There are four primary categories of industry structure generally described in Economics: Perfect Competition, Monopolistic Competition, Oligopoly, and Monopoly.  We’ll cover Perfect Competition here.  And while I’ll do both of us a favor by not including all of the diagrammatic analysis here, there is a lot of insight to glean from a thorough study of Perfect Competition.  And so, it’s worth your time to perhaps dig deeper later on.

Formally we describe an industry as Perfectly Competitive if it has all of the following characteristics:

• Many Sellers – There are many firms actively competing with each other in this industry structure.  For practical purposes, we define “many” as so many that if one firm were to drop out of the industry it’d have no discernable impact on the volume of sales or market price.
• Many Buyers – There are many buyers actively competing with one another to purchase from this industry. 
• No Collusion – Neither the firms nor the buyers collude with one another to artificially increase or decrease price.
• Identical Product – For the industry to be “perfectly” competitive, firms must be unable to differentiate themselves from their competitors and in so doing gain some competitive advantage.  Every participant sells a completely identical product forcing them to rely on product price to generate sales.
• No Barriers to Entry – Should the industry become particularly profitable, the absence of any barriers to entry for new participants will lead to just that – the entry of other firms.  And so, a Perfectly Competitive industry will always remain highly competitive.
• Readily Available Information – For a market to truly competitive buyers must be aware of all potential sellers and their respective prices.  Likewise, the sellers are aware of the buyers and how much they are willing to pay.

Agricultural products are often used as an example of a Perfectly Competitive industry.  There are many growers of corn as well as many buyers.  The growers don’t collude with other growers to set an artificially high market price.  And the buyers generally compete actively with one another when buying corn. 

The corn grown by one family farm is indistinguishable from that grown by their neighbor.  And so, it’s not possible for them to demand any price higher than the market price.  Perfectly Competitive firms are therefore essentially “price takers”.  Unlike other types of businesses, they don’t set their own price.  They simply accept or reject the current overall market price. 

If corn is very profitable, the number of farmers growing corn will increase.  Of course, that doesn’t include me.  I don’t have a farm and agricultural land is expensive.  But there are wheat farmers, soybean farmers, and others who can easily enough shift from producing other products to corn.  And so, profits will attract the market entry of these already existing farmers.

Finally, for corn to be Perfectly Competitive there needs to be readily available price information.  At the end of each growing season, corn farmers take their corn to a regional grain silo where they’ll offer it for sale by auction.  Everyone is aware of what is going on with all other participants at every point in the process this way.

While agricultural products work well for an example, they’re a bit boring.  Many financial markets also come pretty close.  Consider the market for Bitcoin.  On any given day, there are many owners of Bitcoin looking to sell some of theirs.  And there are many potential buyers looking to buy some.  By its very nature, it’s unlikely either the buyers or sellers will collude.  The whole point is anonymity.  Certainly, there’s not product differentiation and anyone can become a Bitcoin investor.  And information?  Since Bitcoin is bought and sold on organized exchanges online, information is readily available.  As an example, Bitcoin works.

So, we know that Perfectly Competitive industries are characterized by a large number of competitive firms competing to sell their goods based solely on market price.  And we know that these firms have no say in setting that price, they must either accept or reject the prevailing market price.  What might be implications of this structure and corresponding behavior? 

First of all, it will be impossible for the firms in this industry to earn any extraordinary level of profit.  If Bitcoin investors were earning double-digit returns on their investments regularly, this would attract many additional investors, drive the price up causing the corresponding yields to decline for everyone.  Perfectly Competitive industries are generally therefore characterized by modest profits, or near-zero “Economic Profit”.  Most people won’t get rich growing corn or trading Bitcoin.*

Another implication of Perfect Competition is that, with price fixed, there is an incentive for firms in such an industry type to work diligently to contain cost.  And so, Perfectly Competitive industries tend to have very high productivity, or productive efficiency.  While the “typical” seller of dog food ingredients will earn only modest profit, one that is particularly good at containing cost might still manage to do reasonably well.

Finally, Perfectly Competitive industries tend to also be “Allocatively Efficient”.  This complex idea is easiest to explain by counter example.  Imagine that you live in a remote community with only one grocery store.  The owner of that store could charge unnecessarily high prices for most products.  For example, perhaps the cost to the owner of a gallon of milk is $2.  But he is able to sell if for $5.  Now imagine that there is a family in that community who is willing to pay $4 for the milk, but they can’t afford $5.  They won’t be able to buy it.  The $2 cost of producing the milk represents the opportunity cost to society for the resources it took to produce the milk.  It doesn’t make sense to produce the milk if these aren’t covered.  The family is willing to pay $4, $2 more than the opportunity cost of making it.  If our concern is only with the efficient allocation of societal resources, we’d prefer to see this milk produced and provided to this family.  But the market power of the grocer causes this transaction to not happen.  And so, we’d say this market is not Allocatively Efficient.

Perfectly Competitive markets, under idealized circumstances, do tend to result in Allocatively Efficient outcomes.  If there were many grocers in that town, the price of milk would be competed down.  The family would be able to buy the milk that’s worth $4 to them.  $2 would go to the owner of the resources used to produce the milk, satisfying their need.  And the remaining difference would go to the grocer, but only enough to keep the number of grocers stable.

One final comment about Perfect Competition before wrapping this up.  The Demand and Supply model actually represents a Perfectly Competitive market.  Remember that the equilibrium price occurred because seller or buyers, frustrated by their inability to sell or buy, drove the price to equilibrium.  As we start relaxing the assumptions of Perfect Competition, this no longer occurs.  Non-Perfectly Competitive industries don’t operate at the intersection of Demand and Supply.  Still, even though it’s fairly rare for these conditions to be met.  The Demand and Supply model is still useful even if it’s not a perfect representation of whatever industry we’re trying to describe.

*When we talk about the tendency to zero economic profits, we’re talking about after everyone who wants to enter has.  I know of many people who made significant amounts of money holding Bitcoin.  But they were the early adopters.  The same is true in any competitive market.  If you’re early, you can still make significant profit before the new entrants drive the profits to zero.