Question

Which of the four market structures encourages the greatest competition and benefits for other businesses and consumers? Explain your answer in terms of price competition and the effect of that business type on the overall economy.

Answer 1

Perfect Competition

Perfect competition describes a market structure, where a large number of small firms compete against each other. In this scenario, a single firm does not have any significant market power. As a result, the industry as a whole produces the socially optimal level of output, because none of the firms have the ability to influence market prices.

The idea of perfect competition builds on a number of assumptions: (1) all firms maximize profits (2) there is free entry and exit to the market, (3) all firms sell completely identical (i.e. homogenous) goods, (4) there are no consumer preferences. By looking at those assumptions it becomes quite obvious, that we will hardly ever find perfect competition in reality. This is an important aspect, because it is the only market structure that can (theoretically) result in a socially optimal level of output.

Probably the best example of a market with almost perfect competition we can find in reality is the stock market. If you are looking for more information on perfect competition, you can also check our post on perfect competition vs imperfect competition.