Learn all about efficiency of perfect competition in just a few minutes! Professor Jadrian Wooten of Penn State University explains how perfect competition leads to maximum efficiency.
The theoretical situation of perfect competition is called perfect because it leads to maximum efficiency in the marketplace.
Perfect competition is called perfect because under the market conditions it describes, both allocative efficiency, an economic state in which production matches consumer preference, and productive efficiency, a situation where the maximum possible production of one good is achieved without harming production of another good, are maximized. Allocative efficiency is maximized because perfect competition leads to price being equal to marginal cost.
Because both allocative and productive efficiency are maximized, goods and services are produced at the lowest possible cost to consumers while producers are not suffering an economic loss. Therefore, the maximum possible sustainable quantity of goods and services is being produced where the demand for those goods and services exists.
Productive efficiency is also maximized because the equilibrium output stabilizes at the point of minimum average cost per unit. Producers with higher costs per unit are driven out of the market by competition; as market prices are the same across the industry, spending more to produce goods and services reduces profits.
In addition, because under perfect competition products across an industry are identical to other products of their kind, there is no opportunity for a producer to innovate or differentiate their product from their competitors' product. With identical products, no firm can gain a market advantage that would allow it to attain market power and manipulate prices without reference to supply and demand. Consequently, some economists believe that perfect competition is not the ideal market structure for encouraging research and development because the economic motivation for doing so does not exist.
Although a state of perfect competition may lead to maximum efficiency, it is a fragile state. If any of the conditions of perfect competition cease to be in place, the markets may become unstable or vulnerable to manipulation and to the hoarding of market power by producers.
In the real world, perfect competition is rare. The stock market for large companies' shares satisfies the conditions for perfect competition. Likewise, some commodity crops (crops that are traded) that are graded, such as #1 red hard winter wheat or West Texas light sweet crude oil, are traded in perfectly competitive markets. However, many companies will not always produce at a minimum of average cost, and prices will not always be equal to marginal cost. Perfect knowledge of the market will never be attainable, and producers and consumers will always make decisions based on other factors in addition to maximizing economic value. For that matter, it is important to remember that maximum efficiency will not always equal maximum desirability from a human perspective.