how perfect competition works
perfect competition is a benchmark or ideal type to which real life market structures can be compared perfect competition is theoretically the opposite of a monopoly in which only a single firm supplies a good or service and that firm can charge whatever price it wants since consumers have no alternatives and it is difficult for would be competitors to enter the marketplace in a perfect competition model there are no monopolies this kind of structure has a number of key characteristics including this can be contrasted with the more realistic imperfect competition which exists whenever a market hypothetical or real violates the abstract tenets of neoclassical pure or perfect competition since all real markets exist outside of the plane of the perfect competition model each can be classified as imperfect the contemporary theory of imperfect versus perfect competition stems from the cambridge tradition of post classical economic thought characteristics of perfect competitiona perfectly competitive market is defined by the following factors there are a large number of buyers and sellers in a perfectly competitive market the sellers are small firms instead of large corporations capable of controlling prices through supply adjustments they sell products with minimal differences in capabilities features and pricing this ensures that buyers cannot distinguish between products based on physical attributes such as size or color or intangible values such as branding a large population of both buyers and sellers ensures that supply and demand remain constant in this market as such buyers can easily substitute products made by one firm for another information about an industry s ecosystem and competition constitutes a significant advantage for example knowledge about component sourcing and supplier pricing can make or break the market for certain companies in certain knowledge and research intensive industries such as pharmaceuticals and technology information about patents and research initiatives at competitors can help companies develop competitive strategies and build a moat around their products the availability of free and perfect information in a perfectly competitive market ensures that each firm can produce its goods or services at exactly the same rate and with the same production techniques as another one in the market governments play a vital role in market formation for products by imposing regulations and price controls they can control the entry and exit of firms into a market by setting up rules to function in the market for example the pharmaceutical industry has to contend with a roster of rules pertaining to the development production and sale of drugs 1in turn these rules require big capital investments in the form of employees such as lawyers and quality assurance personnel and infrastructure such as machinery to manufacture medicines the cumulative costs add up and make it extremely expensive for companies to bring a drug to the market in comparison the technology industry functions with relatively less oversight as compared to its pharma counterpart thus entrepreneurs in this industry can start firms with less to zero capital making it easy for individuals to start a company in the industry such controls do not exist in a perfectly competitive market the entry and exit of firms in such a market are unregulated and this frees them up to spend on labor and capital assets without restrictions and adjust their output in relation to market demands cheap and efficient transportation is another characteristic of perfect competition in this type of market companies do not incur significant costs to transport goods this helps reduce the product s price and cuts back on delays in transporting goods theory vs reality of perfect competitionreal world competition differs from this ideal primarily because of differentiation in production marketing and selling for example the owner of a small organic products shop can advertise extensively about the grain fed to the cows that made the manure that fertilized the non gmo soybeans thereby setting their product apart from competitors this is what s called differentiation the first two criteria homogeneous products and price takers are far from realistic yet for the second two criteria information and mobility the global tech and trade transformation is improving information and resource flexibility while the reality is far from this theoretical model the model is still helpful because of its ability to explain many real life behaviors companies seek to establish brand value through marketing around their differentiation as such they advertise to gain pricing power and market share barriers to entry prohibit perfect competitionmany 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 utility 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 significant obstacles exist that prevent perfect competition from developing in the 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 advantages and disadvantages of perfect competitionperfect competition is an idealized framework for a market economy while it provides a convenient model for how an economy works it is not always accurate and has significant departures from the real world economy like with other models the value of a perfect competition framework is only accurate to the extent that it reflects actual conditions one notable feature of perfect competition is low profit margins since all consumers have access to the same products they naturally gravitate towards the lowest prices firms cannot set themselves apart by charging a premium for higher quality products and services for instance it would be impossible for a company like apple aapl to exist in a perfectly competitive market because its phones are more expensive than those of its competitors another is the absence of innovation the prospect of greater market share and setting themselves apart from the competition is an incentive for firms to innovate and make better products but no firm possesses a dominant market share in perfect competition meaning that the long term profitability of their operations is zero another disadvantage is the absence of economies of scale limited to zero profit margins means that companies will have less cash to invest in expanding their production capabilities an expansion of production capabilities could potentially bring down costs for consumers and increase business profit margins but the presence of several small firms cannibalizing the market for the same product prevents this and ensures that the average firm size remains small provides a convenient framework for modeling market activity demonstrates how producers are incentivized to provide lower prices the perfect competition model does not always reflect real world market conditions the model does not account for geographical differences or variations between products the model does not account for how producers benefit from economies of scale 