Perfect Competition - Approaches and Conditions

Approaches and Conditions

In neoclassical economics there have been two strands of looking at what perfect competition is. The first emphasis is on the inability of any one agent to affect prices. Usually justified by the fact that any one firm or consumer is so small relative to the whole market that their presence or absence leaves the equilibrium price very nearly unaffected. This assumption of negligible impact of each agent on the equilibrium price has been formalized by Aumann (1964) by postulating a continuum of infinitesimal agents. The difference between Aumann's approach and that found in undergraduate textbooks is that in the first, agents have the power to choose their own prices but do not individually affect the market price, while in the second it is simply assumed that agents treat prices as parameters. Both approaches lead to the same result.

The second view of perfect competition conceives of it in terms of agents taking advantage of – and hence, eliminating – profitable exchange opportunities. The faster this arbitrage takes place, the more competitive a market. The implication is that the more competitive a market is under this definition, the faster the average market price will adjust so as to equate supply and demand (and also equate price to marginal costs). In this view, "perfect" competition means that this adjustment takes place instantaneously. This is usually modeled via the use of the Walrasian auctioneer (see article for more information). The widespread recourse to the auctioneer tale appears to have favored an interpretation of perfect competition as meaning price taking always, i.e. also at non-equilibrium prices; but this is rejected e.g. by Arrow (1959) or Mas-Colell et al.

Steve Keen notes, following George Stigler, that if firms do not react strategically to one another, the slope of the demand curve that a firm faces is the same as the slope of the market demand curve. Hence, if firms are to produce at a level that equates marginal cost and marginal revenue, the model of perfect competition must include at least an infinite number of firms, each producing an output quantity of zero. As noted above, an influential model of perfect competition in neoclassical economics assumes that the number of buyers and sellers are both of the power of the continuum, that is, an infinity even larger than the number of natural numbers. K. Vela Velupillai quotes Maury Osborne as noting the inapplicability of such models to actual economies since money and the commodities sold each have a smallest positive unit.

Thus nowadays the dominant intuitive idea of the conditions justifying price taking and thus rendering a market perfectly competitive is an amalgam of several different notions, not all present, nor given equal weight, in all treatments. Besides product homogeneity and absence of collusion, the notion more generally associated with perfect competition is the negligibility of the size of agents, which makes them believe that they can sell as much of the good as they wish at the equilibrium price but nothing at a higher price (in particular, firms are described as each one of them facing a horizontal demand curve). However, also widely accepted as part of the notion of perfectly competitive market are perfect information about price distribution and very quick adjustments (whose joint operation establish the law of one price), to the point sometimes of identifying perfect competition with an essentially instantaneous reaching of equilibrium between supply and demand. Finally, the idea of free entry with free access to technology is also often listed as a characteristic of perfectly competitive markets, probably owing to a difficulty with abandoning completely the older conception of free competition. In recent decades it has been rediscovered that free entry can be a foundation of absence of market power, alternative to negligibility of agents.

Free entry also makes it easier to justify the absence of collusion: any collusion by existing firms can be undermined by entry of new firms. The necessarily long-period nature of the analysis (entry requires time!) also allows a reconciliation of the horizontal demand curve facing each firm according to the theory, with the feeling of businessmen that "contrary to economic theory, sales are by no means unlimited at the current market price" (Arrow 1959 p. 49). Sraffian economists see the assumption of free entry and exit as characteristic of the theory of free competition in Classical economics, an approach that is not expressed in terms of schedules of supply and demand.