Putting It Together: Perfect Competition

Image of four juicy, red tomatoes on a countertop.

Healthy Red Tomatoes by EpSos.de, CC-BY.

Let’s return to the questions posed at the beginning of the module. Why do all tomatoes of the same type cost the same price in a farmer’s market? The answer is because a farmer’s market or a bunch of roadside tomato stands fit the characteristics of perfect competition: many firms (or sellers at the market), all selling a similar if not identical product, where it is easy for buyers and sellers to see what everyone is charging. In this situation, if one seller charged a higher price, none of the customers would do business with that seller, since they could get an identical product from another seller at the lower price. Why would a seller charge a lower price if they can sell all their inventory by the end of the day at the going price?

By contrast, why do different gas stations on the same strip of highway charge different amounts per gallon of gasoline? Why do different pizza restaurants charge different prices for the same product, say a large one topping pizza? We’ll learn the answers to these questions in future modules.

Finally, what’s so perfect about perfect competition? The answer is that perfect competition shows markets operating at their best. Perfect competition is productively efficient, because in the long run firms produce their products as cheaply as possible (i.e. at minimum average cost). What this means in a larger context is that the economy is operating on its production possibilities frontier, rather than inside the frontier.

It’s also allocatively efficient, meaning it’s producing the optimal quantity of output (i.e. where price equals marginal cost), because that quantity maximizes total economic surplus. What this means is that it’s producing at the right point on the production possibilities frontier.

There is a lot going for the model of perfect competition. As a result, it’s the model we typically use to compare real world industries against. We’ll take a look at these real-world industries next.