Monday, June 27, 2011

What is Perfect Competition?


In competitive markets there are:
  1. Many buyers and sellers - individual firms have little effect on the price.
  2. Goods offered are very similar - demand is very elastic for individual firms.
  3. Firms can freely enter or exit the industry - no substantial barriers to entry.
Competitive firms have no market power. Recall that businesses are trying to maximize profits, and Profit = Total Revenue (TR) - Total Cost (TC).

Principle of Economics #7: Governments can sometimes improve market outcomes. Markets do many things well. With competition and no externalities, markets will allocate resources so as to maximize the surplus available. However, if these conditions are not met, markets may fail to achieve the optimal outcome. This is also known as "market failure".

If a big business is involved in activities that, say pollutes water, then it is harming fellow citizens and it's own consumers. This is called a 'negative externality'. This is an example of perfect competition NOT working efficiently. In such situations the government steps in a balances the situation so immoral business practices creating negative externalities can be controlled creating a better community and business atmosphere for everyone. That is why in practice (i.e. in the Real World) perfect competition with no regulation rarely exists, instead we have 'mixed economies' which is what exists in all democracies (and helps a democracy function better if the laws are set and administered appropriately)

More about Perfect Competition from Investopedia:

What Does Perfect Competition Mean?
A market structure in which the following five criteria are met:

1. All firms sell an identical product.
2. All firms are price takers.
3. All firms have a relatively small market share.
4. Buyers know the nature of the product being sold and the prices
charged by each firm.
5. The industry is characterized by freedom of entry and exit.

Investopedia explains Perfect Competition
Perfect competition is a theoretical market structure. It is primarily used as a benchmark against which other market structures are compared. The industry that best reflects perfect competition in real life is the agricultural industry.

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