There Is (Almost) No Such Thing As Perfect Competition

Neo-classicalists argue that the market will naturally come to an equilibrium known as perfect competition. In this ideal utopia everything will be perfect. Consumers get the lowest price, workers get a fair wage and businesses earn only ‘normal’ profits. No one is ripped off or exploited because no such nasty things occur. There is no poverty, unemployment, inflation or recessions. There is no need for government to intervene or even exist. While it does describe agriculture, it is completely irrelevant to the rest of the economy. It is a conservative’s dream, more like Narnia than the real world. Despite being taught in all textbooks and described as the economy without government interference, it is instead a deeply flawed theory. It is based upon 5 unrealistic assumptions that do not reflect the actual economy.

The 5 assumptions of perfect competition (as stated in textbooks) are:

  1. There are a large number of buyers and sellers in the industry and all have such a small market share that they cannot influence the market. This means every firm and consumer is a price taker.
  2. All goods are identical (homogenous)
  3. There are no barriers to entrance or exit of the market.
  4. Consumers have perfect information.
  5. All firms have equal access to resources and technology and there is constant or decreasing returns to scale

1. Due to the their tiny market share all buyers and sellers are price takers

This is the most crucial assumption of perfect competition; it is also the easiest one to disprove. In order for perfect competition to work there must be an enormous number of companies, perhaps numbering in the hundreds. Think for a moment, what industry is actually like this? What industry is comprised of hundreds of sellers equally small and insignificant? The only case where this applies is in agriculture. There are hundreds of carrot farmers for example, each with next to no market power. They sell to consumers with equally little market power, so in this case perfect competition does apply. However even this is being disrupted by the growth of massive agri-businesses in America who would have large market power. Likewise supermarket chains are using their market power to push down the price they pay farmers. In no other industry are there numerous firms, rather there are a small few. It is daft that so important a theory can be so easily rebuked simply by using your eyes.

2. All goods are identical

The theory requires that all goods be identical and considered identical. This way firms are only competing on price, so if one firm decreases its price then consumers will instantly flock to it. While this applies to agriculture and carrots, it doesn’t elsewhere. Firms actively try to differentiate their goods from others. This is done by either creating subtle differences or acting as though there are genuine differences. For example, manufacturers go to great lengths to prove their razor is different and better than the competitions. Or look at the vast number of different car models, each one slightly different from the next so that it is not possible to compete solely on price. This assumption ignores the fact that many companies actively compete based upon their product’s quality. The food industry is based upon similar food being served different ways so that restaurants compete more on quality than on price.

3. There are no barriers to entry or exit

According to the theory if firms in the industry are earning large profits then this will attract new firms to enter the market. Firms will keep entering the market until the profit is reduced to a ‘normal’ level (though it is never stated what this is or means).However there are barriers to entrance in almost all industries. Some of them are official limits on the number of entrants such as in medical and legal professions. However more commonly it is large set up costs that prevent new firms from entering an industry. For example there are only two Irish airlines (as opposed to hundreds) because there are enormous start up expenses involved in buying aircraft. While this may be the most obvious case, almost all industries involve set up expenses such as the purchase of equipment and buildings. These actively debar firms from expanding into new industries and are a major limit on the number of firms. It is also assumed that firms do not try to prevent new entrants by either colluding or reducing their prices in the short run to drive the new entrant bust.

  1. 4.      Consumers have perfect information

It is assumed that all consumers know everything there is to know. So if one firm lowers its price then consumers will find out very quickly. Consumers are assumed to have the knowledge to compare all businesses and pick the best one. Consumers are assumed to be able to distinguish quality differences between goods. If one firm sought to gain an advantage by charging a lower price but selling a lower quality good, they would be quickly found out. Needless to say, consumers do not know everything and can quite often be fooled by the market. For example advertising convinces people that two goods that are fundamentally the same are actually different. In some cases it convinces consumers that they should buy the inferior good. Consumers can and often are ignorant of the finer points of the goods they are buying (think cars) or may not be aware of which firm is selling the cheapest good or the best quality.

5. All firms have equal access to resources and technology and there is constant or decreasing returns to scale

The theory has other flawed assumptions that assume that all firms are on an equal level. Thus it is not possible for one firm to invent or adapt a new technology before its rivals; rather technology comes from an unknown source and is distributed simultaneously and equally. Likewise it is assumed that all firms use the same resources in identical ways, no firm may become more efficient than any others. Most importantly it is assumed there is no such thing as economies of scale. Seeing as this is the heart of the Industrial Revolution and capitalism itself this is absurd. If one firm did avail of economies of scale then it could sell goods at a lower price, increase its sales, which would allow it to become more efficient, allowing it to sell at a lower price, and so on until this firm dominated the market. Therefore for perfect competition to work there must be no economies of scale and instead have an industry full of mini cottage factories.

It is also assumed that there is no brand loyalty, that consumers will ditch their usual firm when it suits them. The theory assumes there is no advertising to convince people to buy a certain good they wouldn’t have otherwise bought. There are no transportation costs and all firms have equal access to the same markets so there is no local advantage. Perfect competition exists in a world where time stands still. There is no development of industry through increasing efficiency or new inventions. Firms do not save or invest in the future. If a firm makes a loss it goes bankrupt, without trying to weather the storm. It is a world where the word profit isn’t mentioned and treated like the sex during Victorian times, it has to happen but everyone pretends it doesn’t.

Perfect competition is the ideal of all conservatives and is the bedrock of neo-classical economics. Unfortunately it exists almost nowhere (agriculture is the only exception). It is a theory that exists only in the minds of its admirers and in the textbooks. It is nowhere to be found where it counts, in the real world. The economy is being compared to a fantasy. Perfect competition, like all dreams of perfection, should be acknowledged for what it is, a dream not the reality.


Filed under Economics

3 responses to “There Is (Almost) No Such Thing As Perfect Competition

  1. Hi Robert, good article. Couple of small comments – perfect competition market outcomes are possible in oligopolies, where the market concentration criterion for perfect competition is violated and there are only a few buyers or sellers. Arguably, supermarkets in the UK during their regular price wars, newspapers and perhaps airlines fall into this category. Each firm has market power, but when they all decide to try and beat each other on price and fight actively for market share, you get perfect competition-like prices and profit levels, to the benefit of consumers. This is quite common in the real world.

    My other comment is on the definition of ‘normal profits’. I agree it is ill-defined in textbooks generally, but it is the level of profit where firms already competing in a market are earning enough not to sell out and exit, but not enough to attract new entrants. This will vary by industry a bit, and is not particularly reflective of the real world where industry profit levels fluctuate with the cycle and supply / demand shocks. So it is a static definition, whereas the real world is never static. Not a totally useless concept though.

  2. Pingback: A New Economic Theory | Robert Nielsen

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