In neoclassical economics and microeconomics, perfect competition describes a market in which there are many small firms, all producing homogeneous goods. In the short term, such markets are productively inefficient as output will not occur where marginal cost is equal to average cost, but allocatively efficient, as output under perfect competition will always occur where marginal cost is equal to marginal revenue, and therefore where marginal cost equals average revenue. However, in the long term, such markets are both allocatively and productively efficient.[1] In general a perfectly competitive market is characterized by the fact that no single firm has influence over the price of the product it sells. Because the conditions for perfect competition are very strict, there are few perfectly competitive markets.
A perfectly competitive market may have several distinguishing characteristics, including:
- Infinite Buyers/Infinite Sellers – Infinite consumers with the willingness and ability to buy the product at a certain price, Infinite producers with the willingness and ability to supply the product at a certain price.
- Zero Entry/Exit Barriers – It is relatively easy to enter or exit as a business in a perfectly competitive market.
- Perfect Information - Prices and quality of products are assumed to be known to all consumers and producers.[2] [3]
- Transactions are Costless - Buyers and sellers incur no costs in making an exchange. [4]
- Firms Aim to Maximize Profits - Firms aim to sell where marginal costs meet marginal revenue, where they generate the most profit.
- Homogeneous Products – The characteristics of any given market good or service do not vary across suppliers.
Some subset of these conditions is presented in most textbooks as defining perfect competition. More advanced textbooks[5] try to reconcile these conditions with the definition of perfect competition as equilibrium price taking; that is whether or not firms treat price as a parameter or a choice variable. It is this distinction which differentiates perfectly competitive markets from imperfectly competitive ones. It should be noted that a general rigorous proof that the above conditions indeed suffice to guarantee price taking is still lacking (Kreps 1990, p. 265).
The importance of perfect competition derives from the fact that price taking by the firm guarantees that when firms maximize profits (by choosing quantity they wish to produce, and the combination of Factors of production to produce it with) the market price will be equal to marginal cost. An implication of this is that a factor's price (wage, rent, etc.) equals the factor's marginal revenue product. This allows for derivation of the supply curve on which the neoclassical approach is based (note that this is also the reason why "a monopoly does not have a supply curve"). The abandonment of price taking creates considerable difficulties to the demonstration of existence of a general equilibrium [6] except under other, very specific conditions such as that of monopolistic competition .
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