There are five main conditions for perfect competition to exist:
1 Many buyers and sellers. Each of these must buy or sell such a small proportion
of the total market output that none is able to have any influence over the
market price.
2 Homogeneous product. Each firm must be producing an identical product, for
example premium unleaded petrol or skimmed milk.
3 Free entry and exit from the market. This means that there are no barriers to
entry or exit that give incumbent firms an advantage over potential competitors
who are considering entering the industry. These barriers, which can
represent either demand or cost advantages, are explained in more detail in
the next section.
4 Perfect knowledge. Both firms and consumers must possess all relevant market
information regarding production and prices.
5 Zero transportation costs. This means that it does not cost anything for firms to
bring products to the market or for consumers to go to the market.
Under the above conditions, firms in the market will be price-takers; there
will be one, and only one, market price, meaning that the product will sell at
the same price in all locations. Most treatments of perfect competition
Market structure and pricing 291
concentrate on the first four conditions, but the last one is relevant, as will be
seen in the following example. It is not uncommon for motorists driving along
a busy road to see two or three petrol stations close to each other, at a major
crossroads for example, with these firms selling petrol at somewhat different
prices. There are many buyers and sellers of petrol, the different prices can be
for the same homogeneous product like premium unleaded petrol, barriers to
entry are not relevant in the short run and consumers can see the different
prices being charged by the different petrol stations. Yet these price differentials
may persist because motorists may not be willing to cross the road to obtain a
cheaper price and then cross the road again to continue in their intended
direction. This is quite rational if the opportunity cost of the time taken to
cross and recross the road exceeds the savings on the cost of the petrol. Thus,
in practice, transportation costs can be important in explaining price differentials
which could not be explained in terms of the first four conditions.
It is clear that these conditions are rarely achieved in reality; however, this
does not negate the usefulness of the analysis of perfect competition. Once
again it is necessary to remember that a theory should be judged not on the
basis of the realism of its assumptions but on its ability to explain and predict.
The conditions are approximately approached in some markets, for example
agricultural products and stock markets. Furthermore, the analysis and conclusions
in terms of conduct and performance provide a useful benchmark for
comparing other forms of market structure.