Introduction

In our previous articles discussing the supply and demand for a good or service, we have assumed the conditions of a perfect market. However, as discussed, the perfect market does not actually exist, but is used as a tool/benchmark against which to compare other market structures that exist in reality.

In this article, we will discuss:

1. The hallmarks of perfect market, including its pros and cons;
2. The elements of a perfect market which cannot be replicated in real life; and
3. The factors which may cause other market structures.

In the articles following this one, we discuss those other market structures in further detail - in particular, monopolies, monopolistic competition, and oligopolies. In this article, where we refer to a good we also mean a service.

Perfect Market

In a perfect market, there are a large number of producers and consumers for any good or service, all of whom are price takers (i.e. they cannot set the price, but must sell at the price determined by the market through the interaction of the demand and supply curves).

All producers produce an identical product (homogenous goods and services), and there is complete freedom for new producers to enter the market in the long run.

Further, both producers and consumers have perfect knowledge of the market i.e. who is selling what good, how much they are selling it for, the respective qualities of the goods on the market, new market opportunities etc.

Pros

Firstly, in a perfect market there is complete allocative efficiency i.e. producers and consumers using their resources to obtain the most benefit from them, which is possible because they are assumed to have having perfect knowledge.

Further, a perfect market promotes survival of the fittest. Inefficient firms are weeded out because they cannot keep prices low enough and still make a profit; they cannot sell at higher prices because consumers have perfect knowledge and know where to get the best price. As a result, a perfect market also promotes productive efficiency - production at the minimum possible cost for the maximum possible output.

Finally, a perfect market serves consumers. If consumers' tastes change then the market will respond to this; the consumer is sovereign in a perfect market.

Cons

There is no guarantee of equity in a perfect market i.e. ensuring resources are allocated fairly in accordance with societal values.

Further, free market prices do not take into account negative externalities. These are the by-products of the production and consumption of a good which may have a negative effect on the public e.g. pollution from manufacturing, disease from unhealthy foods etc.

There is also very little incentive to develop new technology in a perfectly competitive market. Since there are a large number of producers producing identical goods, no producer makes supernormal profits which can be used on research and development.

Moreover, because there is perfect information and freedom to enter the market, if new technology is developed by one producer which allows production at a lower cost, then another firm will also be able to use this, reducing the incentive for innovation. To prevent this, countries may introduce intellectual property laws (we discuss this below).

Finally, in a perfect market, all goods within the market are the same (homogenous), and this lack of choice could be considered to be a bad thing for consumers.

Reasons for other market structures

A number of the conditions assumed in a perfect market may not exist in reality, and there may be other impediments to realising a true, perfect market. It is because of these factors, set out in more detail below, that we have alternate market structures.

Perfect Knowledge

One of the key assumptions of a perfect market is that both consumers and producers have perfect knowledge. This may not always be the case. For example, consumers may not always know where to obtain the cheapest price for a good, and producers may not know the best way to produce a good or of the opportunities within a market. Whilst the level of knowledge may have increased in recent years, with the advance of big data and the internet, we are still a long way off from having perfect knowledge.

Identical Goods

A perfect market assumes that, within an industry, producers are producing identical goods. Given the nature of innovation, and the infinite potential variances of a particular good, this is an unrealistic assumption.

Freedom for Producers to Enter the Market

A key assumption of a perfect market is that, in the long run, producers have the freedom to enter the market. This may not necessarily be the case due to the existence of what economists call barriers to entry. Barriers to entry are impediments to a firm entering a market and may exist in a number of forms, both natural and artificial. Examples of barriers to entry include:

1. ‍High start-up costs/economies of scale - particular goods may require a large initial start-up cost to produce, after which the average cost of production per good goes down. For example, it may cost £1,000,000 to purchase the machinery to produce your widget, plus £1 for the materials for each widget. If only one widget is produced, the average cost of producing that widget is £1,000,001. However, if two are produced, the average cost is £500,001 (£1,000,002 divided by 2), and so on – this is called economies of scale. Due to the high start-up costs and economies of scale, firms entering a market like this will have to have a large amount of cash to invest, and also be able to sell a large number of goods from the outset so that the average cost per good is low and they can provide the goods at a competitive price;‍
2. Regulation - as discussed above, a perfect market does not take into account negative externalities. As such, a government may regulate a market to take these into account. For example, the financial services industry is heavily regulated to ensure fairness for consumers. The costs of complying with regulation may be high, thereby increasing the potential start-up costs;‍
3. Legal Protection - there may be forms of legal protection for firms that are already established within a market. An example of this is intellectual property protection. As discussed above, a perfect market with perfect information would not encourage research and development because firms would be free to use the research undertaken by another. In order to counteract this, governments across the globe allow firms to protect their intellectual property through, for example, patent, trademark and copyright laws;‍
4. Product differentiation and brand loyalty - a firm already established within the market may produce a good that is clearly distinguishable from others and may command brand loyalty from consumers. It will be difficult for new firms to enter such a market. Examples could include the smartphone market, which is dominated by a number of large, key players.

The above are just a few examples of barriers to entry, and others also exist which make it difficult for a new firm to enter into the market. Have a think about the barriers to entry that may exist in a few of the industries from which you routinely purchase goods.

Conclusion

The perfect market is a model / tool we use in economics, and there are a number of assumptions associated with it.

Alternate market structures exist because a number of the conditions assumed in a perfect market are unrealistic, and because of barriers to entry.

Which market structure exists in reality will depend upon (amongst other things) historic conditions with the market, how well the perfect market assumptions can operate within that particular market, and the extent of the barriers to entry. In the next three articles we discuss the following alternate market structures:

1. Monopoly;
2. Monopolistic competition; and
3. Oligopolies.

We describe these markets structures in the extreme. In reality, however, it is possible that a market may not fall squarely within any one of these categories, but somewhere in between.