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Is perfect competition really perfect?

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This article was written by Matthew D.

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For those of you who don’t know, perfect competition is a hypothetical market structure in economic theory. A market structure refers the way in which we categorise a market depending on a set of defining conditions. One you may certainly have heard of is a ‘monopoly’, a market structure where the defining condition is that there is only one seller of a good or service. The defining conditions in a perfectly competitive market structure are:

1. Many buyers and many sellers (Unlike a monopoly, where there is only one seller)
2. Perfect information (Everyone in the market knows everything about everything; prices, sellers, production, attributes of the good in question)
3. Homogeneous product (Essentially means the product sold is identical in every way amongst sellers)

Whilst there are others, these are the most important for this piece, and without getting into the maths or thorny details, these conditions enable us to conclude that in such a market all firms would set an identical market price where supply meets demand and welfare is maximised.

This is deduced through an economic term called efficiency, which can mean several different things but can generally be taken to have positive connotations! Again, without wanting to drag you down with technical detail, once modelled a perfectly competitive market is seen to be highly economically efficient; for example, theoretically it maximises welfare and production potential in the long-run.

Continued below

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The interesting part is how economists and policy makers have often used this model as a benchmark. What I mean by this is that they know markets like this do not exist in the real world (largely because perfect information is near-impossible), but use this theoretically ‘perfect’ market as the standard to aim for. The thinking is that if we make real-world markets as close to this as possible, we will maximise efficiency, making us all happier and wealthier-hooray!

Of course, it is not nearly so simple. This article is really about discussing the trap we often fall into in Economics; thinking that a relatively simple1 and purely hypothetical model is an appropriate way to understand real-world markets and influence our decisions in managing both the economy and individual markets. So, let’s consider whether the above model of ‘perfect’ competition, where firms have identical products, prices and perfect information, will really result in something that delivers a ‘perfect outcome’.

Firstly, if we consider how a real perfectly competitive economy would look, then price-cutting and price wars between firms would cease to exist, as would branding, advertising, and every other means of product differentiation. This is because if the products are identical, there is no point branding or advertising them. Consumers also have perfect information, so they know that there is zero reason to choose one product over another based-on brand or advertising. As discussed, firms have identical prices so out go those frequent supermarket price wars! The point is that when we think of a competitive market we think of these actions; firms neck-and-neck in the race for consumers wallets, lots of different quality products with great variability in design and marketing campaigns.

A ‘perfectly’ competitive market thus sounds boring in comparison; firms don’t really compete with each other. There is no point as they can’t change prices or make their product seem better. They just sit there all selling the exact same thing at the exact same price!

Secondly, this would effectively mean the only form of competition we would see firms use in the chase for profit would be cost-cutting. This means when you try and reduce costs to make more money than your rivals in the market. An example might be research and development, where a firm tries to discover a new or cheaper way of making a product.

However, we must question whether even this form of everyday competition would occur in ‘perfect’ competition, as with perfect information any firm that spends money or effort finding a way to cut costs would enable all other firms to discover the same cost-cutting method (because everyone in the market knows about everything in the market), so profits would be minimal and temporary, leading to a lack of incentive to cut-costs in the first place. In simple terms, no firm would bother researching anything themselves because there would be no point if every other company gets immediate access to the same method. So, there would be no iPod, because Mr Jobs would have never bothered to develop the device if he thought Microsoft would then immediately be able to do the same thing. It begins to seem that actually a lack of perfectly competitive market conditions makes markets more ‘real-world’ competitive!

Additionally, from the perspective of a consumer things are pretty bleak. Thousands of options but each completely identical? This also does not sound like what we think of as a competitive market, it might as well be a monopoly broken up into lots of little suppliers instead of one big one. The good might be cheaper, there might be more of it, but there is no real choice.

In summary, we are arguing that the classic model of an efficient ‘perfect’ competition structure might, if applied literally, actually be a terrible example of a competitive market by the measures we use in real life. Suppliers would not ‘compete’ in any real-world sense, and buyers would not get a sense of a competitive market either, as all goods are identical. It is also simply interesting to look at the gap between what we can do with economic models, and what real life tells us markets are actually like. Perhaps it begs the question as to how Economists are so highly-regarded in policy-making when such flaws in our models exist?
I think this also has use as an argument in A-level studies, particularly when evaluating market structures, which is a very important skill at A-level. Essentially, perfect competition is seen as desirable over imperfect competition, for a range of different mathematical efficiency criteria. However, if we apply the concept to the real world rather than a mathematical diagram, we may instead find that perfect competition would fail to be at all desirable.

Relatively simple, that is, compared to the thing it is attempting to model

Contact Matthew D for more information.