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What Is Perfect Competition?

The term perfect competition refers to a theoretical market structure. Although perfect competition rarely occurs in real-world markets, it provides a useful model for explaining how supply and demand affect prices and behavior in a market economy.

Under perfect competition, there are many buyers and sellers, and prices reflect supply and demand. Companies earn just enough profit to stay in business and no more. If they were to earn excess profits, other companies would enter the market and drive profits down.

How Perfect Competition Works

Perfect competition is a benchmark or ideal type to which real-life market structures can be compared. Perfect competition is theoretically the opposite of a monopoly, in which only a single firm supplies a good or service and that firm can charge whatever price it wants since consumers have no alternatives and it is difficult for would-be competitors to enter the marketplace.

In a perfect competition model, there are no monopolies. This kind of structure has a number of key characteristics, including:

All firms sell an identical product (the product is a commodity or homogeneous).

All firms are price takers (they cannot influence the market price of their products).

Market share has no influence on prices.

Buyers have complete or perfect information (in the past, present, and future) about the product being sold and the prices charged by each firm.

Capital resources and labor are perfectly mobile.

Firms can enter or exit the market without cost.

This can be contrasted with the more realistic imperfect competition, which exists whenever a market, hypothetical or real, violates the abstract tenets of neoclassical pure or perfect competition.

Since all real markets exist outside of the plane of the perfect competition model, each can be classified as imperfect. The contemporary theory of imperfect versus perfect competition stems from the Cambridge tradition of post-classical economic thought.

Characteristics of Perfect Competition

A perfectly-competitive market is defined by the following factors:

A Large and Homogeneous Market

There are a large number of buyers and sellers in a perfectly competitive market. The sellers are small firms, instead of large corporations capable of controlling prices through supply adjustments. They sell products with minimal differences in capabilities, features, and pricing. This ensures that buyers cannot distinguish between products based on physical attributes, such as size or color, or intangible values, such as branding.

A large population of both buyers and sellers ensures that supply and demand remain constant in this market. As such, buyers can easily substitute products made by one firm for another.

Perfect Information Availability

Information about an industry's ecosystem and competition constitutes a significant advantage. For example, knowledge about component sourcing and supplier pricing can make or break the market for certain companies.

In certain knowledge and research-intensive industries, such as pharmaceuticals and technology, information about patents and research initiatives at competitors can help companies develop competitive strategies and build a moat around their products.

Absence of Controls

Governments play a vital role in market formation for products by imposing regulations and price controls. They can control the entry and exit of firms into a market by setting up rules to function in the market. For example, the pharmaceutical industry has to contend with a roster of rules pertaining to the development, production, and sale of drugs.

In turn, these rules require big capital investments in the form of employees, such as lawyers and quality assurance personnel, and infrastructure, such as machinery to manufacture medicines. The cumulative costs add up and make it extremely expensive for companies to bring a drug to the market.

In comparison, the technology industry functions with relatively less oversight as compared to its pharma counterpart. Thus, entrepreneurs in this industry can start firms with less to zero capital, making it easy for individuals to start a company in the industry.

Such controls do not exist in a perfectly competitive market. The entry and exit of firms in such a market are unregulated, and this frees them up to spend on labor and capital assets without restrictions and adjust their output in relation to market demands.

Cheap and Efficient Transportation

Cheap and efficient transportation is another characteristic of perfect competition. In this type of market, companies do not incur significant costs to transport goods. This helps reduce the product's price and cuts back on delays in transporting goods.

Theory vs. Reality of Perfect Competition

Real-world competition differs from this ideal primarily because of differentiation in production, marketing, and selling. For example, the owner of a small organic products shop can advertise extensively about the grain fed to the cows that made the manure that fertilized the non-GMO soybeans, thereby setting their product apart from competitors. This is what's called differentiation.

The first two criteria (homogeneous products and price takers) are far from realistic. Yet, for the second two criteria (information and mobility) the global tech and trade transformation is improving information and resource flexibility. While the reality is far from this theoretical model, the model is still helpful because of its ability to explain many real-life behaviors.

Barriers to Entry Prohibit Perfect Competition

Many industries also have significant barriers to entry, such as high startup costs (as seen in the auto manufacturing industry) or strict government regulations (as seen in the utility industry), which limit the ability of firms to enter and exit such industries. And although consumer awareness has increased with the information age, there are still few industries where the buyer remains aware of all available products and prices.

Significant obstacles exist that prevent perfect competition from developing in the economy. The agricultural industry probably comes closest to exhibiting perfect competition because it is characterized by many small producers with virtually no ability to alter the selling price of their products.

The commercial buyers of agricultural commodities are generally very well-informed and, although agricultural production involves some barriers to entry, it is not particularly difficult to enter the marketplace as a producer.

Advantages and Disadvantages of Perfect Competition

Perfect competition is an idealized framework for a market economy. While it provides a convenient model for how an economy works, it is not always accurate and has significant departures from the real-world economy. Like with other models, the value of a perfect competition framework is only accurate to the extent that it reflects actual conditions.

One notable feature of perfect competition is low profit margins. Since all consumers have access to the same products, they naturally gravitate towards the lowest prices. Firms cannot set themselves apart by charging a premium for higher-quality products and services. For instance, it would be impossible for a company like Apple ( AAPL) to exist in a perfectly competitive market because its phones are more expensive than those of its competitors.

Another is the absence of innovation. The prospect of greater market share and setting themselves apart from the competition is an incentive for firms to innovate and make better products. But no firm possesses a dominant market share in perfect competition, meaning that the long-term profitability of their operations is zero.

Another disadvantage is the absence of economies of scale. Limited to zero profit margins means that companies will have less cash to invest in expanding their production capabilities. An expansion of production capabilities could potentially bring down costs for consumers and increase business profit margins. But the presence of several small firms cannibalizing the market for the same product prevents this and ensures that the average firm size remains small.

Do Firms Profit in Perfect Competition?

Profits may be possible for brief periods in perfectly competitive markets. But the market's dynamics cancel out the effects of positive or negative profits and bring them toward an equilibrium. Because there is no information asymmetry in the market, other firms will quickly ramp up their production or reduce their manufacturing costs to achieve parity with the firm which made profits.

The average revenue and marginal revenue for firms in a perfectly competitive market are equal to the product's price to the buyer. As a result, the perfectly competitive market's equilibrium, which had been disrupted earlier, will be restored. In the long run, an adjustment of supply and demand ensures all profits or losses in such markets tend toward zero.

Perfect Competition vs. Monopoly

The opposite of perfect competition is a monopoly, where a single company controls the supply of a certain product. In monopoly conditions, consumers cannot go elsewhere if the price is too high; they can only decide not to buy the product.

This means that rather than setting prices by supply and demand, the monopolistic firm can simply set a price point that maximizes its profits. Some types of firms are considered natural monopolies because there is a significant first-mover advantage that discourages competitors from entering the market. Other monopolies may be established through government actions, or by cartels, such as OPEC.

Examples of Perfect Competition

As mentioned earlier, perfect competition is a theoretical construct and doesn't actually exist. As such, it is difficult to find real-life examples of perfect competition but there are variants present in everyday society.

Consider the situation at a farmer's market, a place characterized by a large number of small sellers and buyers. There is typically little differentiation between products and their prices from one farmer's market to another. How the produce is grown does not matter (unless they are classified as organic) and there is very little difference in how they're packaged or branded. Thus, even if one of the farms producing goods for the market goes out of business, it will not make a difference to average prices.

Supermarkets

The situation may also be relatively similar in the case of two competing supermarkets, which stock their aisles from the same set of companies. Again, there is little to distinguish products from one another between both supermarkets and their pricing remains almost the same. Another example of perfect competition is the market for unbranded products, which features cheaper versions of well-known products.

Product knockoffs are generally priced similarly and there is little to differentiate them from one another. If one of the firms manufacturing such a product goes out of business, it is replaced by another one.

Technology

The development of new markets in the technology industry also resembles perfect competition to a certain degree. For example, there was a proliferation of sites offering similar services during the early days of social media networks. Some examples of such sites are Sixdegrees.com, Blackplanet.com, and Asianave.com. None of them had a dominant market share and the sites were mostly free. They constituted sellers in the market while consumers of such sites, who were mainly young people, were the buyers.

The startup costs for companies in this space were minimal, meaning that startups and companies can freely enter and exit these markets. Technologies, such as PHP and Java, were largely open-source and available to anyone. Capital costs, in the form of real estate and infrastructure, were not necessary. Remember that Mark Zuckerberg effectively founded Facebook from his college dorm.

What Is Perfect Competition?

What Is an Example of Perfect Competition?

What Is the Difference Between Perfect Competition and Imperfect Competition?

The Bottom Line

Perfect competition describes an imaginary market condition where all consumers have access to the same products and information. In this type of economy, all firms must offer the lowest price possible or risk being undercut by their competitors. Although this is only a theoretical model, perfect competition is useful for demonstrating how economic actors behave in a free market.

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Perfect Competition: Examples and How It Works

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Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and resource mobility are met.

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What Is Monopolistic Competition?

Monopolistic competition exists when many companies offer competing products or services that are similar, but not perfect, substitutes.

The barriers to entry in a monopolistic competitive industry are low, and the decisions of any one firm do not directly affect its competitors. The competing companies differentiate themselves based on pricing and marketing decisions.

Key Takeaways

Understanding Monopolistic Competition

Monopolistic competition exists between a monopoly and perfect competition, combines elements of each, and includes companies with similar, but not identical, product offerings.

Restaurants, hair salons, household items, and clothing are examples of industries with monopolistic competition. Items like dish soap or hamburgers are sold, marketed, and priced by many competing companies.

Demand is highly elastic for goods and services of the competing companies and pricing is often a key strategy for these competitors. One company may opt to lower prices and sacrifice a higher profit margin, hoping for higher sales. Another may raise its price and use packaging or marketing that suggests better quality or sophistication.

Companies often use distinct marketing strategies and branding to distinguish their products. Because the products all serve the same purpose, the average consumer often does not know the precise differences between the various products, or how to determine what a fair price may be.

Characteristics of Monopolistic Competition

Low Barriers to Entry

In monopolistic competition, one firm does not monopolize the market and multiple companies can enter the market and all can compete for a market share. Companies do not need to consider how their decisions influence competitors so each firm can operate without fear of raising competition.

Product Differentiation

Competing companies differentiate their similar products with distinct marketing strategies, brand names, and different quality levels.

Companies in monopolistic competition act as price makers and set prices for goods and services. Firms in monopolistic competition can raise or lower prices without inciting a price war, often found in oligopolies.

Demand Elasticity

Demand is highly elastic in monopolistic competition and very responsive to price changes. Consumers will change from one brand name to another for items like laundry detergent based solely on price increases.

Advantages and Disadvantages of Monopolistic Competition

Monopolistic competition provides both benefits and pitfalls for companies and consumers.

What Is the Difference Between Monopolistic Competition and Perfect Competition?

In perfect competition, the product offered by competitors is the same item. If one competitor increases its price, it will lose all of its market share to the other companies based on market supply and demand forces, where prices are not set by companies and sellers accept the pricing determined by market activity.

In monopolistic competition, supply and demand forces do not dictate pricing. Firms are selling similar, yet distinct products, so firms determine the pricing. Product differentiation is the key feature of monopolistic competition, where products are marketed by quality or brand. Demand is highly elastic, and any change in pricing can cause demand to shift from one competitor to another.

How Does Monopolistic Competition Function in the Short Term and Long Term?

Companies aim to produce a quantity where marginal revenue equals marginal cost to maximize profit or minimize losses. When existing firms are making a profit, new firms will enter the market. The demand curve and the marginal revenue curve shift and new firms stop entering when all firms are making zero profit in the long run. If existing firms are incurring a loss, some firms will exit the market. The firms stop exiting the market until all firms start making zero profit. The market is at equilibrium in the long run only when there is no further exit or entry in the market or when all firms make zero profit in the long run.

What Industry Is an Example of Monopolistic Competition?

Monopolistic competition is present in restaurants like Burger King and McDonald's. Both are fast food chains that target a similar market and offer similar products and services. These two companies are actively competing with one another, and seek to differentiate themselves through brand recognition, price, and by offering different food and drink packages.

What Is the Difference Between Monopolistic Competition and a Monopoly?

A monopoly is when a single company dominates an industry and can set prices for its product without fear of competition. Monopolies limit consumer choices and control production quantity and quality. Monopolistic competitive companies must compete with others, restricting their ability to substantially raise prices without affecting demand and providing a range of product choices for consumers. Monopolistic competition is more common than monopolies, which are discouraged in free-market nations.

The Bottom Line

Monopolistic competition exists when many companies offer competitive products or services that are similar, but not exact, substitutes. Hair salons and clothing are examples of industries with monopolistic competition. Pricing and marketing are key strategies for competing companies and often rely on branding or discount pricing strategies to increase market share.

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Monopolistic Competition: Definition, How it Works, Pros and Cons

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Monopolistic competition exists when many companies offer competitive products or services that are similar, but not exact, substitutes.

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Oligopoly: Meaning and Characteristics in a Market

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An oligopoly is a market structure with a small number of firms, none of which can keep the others from having significant influence.

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What Is a Monopoly?

A monopoly is a market structure where a single seller or producer assumes a dominant position in an industry or a sector. Monopolies are discouraged in free-market economies as they stifle competition and limit substitutes for consumers.

In the United States, antitrust legislation is in place to restrict monopolies, ensuring that one business cannot control a market and use that control to exploit its customers.

Understanding a Monopoly

A monopoly is a business that is characterized by a lack of competition within a market and unavailable substitutes for its product. Monopolies can dictate price changes and create barriers for competitors to enter the marketplace.

Companies become monopolies by controlling the entire supply chain, from production to sales through vertical integration, or buying competing companies in the market through horizontal integration, becoming the sole producer.

Monopolies typically reap the benefit of economies of scale, the ability to produce mass quantities at lower costs per unit.

Types of Monopolies

The Pure Monopoly

A pure monopoly is a single seller in a market or sector with high barriers to entry such as significant startup costs whose product has no substitutes.

Microsoft Corporation was the first company to hold a pure monopoly position on personal computer operating systems. As of 2022, its desktop Windows software still held a market share of 75%.

Monopolistic Competition

Multiple sellers in an industry sector with similar substitutes are defined as having monopolistic competition. Barriers to entry are low, and the competing companies differentiate themselves through pricing and marketing efforts.

Their offerings are not perfect substitutes, such as Visa and MasterCard. Other examples of monopolistic competition include retail stores, restaurants, and hair salons.

The Natural Monopoly

A natural monopoly develops in reliance on unique raw materials, technology, or specialization. Companies that have patents or extensive research and development costs such as pharmaceutical companies are considered natural monopolies.

Public Monopolies

Public monopolies provide essential services and goods, such as the utility industry as only one company commonly supplies energy or water to a region. The monopoly is allowed and heavily regulated by government municipalities and rates and rate increases are controlled.

Pros and Cons of a Monopoly

Without competition, monopolies can set prices and keep pricing consistent and reliable for consumers. Monopolies enjoy economies of scale, often able to produce mass quantities at lower costs per unit. Standing alone as a monopoly allows a company to securely invest in innovation without fear of competition.

Conversely, a company that dominates a sector or industry can use its advantage to create artificial scarcities, fix prices, and provide low-quality products. Consumers must trust that a monopoly operates ethically due to limited or unavailable substitutes in the market.

Regulation of a Monopoly

Antitrust laws and regulations are in place to discourage monopolistic operations, protect consumers, and ensure an open market.

In 1890, the Sherman Antitrust Act was passed by the U.S. Congress to limit "trusts," a precursor to the monopoly, or groups of companies that colluded to fix prices. This act dismantled monopolies including Standard Oil Company and the American Tobacco Company.

The Clayton Antitrust Act of 1914 created rules for mergers, corporate directors, and listed practices that would violate the Sherman Antitrust Act, and the Federal Trade Commission Act created the Federal Trade Commission (FTC), which, along with the Antitrust Division of the U.S. Department of Justice, sets standards for business practices and enforces the two antitrust acts.

The most consequential monopoly breakup in U.S. history was that of AT&T. After controlling the nation's telephone service for decades as a government-supported monopoly, AT&T fell to antitrust laws. In 1982, AT&T, which had telephone lines that reached nearly every home and business in the U.S., was forced to divest itself of 22 local exchange service companies, the main barrier to competition.

What Companies Have Faced Antitrust Violations as a Monopoly?

What Is Price Fixing?

How Do Antitrust Laws Protect Consumers?

The Bottom Line

A monopoly is defined as a single seller or producer that excludes competition from providing the same product. A monopoly can dictate price changes and creates barriers for competitors to enter the marketplace. Antitrust legislation is in place to restrict monopolies, ensuring that one business cannot control a market and use that control to exploit its customers.

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What Is a Monopoly? Types, Regulations, and Impact on Markets

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A monopoly is a market structure where a single seller or producer assumes a dominant position in an industry or a sector. Monopolies are discouraged in free-market economies as they stifle competition and limit substitutes for consumers.

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1. What is so perfect about perfect competition?

2. Why do some firms become price setters?

3. What happens when firms become price setters?