In economics, specifically general equilibrium theory, a perfect market, also known as an atomistic market, is defined by several idealizing conditions, collectively called perfect competition, or atomistic competition. In theoretical models where conditions of perfect competition hold, it has been demonstrated that a market will reach an equilibrium in which the quantity supplied for every product or service, including labor, equals the quantity demanded at the current price. This equilibrium would be a Pareto optimum.Gerard Debreu, Theory of Value: An Axiomatic Analysis of Economic Equilibrium, Yale University Press, New Haven CT (September 10, 1972).
Perfect competition provides both allocative efficiency and productive efficiency: Such markets are allocatively efficient, as output will always occur where marginal cost is equal to average revenue i.e. price (MC = AR). In perfect competition, any profit-maximizing producer faces a market price equal to its marginal cost (P = MC). This implies that a factor's price equals the factor's marginal revenue product. It allows for derivation of the supply curve on which the neoclassical approach is based. This is also the reason why a monopoly does not have a supply curve. The abandonment of price taking creates considerable difficulties for the demonstration of a general equilibrium except under other, very specific conditions such as that of monopolistic competition. In the short-run, perfectly competitive markets are not necessarily productively efficient, as output will not always occur where marginal cost is equal to average cost (MC = AC). However, in the long-run, productive efficiency occurs as new firms enter the industry. Competition reduces price and cost to the minimum of the long run average costs. At this point, price equals both the marginal cost and the average total cost for each good (P = MC = AC).
The theory of perfect competition has its roots in late-19th century economic thought. Léon WalrasGroenewegen, Peter. "Notions of Competition and Organised Markets in Walras, Marshall and some of the Classical Economists." gave the first rigorous definition of perfect competition and derived some of its main results. In the 1950s, the theory was further formalized by Kenneth Arrow and Gérard Debreu.
Imperfect competition was a theory created to explain the more realistic kind of market interaction that lies in between perfect competition and a monopoly. Edward Chamberlin wrote "Monopolistic Competition" in 1933 as "a challenge to the traditional viewpoint that competition and monopolies are alternatives and that individual prices are to be explained in either terms of one or the other" (Dewey,88.) In this book, and for much of his career, he "analyzed firms that do not produce identical goods, but goods that are close substitutes for one another" (Sandmo,300.)
Another key player in understanding imperfect competition is Joan Robinson, who published her book "The Economics of Imperfect Competition" the same year Chamberlain published his. While Chamberlain focused much of his work on product development, Robinson focused heavily on price formation and discrimination (Sandmo,303.) The act of price discrimination under imperfect competition implies that the seller would sell their goods at different prices depending on the characteristic of the buyer to increase revenue (Robinson,204.) Joan Robinson and Edward Chamberlain came to many of the same conclusions regarding imperfect competition while still adding a bit of their twist to the theory. Despite their similarities or disagreements about who discovered the idea, both were extremely helpful in allowing firms to understand better how to center their goods around the wants of the consumer to achieve the highest amount of revenue possible.
Real markets are never perfect. Those economists who believe in perfect competition as a useful approximation to real markets may classify those as ranging from close-to-perfect to very imperfect. The real estate market is an example of a very imperfect market. In such markets, the theory of the second best proves that if one optimality condition in an economic model cannot be satisfied, it is possible that the next-best solution involves changing other variables away from the values that would otherwise be optimal.
In modern conditions, the theory of perfect competition has been modified from a quantitative assessment of competitors to a more natural atomic balance (equilibrium) in the market. There may be many competitors in the market, but if there is hidden collusion between them, the competition will not be maximally perfect. But if the principle of atomic balance operates in the market, then even between two equal forces perfect competition may arise. If we try to artificially increase the number of competitors and to reduce honest local big business to small size, we will open the way for unscrupulous monopolies from outside.Lordkipanidze, Revaz. "Theory of Perfect Competition": 2024: 148 (4-6; 9-10): (PDF),
Idealizing conditions of perfect competition The definition of perfect competition is when the following conditions all hold:Bork, Robert H. (1993). The Antitrust Paradox (second edition). New York: Free Press. .
A large number of sellers and buyers – A large number of consumers with the willingness and ability to buy the product at a certain price, and a large number of producers with the willingness and ability to supply the product at a certain price. As a result, individuals are unable to significantly influence prices.Gretsky, Neil E, Ostroy, Joseph M & Zame, William R, 1999. Perfect Competition in the Continuous Assignment Model. Journal of economic theory, 88(1), pp.60–118. One requirement for this is non-increasing returns to scale (including network effects), ensuring that a monopoly doesn't push out competitors. Homogeneous products: The products are perfect substitutes for each other (i.e., the qualities and characteristics of a market good or service do not vary between different suppliers). Utility maximizing participants: Rational buyers always attempt to maximize their economic utility and sellers attempt to maximize their profit. Perfect information: All consumers and producers know all prices of products and utilities they would get from owning each product. Zero transaction costs: Buyers and sellers do not incur costs in making an exchange of goods. This includes no barriers to entry or exit (no sunk costs) and perfect factor mobility where the factors of production are perfectly mobile and costlessly, allowing workers to freely move between firms and other adjustments to changing market conditions.Robinson, J. (1934). What is perfect competition?. The Quarterly Journal of Economics, 49(1), 104-120. No externalities: Costs or benefits of an activity do not affect third parties. This criterion also excludes any government intervention. Well defined property rights: These determine what may be sold, as well as what rights are conferred on the buyer.
While no real market is perfect, many markets are considered to be near enough to perfect for predictions from economic theory to be reasonably accurate. It has been proven that if the above conditions hold, that every participant will be a price taker and will not have market power to set prices, and all sellers will operate such that their marginal costs equal their marginal revenue.
There are many instances in which there exist "similar" products that are close substitutes (such as butter and margarine), which are relatively easily interchangeable, so that a rise in the price of one good will cause a significant shift to the consumption of the close substitute. If the cost of changing a firm's manufacturing process to produce the substitute is also relatively "immaterial" in relationship to the firm's overall profit and cost, this is sufficient to ensure that an economic situation isn't significantly different from a perfectly competitive economic market.Roger LeRoy Miller, "Intermediate Microeconomics Theory Issues Applications, Third Edition", New York: McGraw-Hill, Inc, 1982. Edwin Mansfield, "Micro-Economics Theory and Applications, 3rd Edition", New York and London:W.W. Norton and Company, 1979. Henderson, James M., and Richard E. Quandt, "Micro Economic Theory, A Mathematical Approach. 3rd Edition", New York: McGraw-Hill Book Company, 1980. Glenview, Illinois: Scott, Foresmand and Company, 1988. John Black, "Oxford Dictionary of Economics", New York: Oxford University Press, 2003. Tirole, Jean, "The Theory of Industrial Organization", Cambridge, Massachusetts: The MIT Press, 1988.
Normal profit In a perfect market the sellers operate at zero economic surplus: sellers make a level of return on investment known as normal profits.
Normal profit is a component of (implicit) costs and not a component of business profit at all. It represents all the opportunity cost, as the time that the owner spends running the firm could be spent on running a different firm. The enterprise component of normal profit is thus the profit that a business owner considers necessary to make running the business worth while: that is, it is comparable to the next best amount the entrepreneur could earn doing another job.Carbaugh, 2006. p. 84. Particularly if enterprise is not included as a factor of production, it can also be viewed a return to capital for investors including the entrepreneur, equivalent to the return the capital owner could have expected (in a safe investment), plus compensation for risk.Lipsey, 1975. p. 217. In other words, the cost of normal profit varies both within and across industries; it is commensurate with the riskiness associated with each type of investment, as per the risk–return spectrum.
In circumstances of perfect competition, only normal profits arise when the long run economic equilibrium is reached; there is no incentive for firms to either enter or leave the industry.Lipsey, 1975. pp. 285–59.
In competitive and contestable markets
Economic profit does not occur in perfect competition in long run equilibrium; if it did, there would be an incentive for new firms to enter the industry, aided by a lack of barriers to entry until there was no longer any economic profit. As new firms enter the industry, they increase the supply of the product available in the market, and these new firms are forced to charge a lower price to entice consumers to buy the additional supply these new firms are supplying as the firms all compete for customers (See "Persistence" in the Monopoly Profit discussion).Chiller, 1991.Mansfield, 1979.LeRoy Miller, 1982. Incumbent firms within the industry face losing their existing customers to the new firms entering the industry, and are therefore forced to lower their prices to match the lower prices set by the new firms. New firms will continue to enter the industry until the price of the product is lowered to the point that it is the same as the average cost of producing the product, and all of the economic profit disappears. When this happens, economic agents outside of the industry find no advantage to forming new firms that enter into the industry, the supply of the product stops increasing, and the price charged for the product stabilizes, settling into an equilibrium.