Characteristics of Perfect Competition

Perfect competition describes a market for goods and services with specific conditions leading that market to an equilibrium, or state in which economic forces are in balance, at the point where the price of a good or service is equal to its marginal cost. Marginal cost (MC) is the additional cost that a firm incurs by producing an additional unit of output, which must be covered in order to remain operational in the short run (for example, if a screw factory already has all the equipment it needs to manufacture screws, the marginal cost of a single screw will simply be the cost of the materials to make the screw plus the labor necessary to manufacture it).

These conditions are never found to hold completely in real-world markets, although there are some that come close. An example is the agricultural market for products such as corn or rice, where the individual units of a good—a grain of rice or kernel of corn—truly are identical and interchangeable. Thus, perfect competition remains a theoretical construct used only for making comparisons to real-world markets, which may have factors such as monopoly or other barriers to entry that create imperfect competition. Analyzing the differences between a real-world market and a state of perfect competition is one way to understand why that real-world market behaves as it does.

Perfect competition has the following conditions:

• Many buyers and many sellers exist for each good or service offered in the market, none of whom are large enough to affect market prices on their own.
• No barriers to entry (external factors that make it difficult to begin production and sales of a good, such as excessive regulation or monopoly) to the market exist, either for buyers or for sellers.
• The buyers and sellers are in a state of perfect knowledge, a theoretical state in which all participants in a market know everything about price, supply, and so on.
• The products are identical, which allows for infinite substitution and perfect efficiency.
• Equivalent products offered by different sellers are equal in value.
• Every seller is a price taker, meaning they must accept the market price for goods and services, as opposed to having market power, which is the ability of a supplier to set the market price and control the amount of the good or service available to consumers.
• There are no transaction costs; in other words, the act of making an exchange in the market does not come with additional fees.

In a state of perfect competition, economic profit (the amount left over from total revenue once explicit and implicit costs are subtracted) tends toward zero, because if profit is being earned from sales of a product, competitors will enter the market to claim that profit. The competition causes sellers to lower their prices to retain customers, and this process continues until the price is so low that economic profit approaches zero. When economic profit approaches zero, no new competitors are motivated to enter the market. Even if economic profit is zero, producers and sellers may earn normal profit, which is an economic situation wherein a firm's total revenue is equal to its total cost. Normal profit provides compensation for the opportunity cost (the value or benefit of the next best alternative given up when making a choice) of producing and selling their products.