Search
LearnBlogCareersHelpLog InSign Up

What is Perfect Competition?

Robinhood LearnJune 18, 2020
Democratize finance for all. Our writers’ work has appeared in The Wall Street Journal, Forbes, the Chicago Tribune, Quartz, the San Francisco Chronicle, and more.
definition

Perfect competition is a hypothetical market situation in which competition is at its highest possible level and no individual buyer or seller can influence the market price of products.

🤔 Understanding perfect competition

In economics, perfect competition is a theoretical market state that occurs when several conditions are met. First, there are many buyers and sellers for a given product. Second, it’s easy for new companies to enter and exit the market. Third, many companies produce identical products. And fourth, buyers and sellers have all the information they need to make rational decisions. The opposite of perfect competition is a monopoly. In reality, a perfectly competitive marketplace does not exist. However, some markets have a higher level of competition than others.

example

There is no real-world example of a market that exhibits perfect competition. Instead, consider the case of fictional lemonade stands in a suburban neighborhood. Every kid on the street has one, so there are plenty of sellers. All the adults regularly drink lemonade, so there are plenty of buyers. Stands are simple and cheap to start, so if a new family moves in, their child can easily launch one. All the sellers get their supplies at the same store and make their lemonade the same way, so the products are identical. And all buyers and sellers have full access to the information they need to make decisions, such as how much everyone else is charging.

Takeaway

Perfect competition is like a row of street vendors selling the same thing in the same neighborhood…

If all the vendors were lined up next to each other, everyone would have all the information they needed to sell their product or make a purchase. Some economists think it would be great if every market was perfectly competitive, and you could get identical products for the same price everywhere. But at the end of the day, it’s a scenario that just doesn’t exist.

illo-perfect competition-desktop mobile

Tell me more...

What are the characteristics of perfect competition?
A large number of buyers and sellers
Homogeneity across companies
Lack of barriers to entry or exit
Perfect knowledge
Lack of government intervention
One firm cannot influence the price
All firms earn normal profits
What is the difference between imperfect competition and monopolistic competition?
What are the advantages and disadvantages of a perfect competition model?

What are the characteristics of perfect competition?

Perfect competition doesn’t exist in the real world (agricultural and foreign exchange markets come closest). For a market to be perfectly competitive, it must have several characteristics:

A large number of buyers and sellers

In a perfectly competitive market, there are so many sellers that a consumer can buy a product anywhere, and no individual firm holds enough of the market to control it. Likewise, there are enough buyers that no individual can affect the price on their own.

Homogeneity across companies

A homogeneous product is one that is identical across different sellers. This uniformity is another characteristic of a perfectly competitive market. For example, each store would sell the same exact coffee maker. Buyers don’t discriminate among sellers, since they know they’re getting identical products.

Lack of barriers to entry or exit

In a perfectly competitive market, there are no obstacles to entry or exit. Any company can freely enter or leave the market, without hurdles like start-up costs, licensing requirements, or patents.

In real markets, there are often barriers to entry. Depending on the market, starting a business can be incredibly costly. In some sectors, this even leads to natural monopolies because it’s too expensive for new firms to enter the market. One example is a utility company. From both a cost and logistical perspective, it wouldn’t make sense to have a bunch of utility companies providing power to a city. The US government allows this type of monopoly but regulates it to ensure companies don’t take advantage of consumers.

Perfect knowledge

Perfect competition requires that consumers and sellers have all the knowledge they need to make decisions about consumption and production. They’re instantly and freely aware of all prices and products from all suppliers and any changes in the market. Because they have perfect information, consumers are always able to make the most rational purchasing decisions. There’s also no need for advertising on the part of firms, since consumers have access to all they need to know.

Lack of government intervention

Perfectly competitive markets lack government influence. Companies don’t have to abide by any regulations to enter a market. This lack of intervention is a critical component in making sure there are no barriers to entry.

In real markets, however, there is usually some government intervention. Governments might regulate who can enter the market, perhaps by requiring a license or permit. Other industries might see government intervention in the form of price controls, like a price ceiling (the maximum a company can charge for a product) or a price floor (the minimum a company can charge). One example of a price floor is the minimum wage, which is the lowest price someone can legally pay for labor.

One firm cannot influence the price

In a perfectly competitive market, no single firm can affect the market price of a product. In other words, every company is a price taker, not a price maker. If one company were to raise its rates, consumers would just buy the product from a different seller. This would be simple in a perfectly competitive market, because buyers don’t have a personal attachment to any one seller, products are homogenous, and prices are fully transparent. A company also wouldn’t charge a lower price, as there would be no incentive or resulting profit.

All firms earn normal profits

In this hypothetical market, all firms make normal profits. In other words, every company earns just enough to stay in business without any excess profit.

What is the difference between imperfect competition and monopolistic competition?

Any market that doesn’t have all the characteristics of perfect competition instead has imperfect competition. In this type of market, sellers have to work harder to get business⁠ — They have to fight for a share of the market. They do this by setting their prices competitively and by advertising to consumers. There are barriers to entry that prevent just anyone from jumping in. There may only be a small number of buyers or sellers, who can then influence prices. Buyers and sellers don’t always have full insight into all products and prices, or have to pay to acquire that knowledge. And products are differentiated from one another. Some companies make more than others — Some have huge profit margins, while others go out of business.

Imperfect competition describes just about every industry in every economy. There is a wide range of imperfectly competitive markets, ranging from sectors with monopolies to those that are highly competitive.

Monopolistic competition is one form of imperfect competition. It differs from a monopoly, in which a single firm dominates a sector and controls prices. In monopolistic competition, barriers to entry for new companies are low, and the pricing decisions of one firm rarely have a significant impact on others in the market. There are lots of competitors (as well as many buyers) in the game, and many companies offer similar but not identical products and services. Companies work hard to make themselves and their products seem unique, including through advertising. Theoretically, monopolistic competition leads to normal profits for companies in the long-run, if not in the short term.

Restaurants are one example of monopolistic competition. A city has lots of restaurants and plenty of potential customers. Many restaurants serve similar food at similar prices, but they’re not interchangeable. Every restaurant works hard to stand out from the crowd and provide a unique dining experience. They try to make their food, service, and atmosphere just a little better than that of their competition, and they use advertising to get on the radar of potential customers.

What are the advantages and disadvantages of a perfect competition model?

In many ways, perfectly competitive markets would be best for consumers, because there is no chance of manipulation or exploitation. Buyers have all the information they need to make rational decisions, so marketing can’t influence them. They can get the same products wherever they go. Companies can’t overcharge them, because no firm has enough of the market share to do so and all products are identical. Products are accessible to every consumer for a fair price.

Not only does perfect competition not really exist, but there are also downsides for both buyers and sellers. Perfect competition would prevent buyers from finding better products. Let’s say someone is looking to buy a television. He or she isn’t happy with the current model and wants better features. The problem is that every store is selling the same television. A consumer can’t just go to a different store and get a better product.

Perfect competition is also problematic for suppliers. First, there isn’t a lot of incentive for companies to enter a market, since they won’t get large profit margins. After all, people usually go into business to make money.

Perfectly competitive markets also lack the opportunity for innovation. Apple made history in 2007 when it released the iPhone — It was the first of its kind. In a perfectly competitive market, the iPhone wouldn’t exist. First, Apple wouldn’t have had the working capital (the difference between a company’s assets and its liabilities) to invest in the research and development of the iPhone. It would have been bringing in just enough revenue to stay in business. Apple also wouldn’t have been able to sell its products at a higher price than competitors charged. And any firm could’ve immediately entered the market and made an identical product.

At first glance, it might seem like perfect competition would be great for everyone. But ultimately, perfect competition would remove our ability to get exactly what we want out of products and eliminate the incentive to innovate.

1197523

You May Also Like

What is Due Diligence?

June 18, 2020

Due diligence is the process of investigating something, usually a potential investment or plan for the future, to ensure that you know all of the details and risks before making a commitment.

This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.
Robinhood Financial LLC provides brokerage services. Robinhood Securities, LLC, provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. Robinhood U.K. Ltd (RHUK) provides brokerage services in the United Kingdom. All are subsidiaries of Robinhood Markets, Inc. ('Robinhood').
© 2020 Robinhood Markets, Inc. Robinhood® is a trademark of Robinhood Markets, Inc.