referenced 2011-11-17.
- ↑Friedrich A. Hayek. "The Meaning of Competition", from Individualism and Economic Order (1948), referenced 2011-11-17.