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Perfect Competition

Perfect Competition

Author: Kate Eskra

This lesson will explain Perfect Competition

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Source: Image of Perfect Competition Graph created by Kate Eskra

Video Transcription

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Hi. Welcome to economics. This is Kate. This tutorial is called "Perfect Competition." As always, my key terms are in red, and my examples are in green. So in this tutorial, we'll talk about perfect competition as one of the market structures that we study in economics. You'll be able to define what perfect competition is, and you'll understand its main characteristics. OK.

So let's just start with some basics here. We all know that it's businesses, or firms, that demand the factors of production. So they take inputs and then they supply us with goods and services, which are known as outputs. What the field of economics studies is the behavior of firms. And we know that not all firms are created equal. They vary, very much depending upon how big they are, what kind of product they're selling, how many competitors they face, how easy or how difficult it was to get into that business, and a lot of other factors.

All of these factors really effect, again, how firms behave. Do you have some favorite businesses that you love to shop at? Do you feel that some businesses offer really great prices, and others are ripping you off? More than likely, the reason why you feel that way about the businesses has something to do with a lot of the characteristics we're going to be talking about today and a lot of these things that go into why they behave the way that they do. OK?

So let's start, though, by talking about perfect competition. In all honesty just to let you know, perfect competition in this market structure is a mostly hypothetical. You'll notice that a lot of the characteristics I talk about in this tutorial, you might say, wow, I can't think of anything in real life that's like that. And that is kind of true. So why in the world do we study it? Well, it's going to help us to start with a simplified model. OK? To break down some of the complexities that we see in the real world. And it will give us a place to start for comparison.

So even though we're not talking about these types of competition in this tutorial, I just wanted to give you a spectrum here that shows you where we are. So perfect competition is on one end of the spectrum, and then most businesses are going to fall somewhere in the middle here. And a monopoly, where there's only one company selling something, would be on the opposite end. But we're going to start here, at perfect competition.

So perfect competition is defined as an industry market structure characterized by very large number of firms selling a homogeneous, or identical, product. Firms have essentially no market power. So you can already kind of see why this would be the exact opposite of a monopoly.

So what does it mean that they're selling a homogeneous product? Well, it is identical. There is absolutely no way to differentiate one seller's product from the next seller's product. We are talking no brand names at all. So you might say to yourself, well, gee, you know, I can't tell the difference between Pepsi and Coke if I closed my eyes, they're basically the same formula.

Well, while that might be true, you certainly know whether you're drinking Pepsi or Coke, because of the bottle that it's in. You know when you're buying it at the store, because it comes in different packaging. You know that they have different commercials. So if there is a way to differentiate it, if there is a way to tell what you're buying, who you're buying it from, then it is not homogeneous or identical.

So commodities offer a good example of what we're talking about here. And a commodity is just something that regardless of who is selling it, it's really all the same. And so because of this, we don't care who we buy it from. We're basically looking for whoever is going to sell it at the lowest price.

In perfect competition, there are many, many, many firms selling the exact same product. So what that means is that no one firm is large enough to really have any market power at all. And because of that, they have no ability to set their own price. They can't say, oh, well I'm going to charge $1 more because I have a better quality product. Remember, they can't differentiate. There is no way to differentiate. So that makes them what we call price takers. They're going to have to take the price that is the going rate, the market price of the good.

So here's an example for you. Because I know you're probably thinking, where in the world is this actually the case? So a close example to this would be, let's say that a big company like Tropicana-- so Tropicana is not the perfect competition that I'm using as the example, it's the orange farmers that Tropicana is purchasing their oranges from. OK? So no individual orange farmer can raise prices on Tropicana.

They can't say, well, my oranges are better, because blah, blah, blah, so I'm going to charge $1 more. They have no ability to do that, because Tropicana has contracts with these farmers. And if any one farmer says they're charging a higher price, no way, they'll go to somebody else. There are so many of them. So what does that mean for their graph?

Well it means if we graph the price of a bushel of oranges, for example, and the quantity, there's only one price that they can charge. If they charge even hypothetically a cent or anything higher than that, they would not be able to sell the Tropicana at all. And this is what we call perfectly elastic demand. All right.

The next characteristic is that there is perfect information. So have you ever purchased something without perfect information about it? I know I have. I know I've gotten something home and said to myself, wow, if I it only realized that this is what I'd be getting, or that this is going to fall apart within five minutes of wearing it, I wouldn't have spent that money on it.

Well in perfect competition, this does not happen. Information flows freely. Firms and consumers know everything about one another. They know what the market price is going to be, they know how much is going to be produced, they know exactly the cost to produce it. So there are no secrets. Everything is in real time. There's no time delays or anything. And again, I understand that that sounds very hypothetical, and it is. But it's an ideal situation where there's perfect information. So there'd be no uncertainty at all in the market. OK.

Now we have instantaneous entry and exit. What does that mean? Here, we're talking about barriers to entry or exit. A barrier is anything that's going to make it difficult to get in or get out of this business. In perfect competition, it is very easy to get in and get out. So for example, there would be very low start up costs. There would be little government regulation, and there would be really no benefit or cost savings from becoming a very large producer.

And why that's important to note is because once there are really large producers out there, really large companies, it becomes very difficult for small companies to then enter and compete with them. In perfect competition, remember, there are many, many small firms producing the same thing. So this would not be the case. There would be no large producers

So again, I want to remind you that this is a simplified view of a market, and it is hard to find examples of perfect competition in real life. The example I gave you, some agricultural examples, or commodities, are the closest thing that we can find. So why in the world would we study it? Well again, when we study the extremes, it's going to give us a place to start when looking at the complexities of the real world. It's going to help us compare and contrast.

So looking back at the spectrum, for example, we might say, well, the closer we are to this end of the spectrum, the better that's going to be for consumers. The closer we are to here, ooh, that's going to be bad for us as consumers. So just keep that in mind. That although kind of hypothetical what we just went over, it's a really good place to offer a comparison and to start.

So in this tutorial, we talked about perfect competition as one of these market structures. And the main characteristics we discussed were that it sells a homogeneous product, that there are many sellers with no individual market power, meaning that there are price takers-- they have no control over price-- there's perfect information, and there's easy entry and exit.

Thank you so much for listening. Have a great day.

Terms to Know
  • Perfect Competition

    An industry market structure characterized by a very large number of firms selling a homogeneous (identical) product. Firms have essentially no market power.