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Efficiencies of Perfect Competition and Sources of Market Failure

Updated on July 16, 2014
Perfect Competition
Perfect Competition

The U.S. economy is known to be one of the most complex and advanced markets in the world, but with that being said there is still much room for improvements in every industry. There are two extreme market conditions that are regularly used by economist to compare current market situations. The first condition is perfect competition in a market. This is basically a market running perfectly with large positive outcomes. The second condition is a market failure. This is essentially an inefficient market with many negative outcomes. One condition is at the positive extreme and one is at the negative extreme. The U.S. economic state right now, is in between the two extremes, fluctuating all the time, depending on events in the market. I will explain each extreme condition in greater detail, starting with perfect competition.


Perfect competition is a market form where buyers or sellers have no power to influence the price of a specific product or service. There would be no room for monopolies or oligopolies in a perfect competition, because both have influence over price. Perfect competition would lead to a completely efficient market.


Barron’s (2006) defines perfect competition as the following:

Market condition wherein no buyer or seller has the power to alter the market price of a good or service. Characteristics of a perfectly competitive market are a large number of buyers and sellers, a homogeneous (similar) good or service, an equal awareness of prices and volume, an absence of discrimination in buying and selling, total mobility of productive resources, and complete freedom of entry. Perfect competition exists only as a theoretical ideal. Also called pure competition.

Barron’s definition states the characteristics that play significant roles in the achievement of an actual perfect competition. The first characteristic stated is a large amount of buyers and sellers. When there is a large number of buyers and sellers everyone has a small part of the market, leaving no one group or person with power over prices. This is beneficial to the market as a whole. The next characteristic is when all goods in a market are similar, so consumers don’t have a preference for one product over another. Without a company being able to gain favoritism from a product, it inhibits its ability to control the price, which is good for the overall market. An equal awareness of prices and volume is the next contributing characteristic. When all buyers and sellers are aware of the market prices and volumes, sellers will not be able to overcharge for a product or service because the buyer will be educated enough to make the decision of buying somewhere else, where the price is fare. The absence of discrimination in buying and selling is another characteristic that is important because in order for the market to act perfectly there cannot be favoritism towards others. If some were favored, it would leave others less fortunate creating an advantage. In a perfect competition there can be no advantages in the marketplace. The last characteristic mentioned is the total mobility of resources and complete freedom of entry. There cannot be any barriers inhibiting a future seller to start a business in a certain market. If there are government restrictions or start up cost, there would not be freedom of entry because not everyone would be able to surpass the barriers, making it unfair to some. The sellers who could pass the barriers and enter the market would have some sort of power over price, leaving the market imperfect. When all these characteristics are in place at the same time, it creates a perfect competition which has three main efficiencies. The first being the allocation of resources among companies efficiently with no favoritism. The second being the distribution of products among households efficiently, while the third is the production of goods that people want. Perfect competition often sounds good and sometimes may even sound obtainable, but the reality is perfect competition is an idealized market structure that has not yet been obtained by the real world. Even though this idea has not been obtained yet, it still provides a scale to analyze real world market structures. As mentioned earlier the opposite market condition to a perfect competition, is a market failure. I will now explain in detail, market failure and its sources.


Market Failure is a condition of the market when the quantity of a product demanded by consumers does not equate to the quantity supplied by suppliers. This condition negatively affects the economy because an optimal allocation of resources is not obtained. The definition Case and Fair (2004) give in their latest Principles of Economics textbook is “Market failure occurs when resources are misallocated, or allocated inefficiently. The result is waste or lost value” (Case & Fair, 2004). Just by reading current events you can see which direction the market is moving in terms of positively or negatively affecting consumers and investors. A recent article in the Wall Street Journal Online by Lauricella, Anand and Richardson (2008) has an interesting opening sentence “A week of multibillion-dollar losses by Wall Street rattled investors, who instead of thinking the worst is over, sold off stocks in the belief that there is more damage to come from the subprime-mortgage crisis.” A brief statement like this can be eye opening to unaware individuals, and can cause some to learn more about the actual events or problems that are causing such changes or conditions. Market failure as a whole is a negative condition of the market, but in order for market failure to be present, certain events or problems must be taking place. The four main sources of market failure are: an imperfect market structure, the existence of public goods, externalities, and imperfect information. The four sources will now be explained in detail starting with the first. An imperfect market is when some buyers or sellers are large enough to affect the price and quantity of good by their actions alone. Basically an imperfect market is the opposite of a perfect market and unfortunately most of the markets today have a resemblance of an imperfect market rather than a perfect market. The next main source of market failure is simply the presence of public goods. In an unregulated market, public goods would either be under-produced or not produced at all. Because of this very problem a truly perfect market will probably never be achieved. The third source of an ineffective and failed market is the existence of externalities in the market. An externality is basically a side-effect on others resulting from the actions or decisions made by individuals or groups. A very simple example of this is an individual owning a car. The car might give that particular individual mobility which is positive, but in retrospect third parties are likely having to deal with unwanted after-effects of that one car, such as pollution and added congestion. The last mentionable source of market failure is the dissemination of imperfect information. There are many times when buyers cannot fully understand a product or it’s pricing, so when a decision is made, it is likely it was not the best decision for the buyer. An example of this could be an individual trying to buy a new computer. If that individual is uneducated on the latest technology or unaware of technology terms, he could easily be persuade to buy a product that was not truly his best choice. When there is an influx of imperfect information in a given market, the chances of buyers getting the good that would best fit them are unlikely, and because of this, inefficiencies in the market will be present.


Having the two opposite models (perfect competition and market failure) to compare against our economic society can be very helpful in interpreting data and how current events might affect the market. I feel everyone could benefit from learning not only about these two market conditions, but about the whole economic system. The more individuals know about economics, the more aware they can be about what is happening economically in their own country.



References

Perfect Competition. 2006. Barron’s Financial and Investment Dictionary.Retrieved on January 16, 2008 on Answers.com Business and Finance: http://www.answers.com/topic/perfect-competition?cat=biz-fin#copyright

Case K. E., & Fair R. C. 2004. Principles of Economics: 7th Edition. UpperSaddle River, NJ: Prentice Hall

Lauricella, T., Anand, S., Richardson, K. (January 18, 2008). More Zeros forInvestors. The Wall Street Journal Online. Retrieved January 18, 2008 from: http://online.wsj.com/article/SB120062592220899805.html?mod=todays_us_nonsub_money_and_investing

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