Perfect competition (20TH CENTURY)

Perfect competition is a competitive system in which a large number of firms produce a homogenous product for a large number of buyers.

All the firms share the same product/market knowledge and enjoy free entry/exit to and from the industry. They are price-takers and sell as much of the product as possible at the market price.

Output is set where marginal cost equals marginal revenue. In the long run, average revenue equals marginal cost and firms enjoy only normal profits.

Also see: imperfect competition, monopolistic competition, monopoly, duopoly theory

Source:
G Stigler, ‘Perfect Competition, Historically Contemplated’, Journal of Political Economy, vol. LXV (1957), 1-17

In economics, specifically general equilibrium theory, a perfect market, also known as an atomistic market, is defined by several idealizing conditions, collectively called perfect competition, or atomistic competition. In theoretical models where conditions of perfect competition hold, it has been demonstrated that a market will reach an equilibrium in which the quantity supplied for every product or service, including labor, equals the quantity demanded at the current price. This equilibrium would be a Pareto optimum.[1]

Perfect competition provides both allocative efficiency and productive efficiency:

  • Such markets are allocatively efficient, as output will always occur where marginal cost is equal to average revenue i.e. price (MC = AR). In perfect competition, any profit-maximizing producer faces a market price equal to its marginal cost (P = MC). This implies that a factor’s price equals the factor’s marginal revenue product. It allows for derivation of the supply curve on which the neoclassical approach is based. This is also the reason why a monopoly does not have a supply curve. The abandonment of price taking creates considerable difficulties for the demonstration of a general equilibrium except under other, very specific conditions such as that of monopolistic competition.
  • In the short-run, perfectly competitive markets are not necessarily productively efficient, as output will not always occur where marginal cost is equal to average cost (MC = AC). However, in the long-run, productive efficiency occurs as new firms enter the industry. Competition reduces price and cost to the minimum of the long run average costs. At this point, price equals both the marginal cost and the average total cost for each good (P = MC = AC).

The theory of perfect competition has its roots in late-19th century economic thought. Léon Walras[2] gave the first rigorous definition of perfect competition and derived some of its main results. In the 1950s, the theory was further formalized by Kenneth Arrow and Gérard Debreu.[3]

Real markets are never perfect. Those economists who believe in perfect competition as a useful approximation to real markets may classify those as ranging from close-to-perfect to very imperfect. Share and foreign exchange markets are commonly said to be the most similar to the perfect market. The real estate market is an example of a very imperfect market. In such markets, the theory of the second best proves that if one optimality condition in an economic model cannot be satisfied, it is possible that the next-best solution involves changing other variables away from the values that would otherwise be optimal.

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