Perfect Competition

In a perfect world, we’d have perfect competition. Perfect competition happens when, in a market for a particular good or service:

1. Everyone sells the exact same thing (yeah, not in real life); there's no differentiation in goods and services, i.e. all firms are selling the same stuff within one market. For instance, in order for the lemonade market on Maple Street to be in perfect competition, Jill, Joe, and Sammy would all be selling the exact same kind of lemonade; there's the same amount of lemons, sugar, and water in each cup. In reality, though, Jill's differentiated her product by making it raspberry lemonade, Joe's added extra sugar for the sweet tooth crowd, and Sammy's playing the "organic" card. When there's differentiation in products, that makes competition imperfect, since firms are signaling to customers why their specific product is preferable to the other, similar ones. This commonly-seen type of imperfect market structure...a market selling differentiated products...is called monopolistic competition.

2. Demand of the thing dictates the price of the thing (that would mean prices aren’t artificially jacked up by companies colluding). In perfect competition, all firms are price takers. When firms are price takers, it means they're at the mercy of the price set by the market. In the Maple Street lemonade market, that would mean Jill, Joe, and Sammy's identical lemonades would all sell for the same amount...say, one dollar. If Joe tried to raise the price of his lemonade to a dollar and a quarter, consumers would just go buy Jill or Sammy's lemonade instead, which would put Joe out of business. Remember, they're all selling the exact same stuff in a perfectly competitive market. But in reality, Joe is charging a dollar and a quarter, and he's still in business. Joe’s clientele is willing to pay that extra quarter for that extra sugar. Sammy's organic lemonade is even more expensive than Joe's at two dollars, but it also sells fine, because Sammy's consumer market only buys organic. Jill still gets her fair share of customers too, because there's a niche market for raspberry lemonade. These kiddos are all making their own prices with their differentiated lemonade, rather than being at the mercy of the market's deemed price.

3. Each seller is only taking up a small piece of the market (lots of competition). Buyers know all of the details on products and prices in perfectly competitive markets. That's how buyers enforce perfect competition: they'll put anyone out of business by not buying from them if they can find the same product for a better deal elsewhere. Like how Joe would run himself out of business if he was selling the same lemonade as the others at a higher price. In the real world, buyers don't have perfect information. We have what marketers
tell us, who may or may not be overselling, and we have things like online reviews (many of which are fake), and recommendations from friends. We can comparison-shop products and their prices. While all of the tech we have nowadays has given us access to more information than ever before, it's also given us access to more products and services than ever before.

4. Buyers have complete information (think: price-compare on Amazon). In a market with perfect competition, there are no barriers to enter and exit the market. In the lemonade market, any kid could open up a lemonade stand with no startup costs. And if the market was too competitive, any kid could close their lemonade stand without worrying about trying to stick it out, since they already bought all of their lemonade-makin’ paraphernalia. When markets are easy to enter and exit, it keeps firms as price takers. If the lemonade kids...er, business owners...created an oligopoly, deciding to collude on price, new lemonade stands would pop up and undercut their plan. For instance, if Jill, Joe, and Sammy all agreed to sell their identical lemonade at a buck fifty instead of a buck, then new kids on the block (Jake, Jordan, and Sarah) might all open their own lemonade stands, charging the usual one dollar. Jill, Joe, and Sammy would then either have to lower their prices back to a dollar...or go out of business.

5. There are no barriers to entering the market as a seller (eBay and others take 30 seconds to fill out a form and you're in, more or less). Perfect competition is only a theoretical Thing, pretty useless for the real world. It's just a good model on which to riff, because it gives you a bar under which to compare the real world, showing you just how imperfect competition is. It’s true; in the real world, nothing’s perfect, and markets are no exception. Perfect competition is a hypothetical market structure, one where no firms are undercutting each other, and consumers never get ripped off. While perfect competition doesn’t exist in the real world, it’s a useful bar to compare other market structures to, like oligopolies, monopolies, monopolistic competition, etc. There are only small firms in perfectly competitive markets...definitely no oligopolies, monopolies, or...Amazons. Which would mean Jill, Joe, and Sammy all have a small share of the regular-ol'-lemonade market. In the real world, firms are incentivized to grow, since it usually means they can benefit from increasing returns to scale, making more with less.

For example, in the real world, Jill's raspberry lemonade is able to sell at a lower price, because she owns about half of the lemonade market on Maple street. Actually, Jill ran Jamie's raspberry lemonade stand out of business, because Jill was selling her raspberry lemonade at a lower price than Jamie could afford to make hers. You know...like how Walmart, Target, Costco, and other big corporations ran their smaller Mom 'n' Pop shop competitors out of business. When there are a few firms (or one big one) in a market, it’s typically when they become oligopolies or monopolies, which makes them price makers instead of price takers.

So...to recap: perfect competition is a hypothetical market structure where: 1. There’s no differentiation in products, 2. Firms are price takers, 3. Buyers have complete information, 4. There are no barriers to enter or exit the market as a seller, and 5. All firms are small and modest.

Commodity markets like grain and oil are the closest things we have to perfect competition. There’s not too much differentiation happening, and buyer information is more complete in those markets than in most. We can use the concept of perfect competition to analyze what’s happening in imperfectly competitive markets, and why.

While perfect competition sounds great for consumers since it prevents price setting by firms, the real world isn't all that bad. Differentiation is great...without it, we wouldn't have Coke and Pepsi, Android and Apple. And economies of scale can make prices even lower than before. A world with complete information would be nice...but sometimes life hands you lemons. And you’ve got to know how to squeeze the juice out of ‘em.