Perfect competition – a pure market
Perfect competition describes a market structure whose assumptions are extremely strong and
highly unlikely to exist in most real-time and real-world markets. The reality is that most markets
are imperfectly competitive. Nonetheless, there is some value in understanding how price,
output and equilibrium is established in both the short and the long run in a market that holds
true to the tough assumptions of a world of perfect competition.
Economists have become more interested in pure competition partly because of the rapid growth
of e-commerce in domestic and international markets as a means of buying and selling goods
and services. And also because of the popularity of auctions as a rationing device for allocating
scarce resources among competing ends.
Basic assumptions required for conditions of pure competition to exist
Many small firms, each of whom produces an insignificant percentage of total market
output and thus exercises no control over the ruling market price.
Many individual buyers, none of whom has any control over the market price – i.e.
there is no monopsony power
Perfect freedom of entry and exit from the industry. Firms face no sunk costs - entry
and exit from the market is feasible in the long run. This assumption ensures all firms
make normal profits in the long run
Homogeneous products are supplied to the markets that are perfect substitutes. This
leads to each firms being passive “price takers” and facing a perfectly elastic demand
curve for their product
Perfect knowledge – consumers have readily available information about prices and
products from competing suppliers and can access this at zero cost – in other words, there
are few transactions costs involved in searching for the required information about prices
No externalities arising from production and/or consumption which lie outside the
market The real world of imperfect competition!
Clearly the assumptions of pure competition do not hold in the vast majority of markets. Some
suppliers may exert some control over market supply and seek to exploit their monopoly power.
On the demand-side, some consumers may have monopsony power against suppliers because
they purchase a high percentage of total demand. There are nearly always some barriers to the
contestability of the market (see revision notes on barriers to entry) and far from being
homogeneous, most markets are full of heterogeneous products due to product
Consumers nearly always have imperfect information (for example information gaps) and
their preferences and choices can be influenced by the effects of persuasive marketing and
advertising. In every industry there is always asymmetric information where the seller knows
more about quality of good than buyer. The real world is one in which negative and positive
externalities from both production and consumption are numerous – both of which can lead to a
divergence between private and social costs and benefits. Finally there may be imperfect
competition in related markets such as the market for essential raw materials, labour and capital
We can come fairly close to a world of perfect competition but in practice there are nearly
always barriers to pure competition.
Establishing price and output in the short run under perfect competition
The previous diagram shows the short run equilibrium for perfect