Perfect Competition: Meaning and Assumptions

Meaning of Perfectly Competitive Market

A market form refers to the mode in which the firms respond and interact with each other. It is the environment in which the firms make their pricing and output decisions. The market forms are usually studied with respect to the degree of competition prevailing in the market. There are perfectly and imperfectly competitive markets operating in the economic world.

A perfectly competitive market is the extreme case where the market structure is absolutely impersonal, and the ‘invisible hand’ leads to the allocation of resources unhindered. There is a large number of firms behaving in a completely competitive manner. However, it is more of a theoretical model with only close approximations in reality.

Nevertheless, it forms the benchmark for studying the market forms and provides some useful insights into the economic world. In order to study the pricing and output decisions of a perfectly competitive market, it is important to look at the basic assumptions of this market and understand the environment in which it functions.

Assumptions of Perfectly Competitive Market

1. Large Number of Buyers and Sellers

In a perfectly competitive market, there is a large number of buyers and sellers. Every consumer demands only a small fraction of the market output and similarly, every individual firm produces a negligible fraction of the market supply. Therefore, no single producer/consumer can make an impact on the market price prevailing in the market.

The market price in a perfectly competitive market is determined by the interaction of market demand and market supply curves, and each firm takes that market price as given.

This assumption implies that the firms and the consumers in a perfectly competitive market are price takers. The firms and the consumers in such a market are independent and correctly believe that their decisions will not affect the market price.

2. Product Homogeneity

In a perfectly competitive set-up, each firm produces and sells a homogeneous product. The homogeneity aspect relates not only to the physical or technical characteristics of the product or commodity but also to the services associated with the product and the ‘environment’ in which the purchase is made.

When the products of all the firms in a market are perfectly substitutable with one another, then no firm can raise the price above the market price without losing its market share to other firms. This reinforces the point that the firms in a competitive market are price takers. Agricultural products, copper, cotton etc., could be apt examples of such goods.

On the other hand, if the products are heterogeneous, then the consumers make their buying decisions depending on the quality of the products. As the goods are not perfectly substitutable, each firm has the opportunity to raise its price above that of its competitors without losing any of its sales.

3. Free Entry and Exit

In a perfectly competitive market, firms are free to enter or leave the industry in response to monetary incentives. It means that there are no special costs attached if a firm enters the industry or exits if it is not making any profit.

Moreover, there are no hidden hurdles in terms of copyrights and patents obstructing new firms from entering the market. For example, the aircraft industry is not perfectly competitive as entry requires immense investment in plant and equipment, which has little or no resale value.

An important implication of this assumption is that new firms enter the market if the existing firms are making exorbitant profits, diluting the profits of incumbent firms in the process.

Similarly, the firms are free to exit the industry in case of losses thereby increasing the market share (and profits) of the remaining firms. Free entry and exit of firms, thereby, implies that in the long run, all firms in the industry are making exactly zero economic profits.

The assumption is important for the competition to be effective. It means that the consumers can easily switch to a rival firm if the current supplier raises the price.

4. Other Assumptions

A large number of buyers and sellers, product homogeneity and free entry and exit are the basic three assumptions of a perfectly competitive market structure.

Apart from them, it is assumed that there is no government regulation in this market. Intervention, like taxes, subsidies, rationing, patents etc., is ruled out when there is the free play of market forces, as in the case of perfect competition.

Moreover, there is perfect mobility of factors of production, implying that the factors are free to move from one firm to another and from one industry to another. The consumers and producers are assumed to have perfect knowledge about the present as well as the future conditions of the market.

In other words, they are assumed to possess all relevant information essential for making economic decisions.

Though the assumptions of perfect competition are rigid and unlikely to be fulfilled in reality; however, moderate deviations from them do not undermine the usefulness of the model.

Examples of Perfect Competition

The markets of agricultural commodities are close approximations of a perfectly competitive market. The agricultural produce is more or less homogeneous among the producers, and each producer’s supply accounts for only a small fraction of the total output.

A single potato seller cannot individually influence the market price of potatoes as his produce is approximately homogeneous to other producers. If he charges a price higher than the market price, then none of the consumers will buy from him. Also, the barriers to entry and exit in terms of the movement of resources are practically non-existent.

Another example of a perfectly competitive structure could be the stock market. The market price of a particular stock is determined by the free play of its demand and supply in the market. Individual buyers and sellers are too small to influence the price and are, thus, the price takers.

Moreover, all the units of stock are identical or homogeneous. The resources are perfectly mobile as the stocks can be traded as frequently as desired. The assumption of perfect knowledge is also met as the information on the share market is easily available.

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