Economics Online Tutor

Perfect Competition
Perfect competition is a market structure in which many firms sell
identical products, and no barriers to entry into the market exist for new
potential sellers.

The characteristics of perfect competition are:
Many sellers: each seller represents a very small portion of the overall market. Since supply and
demand in the overall market set the equilibrium price and quantity, one small firm cannot influence the
market price. Each firm must accept whatever market price exists. Because of this, firms in perfect
competition are called price takers.

Identical products: you may see this referred to as standardized products, or homogeneous products.
Consumers have no preference for a product from one firm over the product of any other firm. The
products of each firm are perfect substitutes for one another. There is no difference in quality.
Consumers would always choose to purchase the product from the lowest priced source. Firms cannot
differentiate products in any way, including packaging or advertising.

Easy entry and exit: new firms can enter the market freely. This implies that economies of scale do not
exist. Existing firms can just as easily stop production and exit the market.

Buyers know where the product is being sold, and at what price. Sellers know the strategies used by
their competitors, including price and quantity decisions.
Perfect competition and efficiency

Perfect competition is considered to be the most efficient market structure
within any given equilibrium situation. Other market structures have some
long term advantages over perfect competition, such as: economies of
scale, consumer choices, and incentives for advances in technology.

But within any given equilibrium, perfect competition is the most efficient
market structure.
Types of efficiency:

Productive efficiency:
using the least cost
combination of
resources to produce a
specific output level.

Allocative efficiency:
producing what the
consumers want at a
price equal to marginal

Economic efficiency: a
situation in which both
productive efficiency
and allocative efficiency
The reasons for this efficiency can be seen by understanding how
economists define efficiency.

Efficiency means having the maximum benefit at the least cost.

In a market (as opposed to an individual firm) supply and demand diagram,
the intersection of the supply and demand curves will set the equilibrium
price and quantity.

In perfect competition, with each firm being a price taker, firms cannot stray
from this equilibrium price. The individual firm will produce a quantity so that
the sum of all firms will produce the quantity that equals market equilibrium.
The least cost component of efficiency will be a product of this market
equilibrium. This will be shown in the discussion of
individual firm behavior
in perfect competition.
The maximum benefit component of efficiency can be seen from the market supply & demand
diagram. Benefit in this context refers to the concept of surplus:

Consumer surplus refers to the difference between what consumers are willing to pay and the
amount that they actually pay. The amount that they are willing to pay is based on the demand curve.
The amount that they actually pay is based on the market equilibrium price. On a supply & demand
diagram, consumer surplus is measured by the area that lies both below the demand curve and
above the market price.

Producer surplus refers to the difference between the price the sellers are willing to sell the
product for and the price that the sellers actually receive. The amount that they are willing to sell for
is based on the supply curve. The amount that they actually receive is based on the market
equilibrium price. On a supply & demand diagram, producer surplus is measured by the area both
above the supply curve and below the market price.

Total surplus is the sum of consumer surplus and producer surplus. Efficiency is achieved by
maximizing total surplus.

On the market supply & demand diagram, the only area that can potentially be a part of total surplus
is the area defined by the triangle formed by these three points: market equilibrium, the point where
the demand curve intersects the price axis, and the point where the supply curve intersects the
price axis.perfect competition is the only market structure that includes this entire area in total
surplus. This makes perfect competition the most efficient market structure.
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