The structure of the market has a significant impact on the efficiency with which firms operate and the profits they generate but before we consider the results of a perfectly competitive market let's have a look what one is in a little more detail.
For a market to be perfectly competitive a number of things must be true. These are listed in the presentation at the bottom of the page so we will not discuss them all now but there are 3 major features to consider:
Infinite numbers of buyers and sellers: This is important because it means that there is lots of choice. Buyers can buy from whomever they like and sellers can sell to whoever they wish. This means that no one buyer or seller will be able to affect the price. If a seller were to increase the price then buyers would simply go elsewhere, provided that there were no transaction/transport costs that might make one seller preferable to another
Perfect information: This means that buyers and sellers all know the various prices goods are on offer for and how much the product is worth. Sellers also know about all the production techniques that their competitors are using.
No barriers to entry: If there is nothing to stop a new firm entering the market, for example no large setup costs, then any time it is possible to make a profit new firms will enter the market. You will remember from AS that if more firms enter the market the supply curve shifts out and the price falls, reducing the profit to zero.
There are other features required of a perfectly competitive market but these are the main ones. If all these things are true then we will have the most competitive market we can possibly imagine:
- If a firm put it's price up by just a penny then, perhaps because they are inefficient, buyers would simply go elsewhere and the inefficient firm will have to become efficient or go out of business.
- If costs fall and firms make a profit, new firms will come in and compete away the profit.
- If someone makes a better product then everyone else knows about it and will copy it - there is no patent system because that is a barrier to entry.
The most important result, though, is that firms will be productively and allocatively efficient.
Productively efficient: This means that they are working at their lowest possible average cost. There is no waste at all. If there were then someone else would do it more efficiently, be able to sell for a lower price and take all the customers.
Allocatively efficient: This means that firms are not just making things without waste but also in the right amounts. They keep making more until the benefit that consumers get from the next unit (marginal benefit) is the same as the cost of making it (marginal cost).
If you are not to sure what all that means, have a look at the page on economic efficiency (just search for 'efficiency').
The presentation below will take you through in a little more detail, including how to draw the diagram for perfect competition. Don't forget to print off the work sheet using the button at the bottom of the page so that you can work along with it.
