13  Perfect

Perfect markets with perfect competition and perfect information are hard to spot in reality. However, it is a useful theoretical model that serves as a reference point for analyzing real-world markets. It provides valuable insights into market functioning and informs policymakers on how to address instances of market failure, where at least one assumption of perfect markets is not met.

The assumptions of perfect markets and perfect competition, respectively, are:

  1. Many buyers and sellers: In a perfectly competitive market, there are numerous buyers and sellers, none of whom have a significant influence over market price. Each participant is a price taker, meaning they have no control over the price at which goods or services are exchanged.

  2. Homogeneous products: The products offered by all firms in a perfectly competitive market are identical or homogeneous. Consumers perceive no differences between the goods or services provided by different sellers. As a result, buyers base their purchase decisions solely on price.

  3. Perfect information: All buyers and sellers in a perfectly competitive market have complete and accurate information about prices, quality, availability, and other relevant factors. This assumption ensures that market participants can make rational decisions and respond efficiently to changes in market conditions.

  4. Free entry and exit: Firms can freely enter or exit the market in response to profits or losses. There are no barriers to entry or exit, such as legal restrictions or substantial costs, that prevent new firms from entering the market or existing firms from leaving it.

  5. Perfect mobility of factors of production: The resources used in production, such as labor and capital, can move freely between different firms and industries. There are no constraints on the mobility of factors of production, allowing firms to allocate resources efficiently.

  6. Profit maximization: All firms in a perfectly competitive market are profit maximizers. They aim to maximize their profits by adjusting their output levels based on prevailing market conditions. If firms can increase their profits, they will expand production, and if they incur losses, they will reduce output or exit the market.

  7. No externatlities: There are assumed to be no externalities, that is no external costs or benefits to third parties not involved in the transaction.

These assumptions collectively define perfect competition and form the foundation of its analysis. If all conditions are fulfilled, there is no need for government regulation. Welfare is maximized and no pareto-improvement can be achieved.

Theory would predict that if firms in an industry would make some profits, new firms will enter the market or existing firms would produce more which both yields an increase in supply. That, in turn, will drive down market prices until all firms earn zero profits and no more firms would have an incentive to enter the market. In the equilibrium, total revenue equals total cost. Thus, firms do not make profits. Firms can only make profits if they have some sort of competitive advantage and hence are not price takers which would be against assumption 1. The most extreme form of competitive advantage is a monopoly. It describes that one firm is the only provider of a certain good or service. This firm can set prices and the supply of the good and service completely. We will discuss that extreme case in the next section.