In the real world, there is no market that is ‘perfectly competitive’, although some markets do come close, such as the markets for fruit and vegetables in Melbourne, including the Queen Victoria Market and the Prahran Market. A perfectly competitive market requires the following conditions or assumptions:
In a perfectly competitive market, the above conditions would ensure that no single business possessed any market power. Each business would be a ‘price taker’ in the sense that they would be unable to charge a price higher than their competitors without going out of business in the longer term. This is because, if any business did charge a price higher than their competitors, buyers would buy the cheaper product, because the products are interchangeable and the buyer would have perfect knowledge about the prices available from each seller. In addition, production would occur at the lowest possible cost given that there is always incentive for businesses to maximise efficiency to keep prices low enough to compete with other low-price competitors. Consequently, consumers would be able to purchase those goods and services they desired at the lowest possible prices.
Competition would ensure that businesses priced their products at the lowest possible level, one where profits are only just at a high enough level to justify continued operation in that market. In Economics, this price is said to be one where only ‘normal profits’ are made. Businesses are making just enough profit to justify ongoing supply to that market. Prices above this level lead to ‘supernormal profits’ or ‘abnormal profits’, whereas prices below this level lead to less than normal profits or even losses (which would encourage the exit of firms from the market).
While it is possible for supernormal profits to be made by suppliers in the short term in a perfectly competitive market structure, this will quickly be eroded by the entry of new suppliers seeking to share some of these relatively high profits. As new suppliers enter the market, the total supply of products in that market will increase, which then drives the price downwards. Accordingly, suppliers in the market will no longer be able to enjoy supernormal profits. Instead, profits will return to a level that is just enough to justify each existing supplier staying in that market. In other words, profits will return to their ‘normal’ levels.
Sometimes it is possible for high levels of competition to drive prices too low, such that losses are made by suppliers. However, this is only likely to persist for the short term because some suppliers will eventually exit the market. This will then reduce the total supply of products in that market, which will then drive the price back up and allow the remaining suppliers to once more make ‘normal profits’.