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Perfect competition is a microeconomic concept meant to represent a theoretical situation in which large numbers of firms operate at once.
In the basic model there is a perfectly horizontal demand (D) curve, meaning that consumer demand is perfectly elastic. The demand curve can also be thought of as the marginal revenue curve. Any firm that tried to raise price will immediately begin to lose consumers because they can immediately get the same product from another firm. There is a marginal cost (MC) curve sloping upwards to the right, representing increasing costs. The marginal cost curve can be thought of as the firm's supply curve. The firm's output is determined by where the MC curve and demand curve intersect. There is a third curve, representing average total cost (ATC). The gap between the point at which the MC curve and demand curve intersect and the ATC is the profit margin. That profit margin is multiplied by the total quantity produced to estimate total profit. The existence of economic profit is considered abnormal in the perfectly competitive market, because of how easy it is for new firms to enter the market. Over time the demand curve will fall to where the ATC and MC are both equal to demand as new competitors increase supply and bring down the price.
The model for the overall market is a normal supply and demand curve, with a downward sloping demand curve and upward sloping supply curve. The market sets the price that each firm has to accept.
There are four necessities for a market to be considered perfectly competitive.[note 1]
- Large numbers of buyers and sellers: No single firm or consumer can set prices.
- Perfect Information: Both buyers and sellers have easy access to new information.
- Low barriers to entry: Clearly defined property rights with no excess licensing or regulation of new entrants.
- Homogenous product: Some type of product that can be perfectly substituted for one another (e.g., 2%-fat milk).
Perfect competition is more of a theoretical model, meant to illustrate a hypothetical market situation, than it is something commonly observed in the real world. So it's more of a tool used to help teach economics students how to conceptualize economic modeling more generally while teaching basic abstract concepts. The ideal can also be used to access the competitiveness of real markets. Despite all that, there are some agricultural primary goods that come close to meeting the description of perfect competition:
- ↑ The exact number of criteria varies with different textbooks and websites. These four are the essential core each one will mention.
- ↑ Hayes, Adam. "Understanding Perfect Competition". Investopedia. Retrieved 2020-01-26.
- ↑ "OECD Glossary of Statistical Terms - Perfect competition Definition". stats.oecd.org. Retrieved 2020-01-26.