Perfect competition is an ‘ideal type’ of theoretical market structure which economists use as a benchmark to compare to real-world markets. It is defined by several idealizing conditions:

There is a large number of small independent firms in the industry. Therefore, no firm can hold a substantial share of the market
There is zero barriers to entry or exit. That is, firms are free to enter or exit the industry without facing hindrances such as high start-up costs, government regulations or industry patents which could prevent newcomers from participating in the market
All firms in the industry sell identical or homogenous products. This means that the products of one firm cannot be differentiated from the products of another firm in the same industry and there is no branding
All firms are price-takers. As such, any firm which deviates from the market price will lose all of its sales to its competitive rivals. Thus, no single firm can influence the market price of a product

Perfect competition as an ‘ideal type’

Perfect competition is not intended to be a description of real-world markets; it is an ‘ideal type’ used for comparison. Indeed, almost all markets substantially differ from the conditions described above. However, there are a small number of industries which can approximate perfect competition. For example, at a farmers’ market there are many small vendors selling nearly indistinguishable commodities, such as fruits and vegetables, and at very similar prices to one another.

Normal profit, supernormal profit and negative profit

In the long-run equilibrium of perfect competition, firms will earn a normal profit. This is a situation where revenues are just enough to cover total costs, and therefore firms will earn zero profit. However, the owner will still derive a salary from the operation of the firm which is factored into total costs. Thus, there is no reason to close down the business even when profit is at zero.

In the short-run, in addition to earning a normal profit, firms are also able to earn an abnormal profit (aka. supernormal profit) or a negative profit. Abnormal profit is a situation where revenues are greater than total costs, and therefore firms will make a profit. A negative profit is a situation where revenues are less than total costs, and therefore firms will make a loss.

Causes of normal profit in the long-run

If firms are earning an abnormal profit, in the long-run more competition will enter the market. This will put downward pressure on the market price, until all firms are earning a normal profit again. Conversely, if firms are earning a negative profit, in the long-run many owners will choose to shut down their business. This will put upward pressure on the market price, until all firms are earning a normal profit again.

Efficiency under perfect competition

By definition, firms under perfect competition exist in a highly competitive market. Due to the condition of being price-takers, firms that have a high cost of production will be unable to make a profit. Moreover, firms which are unable to respond quickly to changes in consumer preferences will face difficulties selling their products and services. In both cases, such firms will be quickly driven out of business and their resources will flow to more efficient firms.

As a result, the conditions of perfect competition are expected to maximize both productive efficiency and allocative efficiency. Productive efficiency refers to a level of production where the production point sits anywhere along the curve of the production possibility frontier (PPF). Allocative efficiency means that the production point sits at a point along the PPF curve where marginal benefit is equal to marginal cost. That is, the industry is producing the ‘right’ quantity of the good according to the wants of the society.

Author Profile

Luke Watson

Luke Watson has a BSc (Hons) in international business and economics. He is currently working as an IBDP economics teacher at Shanghai United International School in China.