‘Perfect Competition’ (also known as ‘pure competition’) in economics is an ideal form of an industry where price competition is not only dominant but also the only form of competition available or possible. The concept and terminology is quite popular and yet, is not completely universal.
For any industry to have perfect competition, it should have the four characteristics that define the structure of perfect competition.
1. Many buyers and sellers
2. A homogeneous product
3. Free entry
4. Sufficient knowledge
Many buyers and sellers
In perfect competition, a number of businesses (goods or service providers) compete with each other for gaining the attention of customers,
but, there is no single business that dominates the market to such an extent that it sets the standards in terms of pricing of the concerned good or service. Markets fitting this condition usually have large number of sellers catering to the needs of a sizable amount of consumer market and compete actively or rigorously with each other for the business of the consumers.
Say, if I am a seller in such a market, I am bound to think, ‘ if I try to change the price of the product I sell to a price higher than that of the market, then my customers will turn to my competitors for that product. Since my share of the market is small and I do not control the market, my customers will buy what they want from my competition and I will be left with no customers’. Due to this, the sellers and buyers in the market are discouraged from even trying to control prices in the market and instead encourages them to compete with each other, which in turn drives the price of the good or service to the equilibrium of supply and demand.
A homogeneous product
‘Homogeneous product’ applies that all the suppliers sell goods or services that are perfect substitutes of each other. The customers may be reluctant to switch if a seller raised the price of the product in the scenario that there are different sellers that sell different products. The customer will mostly stay with the same supplier even though the prices are high because they like the good or service of their current firm better than that of another entity or firm. The homogeneity of products encourages price competition by ruling this out.
First and foremost a legal condition, free entry means that in ‘perfectly competitive’ markets there are no restrictions on the entry of a new business to compete with established businesses. Hence a new company, if its feels that the investment is justified (due to high profits), can set up is its business without any governmental restrictions.
A few structures of the ‘perfect competition’ model include an additional factor known as ‘perfect knowledge’. However, we know that such a thing as ‘perfect knowledge’ does not exist. Hence, we cannot assume that the customer knows everything about the good or service, whereas, it is important that the producer/seller and the consumer both know of the options and opportunities available to them.
We discussed earlier about the ‘many sellers and buyers’ and according to that characteristic a seller will know if some competitor is selling the good or service cheap. If the consumer on the other hand does not know that there exists a seller who is selling the good or service cheaper than what he/she is paying for, the current seller might get away with even increasing the price, without loosing out many customers. This characteristic assumption complements the others assumptions like the assumption that there are many buyers and sellers and the assumption of free entry and translates into the buyers and sellers knowing of the potential buyers and sellers that they can choose from. Sufficient knowledge simply assumes that they know of those buyers and sellers.
There are however, some drawbacks related to perfect competition. Consumer, especially those reluctant to try new things or brands, might feel intimidated by the sheer number of options available to them. In such a case, the potential of doing business with each consumer is diminished and this can ultimately limit the entry of new firms. Also, there is a lack of a single company that is big enough to drive the market prices in such a marketplace. This also translates to the absence of a single big entity to set the standards for other companies in terms of the goods and services of that market. The other repercussion of this would be that there would be wide differences in the quality of the product and even its pricing. This would mean that good or services of higher quality will be offered along other products of inferior quality. The industry watchdogs that focus on quality would find this as unhealthy.