What is Perfect Competition?

A market situation where a large number of buyers and sellers deal in a homogeneous product at a fixed price set by the market is known as Perfect Competition. Homogeneous goods are goods of similar shape, size, quality, etc. In other words, in a perfectly competitive market, the sellers sell homogeneous products at a fixed price determined by the industry and not by a single firm. In the real world, the situation of perfect competition does not exist; however, the closest example of a perfect competition market is agricultural goods sold by the farmers. Goods like wheat, sugarcane, etc., are homogeneous in nature and their price is influenced by the market.

Features of Perfect Competition

1. Homogeneous Product: The products offered by firms for sale under perfect competition are homogeneous. It means that the goods are identical in every respect such as size, shape, colour, quality, etc. As the goods are identical, these can be easily substituted for each other, which results in zero specific preference of the buyer from any particular seller. As the products are homogeneous, the buyers are willing to pay the same price only for the products of every firm of the industry. It also means that an individual firm cannot charge a higher price for their product, ensuring uniformity in price in the market.

As the products under perfect competition are homogeneous, the purchase of a good is not a matter of choice, but a matter of chance.

2. Very large number of Buyers and Sellers: The number of buyers and sellers in a perfect competition market is very large. It means that the number of buyers in a perfect competition market is so large that the total share of one single buyer is insignificant to the total purchase; therefore, a single buyer cannot influence the price of a product in the market. Similarly, the number of sellers is so large that the share of one single seller is insignificant to the total supply of the economy; therefore, a single seller cannot influence the price of a product in the market.

Because of the large number of buyers and sellers, the firms under perfect competition are just price-takers. It means that the firms do not have any option over the price of a product and have to just sell the products at the price determined by the industry. In the same way, the buyers are also just price-takers and cannot influence the price of a product in the market by changing their demand.

3. Freedom of Entry and Exit: The sellers under the perfect competition market have the freedom of entry and exit in/from the industry. It means that there are no artificial restrictions or barriers to the entry of a new firm or exit of an existing firm. This feature of a perfect competition market ensures that abnormal profits and abnormal losses do not exist in the long run.

Freedom of Entry of the new firms under a perfect competition market indicates that there are no barriers for the new firms to enter the industry. When the existing firms in the industry are making abnormal profits from their business, it attracts new firms to enter for profit, which in result increases the market supply of goods, ultimately resulting in the reduction in market price and profits. Hence, the entry of new firms into the industry only happens until every firm in the industry is earning normal profits only.

Freedom of Exit of the existing firms under a perfect competition market indicates that there are no barriers for the existing firms to leave the industry. Firms generally exit the industry when they are facing losses, and their exit decreases the market supply of goods resulting in an increase in the market price of those goods. However, their exit also reduces the losses, and hence the firms exit the industry until all the losses are wiped out from the industry and each of the existing firms earns normal profits.

A short period in this case is too short for a firm to exit from the industry or a new firm to enter into the industry. Similarly, a long period is too long for a firm to exit the industry or for a new firm to enter into the industry.

Normal Profits:

The minimum profit required by a firm to run the business is Normal Profit. Normal profits are included in the total production costs of a firm.

Abnormal Profits:

The excess amount of earnings of a firm over its total production cost is known as Abnormal Profit.

Abnormal Losses:

The shortage in the amount of earnings of a firm over its total production cost is known as Abnormal Losses.

4. Perfect Mobility of Factors of Production: The factors of production such as land, labor, capital, and entrepreneurship under a perfect competition market are perfectly mobile. There is no occupational and geographical restriction on the movement of factors of production, i.e., they are free to move to the industry with the best price.

5. Perfect Knowledge among Buyers and Sellers: Under a perfect competition market, the buyers and sellers have complete knowledge about the market price of the products. It means that no firm/seller can charge a different price from the customers and no buyer will pay a higher price than the price in the market. In other words, it results in uniformity in the market price of a product. Besides, the sellers of the product have perfect knowledge regarding the input markets. It means that each firm has equal access to the inputs and technology used for the production of goods, resulting in a uniform cost structure. Also, as the price and cost of a product is uniform, the profits earned by the firms are also uniform.

6. Absence of Selling Costs: Selling cost is the cost of the advertisement of a product. As the goods under perfect competition are homogeneous, they do not include selling costs. The perfect knowledge of the buyers and sellers regarding the product, makes it easy for the firms to sell the goods without selling cost.

7. Absence of Transportation Costs: To ensure uniformity in the price of goods, it is assumed that there is no transportation cost under perfect competition. In other words, it is assumed that a manufacturer can sell the product at any place, and the buyers can purchase the product from any place of their choice.

Perfect Competition and Pure Competition

Pure Competition is used in a narrower sense as compared to Perfect Competition. The market must have the following three fundamental conditions to become purely competitive:

  • Homogeneous Products
  • A very large number of buyers and sellers
  • Freedom of entry and exit

Perfect Competition is used in a wider sense as compared to Pure Competition. The market, in addition to the three conditions of pure competition, must have the following four conditions to become perfectly competitive:

  • Perfect mobility of factors of production
  • Perfect knowledge among buyers and sellers
  • Absence of selling costs
  • Absence of transportation costs

Firm is a Price-Taker

As there are a very large number of buyers and sellers under perfect competition, every firm is a price-taker. It means that no single firm has the ability to influence the price of a product in the market, and has to therefore sell the product at the price determined by the industry. It is so because the share of firms under perfect competition in the total market supply is negligible.

A firm is different from an industry. A firm is a single unit producing or providing the market with goods and services. However, an industry is the total of all the firms manufacturing the same goods in the market. For example, Cadbury is a chocolate manufacturing firm, which comes under the chocolate industry with other firms producing chocolates.

Hence, it can be concluded that a firm does not play any role in the price determination of a product, as it can neither affect the supply of a product nor it can affect its demand in the market. Therefore, a firm is a Price-Taker and an industry is a Price-Maker. The price of a product is determined by the industry at the point where the market demand curve and supply curve of the product meets, and every firm has to sell their product at this price only. This concept can be understood with the help of a graphical representation.

In the above graph, the market demand for a product is shown by the DD curve and its supply is shown by the SS curve. The DD curve and SS curve intersect with each other at point E, which means that the price determined by the industry through demand and supply of the product is OP. This price is adopted by the price taker firms, and they are free to sell any unit of quantity OQ, OQ1, etc., at this price. It means that the AR curve of the product becomes perfectly elastic and parallel to the X-axis. Besides, when AR remains constant, it becomes equal to MR (AR = MR).

Demand Curve under Perfect Competition

As the firms under perfect competition sell homogeneous products at a uniform price fixed by the market and have a large number of buyers and sellers, each firm in this market is a price-taker and has a perfectly elastic demand curve.

In the above graph, the X-axis represents the Output of a product, and the Y-axis represents Price and Revenue. The horizontal straight line parallel to the X-axis is the demand curve of a firm under perfect competition. As the price of goods is determined by the market with the help of demand and supply of the good in the market, every firm has to sell the goods at this price. In this case, the price is determined by OP. At price OP, a seller can sell different quantities like OQ1, OQ2, etc. However, a firm cannot change the price of the good.

As each firm (being a price-taker) has to sell the goods at the price determined by the forces of supply and demand, uniform price prevails in the market. It means that the revenue generated by the firm from every extra unit, also known as MR, is equal to the price of the product, also known as AR.

Therefore, under perfect competition, AR = MR.

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