The Conditions of Perfect Competition

By Lynne Pepall, Peter Antonioni, Manzur Rashid

Following are some of the conditions that determine which markets are oh so perfect and which fall below the standard. A number of factors are required for a given market to be in perfect competition:

  • Each firm is small relative to the market and has no influence on price.

  • Firms and products are substitutable.

  • Each consumer is small relative to the market and has no influence on price.

  • Perfect information about prices and quantities is available.

  • There is easy entry into and exit from the market.

If you fail to find any of these conditions holding in a given market, the market is not perfectly competitive.

Each firm is small relative to the market

In a perfectly competitive market, no firm is individually able to influence the price or quantity sold of a given good. For this to be the case, each firm has to be a small producer relative to the quantity demanded. Typically, this means there are many firms to supply the market, none of which has a significant share of the market. This is obviously not always the case in many markets, because many markets are dominated by one firm or a small group of firms.

The small firm condition leads to economists describing firms in the market as price takers (the opposite being price makers or price setters). None of them can influence market price or demand, and so firms have no option but to take whatever price is determined by the market as a whole.

Firms and products are substitutable

Products in a perfectly competitive market are said to be homogenous, that is, indistinguishable from one another. If, for example, you’re shopping at a fruit and veg market with many sellers (so that none can influence the price paid for apples), the apples that each sells must be the same: no better or worse apples and no stalls that are the only ones selling Macintosh or the only ones selling Granny Smith. Instead, all must be selling the same, indistinguishable product.

Similarly, the firms must have the same production technology. If they don’t, long-run differences between firms are possible, which leads to differences between the firms in the market. This would open up the possibility of one firm being different enough from the other firms to be considered as being in a different market altogether and to be able to influence that market.

Again, these conditions may not reflect real-world conditions. Although some goods are entirely homogenous, they aren’t necessarily always produced by firms with the same production technologies. Take commodities, which are defined by their homogeneity: Gold is either gold or something else. An atom of the metal is either a gold atom or an atom of a different metal, not a different kind of gold atom. But this isn’t to say that firms mining gold produce it to the same level of efficiency everywhere in the world.

Each consumer is small relative to the market

A similar issue is the degree to which consumers are small relative to the market. This means that there is not a consumer whose purchasing behavior is able to influence the price. For many markets, this is a pretty plausible condition. A regular at Starbucks does not influence the price of a latte. However, a large pharmacy chain such as CVS is likely to be able to influence the price it pays for the prescribed medications it sells to consumers.

Perfect information about products and prices

A perfectly competitive market contains no hidden surprises. Consumers are perfectly informed about what products are available, the qualities of the products, where they are sold, and at what prices. Thus they’re immediately able to assess whether they want to purchase from one firm or another.

This information does not come at a cost. If consumers have to work to find out prices, the competition may not be perfect.

Easy entry and exit

Easy entry into and exit from the market is an extremely important condition. If an entrepreneur sees profits being made in a perfectly competitive market, he’s able to enter that market immediately and begin competing profits away from the firms in the market. Similarly, if he’s in a market and not making profits, he’s able to pack up and leave without his leaving incurring any costs that can’t be recovered.

This condition doesn’t mean that starting up involves no costs — just that it doesn’t involve any costs above and beyond those of producing whatever he’s producing in that market: no fees for entering and no costs of closing.