Perfect competition

In economics and general equilibrium theory, a perfect market is defined by several conditions, collectively called perfect competition . These conditions are:

When conditions of perfect competition hold, it has been proven that a market will reach an equilibrium in which the quantity supplied for every product or service, including labor, equals the quantity demanded at the current price. This equilibrium will be a Pareto optimum, meaning that nobody can be made better off by exchange without making someone else worse off.

Such markets are allocatively efficient, as output will always occur where marginal cost is equal to marginal revenue (MC = MR). But perfectly competitive markets are not necessarily productively efficient as output will not always occur where marginal cost is equal to average cost (MC = AC).

In perfect competition, any profit-maximizing producer faces a market price equal to its marginal cost (P = MC). This implies that a factor's price equals the factor's marginal revenue product. It allows for derivation of the supply curve on which the neoclassical approach is based. This is also the reason why "a monopoly does not have a supply curve". The abandonment of price taking creates considerable difficulties for the demonstration of a general equilibrium except under other, very specific conditions such as that of monopolistic competition.

Real markets are never perfect, but range from close-to-perfect to very imperfect. Share and foreign exchange markets are commonly said to be the most similar to the perfect market. The real estate market is an example of a very imperfect market.

In a perfect market the sellers operate at zero economic surplus: sellers make a level of return on investment known as normal profits.

Normal profit is a component of (implicit) costs and not a component of business profit at all. It represents the opportunity cost, as the time that the owner spends running the firm could be spent on running a different firm. The enterprise component of normal profit is thus the profit that a business owner considers necessary to make running the business worth her or his while i.e. it is comparable to the next best amount the entrepreneur could earn doing another job. Particularly if enterprise is not included as a factor of production, it can also be viewed a return to capital for investors including the entrepreneur, equivalent to the return the capital owner could have expected (in a safe investment), plus compensation for risk. In other words, the cost of normal profit varies both within and across industries; it is commensurate with the riskiness associated with each type of investment, as per the risk-return spectrum.

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