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The concept of perfect competition is an idealization of friction-free, smoothly functioning, anonymous markets that, at best, serves as a benchmark to the markets that exist. Perfect competition is an abstraction based on underlying assumptions concerning: (1) the number of competitors; (2) the homogeneity of the product being sold; (3) the ease of entry into the market; (4) the level of knowledge and competence of competitors; and (5) the independence of competitors’ behavior.
Heuristically, these five conditions are satisfied when: (1) both the number of buyers and the number of sellers are sufficiently large that it is virtually costless to switch trading partners; (2) the goods being traded by various sellers are more or less perfect substitutes for each other; (3) the entry and exit by buyers and sellers are more or less cost free and swift; (4) all agents are more or less aware of the previous market prices, and they are close together; and (5) the agents do not form coalitions in trading, and they act independently and more or less anonymously.
These conditions are easy to grasp in nontechnical terms, but making them mathematically precise is both worthwhile and difficult. Historically, the work in the economics of oligopoly of A. A. Cournot (1836) and Edward Chamberlin (1933) provides the basic examples for competition with homogeneous and differentiated goods. In the first instance, perfect substitutes are traded; in the second, the product of each individual differs from the others. The difference between oligopoly and perfect competition is that in the latter, numbers are assumed to be so great that it is not worthwhile for individuals to attempt to consider the detailed actions of other individuals. They thus view price and the market as an aggregate.
In perfect competition, the conditions for entry into the market amount to the proposition that there are no high barriers, such as hard-to-obtain licenses, social pressures, or extremely high set-up costs, to prevent potential new entrants from going into business. The condition that is possibly the most difficult to make precise is that on information. In the dynamics of the market, it is extremely difficult to determine who knows what from minute to minute. If there is a formal trading mechanism that forms price, such as a simultaneous sealed bid, the conditions can be described precisely. In an open-cry market, however, with bidders milling around the floor, description at best is only of aggregates.
In markets that meet frequently with established traders, it is feasible that over time implicit or explicit collaboration or collusion could evolve, even with numbers such as ten or twenty. This is ruled out by assumption in a competitive market; but it raises the question of how many competitors are necessary before collusion can be ruled out.
The formal methods of the theory of games have been utilized since the 1960s to make these intuitively simple concepts precise (see Shubik 1984). Even today, however, in highly practical problems, such as information leaks and insider trading in the stock market, an understanding of how to guarantee the appropriate conditions on information has not been reached.
Perfect competition is a useful ideal if it is not followed too slavishly. Possibly the closest approximation to it is provided by the New York Stock Exchange, where a reasonably close level of approximation to competition has been achieved through the building up of an enormous body of laws and regulations required to level the playing field in an actual market.
- Chamberlin, Edward. 1933. The Theory of Monopolistic Competition. Cambridge, MA: Harvard University Press.
- Cournot, A. A.  1897. Researches into the Mathematical Principles of the Theory of Wealth. Trans. Nathaniel T. Bacon. New York: Macmillan.
- Shubik, Martin. 1984. A Game Theoretic Approach to Political Economy. Cambridge, MA: MIT Press.
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