Perfect competition | Microeconomics | Khan Academy

In our study of the different types of markets, we are now going to dive a little bit deeper and understand perfect competition. Now, this notion of something being perfectly competitive, you might have a general idea of what it means. You might feel like it's very competitive, that there's a lot of people there maybe competing for your business, or maybe there's a lot of buyers and there are a lot of sellers. That is generally true, but we're trying to be economists here, so we want to be very precise with our language.

When economists talk about perfect competition, they're talking about this somewhat very abstract state where you have many buyers and sellers. Many sellers and buyers. Now, that doesn't seem too abstract so far. We can imagine a lot of markets that have many sellers and buyers. Now another thing that defines perfect competition from an economics point of view is that they're selling identical products or services. Products, products, or services.

Now, this one seems a little bit harder because even when you can imagine a fairly competitive market, does everyone sell exactly the same thing? Well, you can imagine certain markets — maybe the market for water, or maybe the market for some type of energy, or maybe the market for produce — gets pretty close to identical products or services. So, so far, it doesn't seem like that abstract of a thing.

Now, another aspect of perfect competition is that every agent — so that would be the buyers, the sellers, the producers, the consumers — they have perfect information. Perfect information. Now, what does perfect information mean? It means that every participant in the market, the buyers and the sellers, they all know exactly what is happening in the market. So, what goods or services are selling for what price, and who is selling to whom?

So, once again, this gets a little bit more abstract because to get truly perfect information, you can't. Not everyone in a market will always know everything that's going on. So, once again, this is a little bit of an abstract idea that economists have introduced to be a little bit more precise.

The last aspect we're going to talk about, and this is also something that is a bit idealized that doesn't truly exist in the real world — some things close to this exist in the real world — is that there's no barriers to entry or exit. Now, we already mentioned some markets, say the market for agriculture, that doesn't quite have no barriers to entry or exit. You would somehow have to get land, you would have to get seeds, you would have to get fertilizer, you would have to hire people to put the seeds in and to harvest the crops.

Almost any industry, any market you imagine, will have some barriers, but this is an idealized notion that economists like to think about. Of course, in the real world, things might approach this or be closer to perfect competition than, say, other markets. But when you're in this situation, let's analyze what will be happening.

So, we can look at the market as a whole for whatever this product and service. So, let me draw price versus quantity here for the market as a whole. So, this is price, and this is quantity. And this is the market right over here. And so, we've seen this multiple times in our economics journey that you have an upward sloping supply curve. And once again, this is for the entire market.

Let me do this in a different color. So, you have an upward sloping supply curve like that, and you would have a downward sloping demand curve like that. And we know what the equilibrium price and quantity would be for the market. So, this right over here would be the equilibrium quantity for the market, and this right over here would be the equilibrium price for the market.

Now, how would this affect the decisions for the firm in perfect competition? Well, let's draw a similar analysis, but now at the firm level. So, on this axis, you could view this for the firm, and so this is going to be the firm right over here — one of the participants in the perfect competition, one of the producers, one of the sellers.

So, on this axis, you could view this as price, you could also view this as marginal revenue, and you could also view this as marginal cost because we're going to plot different curves here. And then, on the horizontal axis, we're going to have quantity again, but this is once again the quantity that the firm produces.

Now, first of all, we can think about the marginal cost for the firm. And we've seen this multiple times that the marginal cost for the firm might look something like this. It over time might trend upwards, something like this, where at some point every incremental unit is costing more and more to produce. Maybe it's harder to get the resources, harder to get the labor, or whatever you want to say. So, that's the marginal cost curve — fairly typical for a firm.

Then we could think about their average total cost. And so, the average total cost curve might look something like this — let's draw it something like this. So, our average total cost, we've seen this multiple times. Now, what is going to be the marginal revenue for this firm that is operating in perfect competition?

Well, when it's operating in perfect competition, it just has to be a price taker. So, every unit it sells is just going to get the market price for that unit. So, in perfect competition, the firm — every participant that is really identical in a lot of ways — they're just going to take that price. Think about it. They won't be able to charge any more for their product or service than the market price because their product or service is identical to everyone else's, and everyone knows it because of perfect information.

They would have no motivation to charge less either; they're just passive. You could view it that way when it comes to price. So, if we just take this market price across just like that, this right over here, this price is going to define the marginal revenue curve for that firm. So, let me make this a bold curve right over here.

This is going to be the marginal revenue for the firm. For every unit it sells on the margin, that's how much more revenue it's going to get. Now, you could also view this as the demand curve for the firm's product. You could also view this as the average revenue for the firm's product. And let me make this clear: this is for the firm, demand for the firm, which is equal to the price that the firm actually gets.

So, the big takeaway here is in perfect competition, which is this somewhat idealized state that doesn't quite exist in the real world — certain markets can approach it — the firms are passive price takers. They have no say on what the price is going to be, and so it would be rational for them to just produce where their marginal cost intersects with their marginal revenue because anything more than that, then for every incremental unit they're going to be spending more money than they get in terms of revenue.

This passivity goes a little bit against some of our everyday notions of fierce competition. When we think about fierce competition, we often think about many players trying to constantly undercut each other. In future videos, we'll talk about scenarios where that might happen. You might think about whether or not you would want certain markets to have perfect competition because no barriers to entry means that, frankly, anybody could get into that industry.

So, for example, you might not want perfect competition when it comes to someone being, say, your doctor because you want barriers to enter. You want some level of training; you want some level of experience before someone gets into that service.