Monday, July 18, 2016

Perfect Competition

A perfectly competitive market is a hypothetical market where competition is at it's greatest possible level. Economists argue that perfect competition would produce the best possible outcomes for consumers and society.

Key Characteristics of a Perfectly Competitive Market

Perfect Knowledge About the Product

There is perfect knowledge, with no information failure or time lags in the flow of information. Knowledge about all products is freely available to all market participants, which means the risk taking is minimal and the role of any single firm is limited.
Given that the producers and consumers have perfect knowledge, it is assumed that they make rational decisions to maximise their self interest. Consumers look to maximise their utility, and producers look to maximise their profits.

No Barriers to Entry & Exit

There are no barriers to entry or exit into the market.

Homogeneous Products

Firms produce homogeneous or identical units of output that are not branded. Each unit of input, used by the firm to produce the product such as units of labour or raw materials are also homogeneous.

Firms Cannot Influence Market Price to Increase Their Profits

No single firm can influence the market price, or market conditions, given that there are a lot of sellers or producers and homogeneous products in the market, which a result of having no barriers of entry and exit.

Absence of Regulators

There is no need for government regulations, except to make the market more competitive.

No Involvement Of Third Party

There are no externalities, that is no external costs or benefits goes any third party not involved in the transaction.

No Branding or Advertising

There is no need to spend money on advertising, because there is perfect knowledge about the products. Selling unbranded goods makes it hard to construct an effective advertising campaign. So no single firm can influence or bend the market sentiments towards itself by promotional methods. All firms face a perfect competition in this way.

Industry as the Price Maker

A single firm takes its price from the industry which is a Price Maker, and consequently referred to as a Price Taker. The industry is composed of many firms and the Market Price is where the Market Demand is equal to the Market Supply. Each single firm must only charge this price and cannot diverge from it.

Normal Profits in Long Run

Firms can only make normal profits in the long run, that is they can only cover their opportunity cost.  Although sometimes they can make abnormal (super normal) profits or losses in the short run. If the incumbent firms are making super normal profits, new firms will be attracted to the industry and the market as there are no barriers to entry. The effect of this entry into the industry is that the supply of the product will increase which drives down the price until the point where all super normal profits are exhausted.
The super normal profit made by some firms in the short run acts as an incentive for new firms to enter the market, which increases the industry supply and market price falls for all firms until only normal profit is made. If the firms are making losses, they will leave the market, as there are no exit barriers, and this will decrease the industry supply, which raises prices and enables those left in the market to derive normal profits.