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6.3: Perfect Competition

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    Perfect competition is a market structure in which firms face intense competition. It is easy for firms to join and exit the industry, the product is homogenous, and there are many small firms competing for a tiny share of the market.

    Based just on the competitive situation, you could assume that a firm in an industry which is perfectly competitive has a bleak outlook for economic profit.

    Economic Profit

    Most textbooks discuss economic profit by contrasting it to accounting profit. However, there is another way of looking at it. Think of economic profit as a level of profit that is larger than the average level of profit (sometimes referred to as normal profit). Since economic profit is above average, it is difficult to achieve for most firms and, more importantly, it attracts attention to the firms earning it.

    The perfectly competitive market structure is not very realistic. There are no industries that fit the perfect competition criteria. But there are some industries that come close. Some agricultural industries are the closest example in today's economy. The rice grown by one farmer is virtually identical to the rice grown by another farmer, and the current market controls the price the farmers receive for their crops.

    Because of intense competition, a firm in a perfectly competitive industry has zero chance of earning an economic profit in the long run. Now, it is possible for a firm to earn an economic profit in the short run, but because there are no barriers to entering the industry, new competitors can join the industry and contribute to the erosion of industry-wide profit.

    Think of economic profit as treasure. If a knight, in medieval times, discovered a chest full of treasure and his rivals got word of this discovery then it would be impossible for our knight to defend his share of the treasure. See figure 6.

    A cartoon of a knight and a treasure chestDescription automatically generated

    Figure 6

    The only way a medieval knight or a firm in a perfectly competitive industry can keep their bounty is to erect barriers to keep the competition out. For example, our knight could build walls around his treasure. See figure 7.

    A group of people in armor holding a chestDescription automatically generated with medium confidence

    Figure 7

    Unfortunately, perfectly competitive firms cannot erect barriers to keep new competitors out of the industry and therefore cannot protect their short-run profits. Later in this module we will discuss the process in which market entry will exert downward pressure on market prices and eliminate all economic profit.

    This page titled 6.3: Perfect Competition is shared under a not declared license and was authored, remixed, and/or curated by Martin Medeiros.

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