Most of the discussion of price theory by classical economists has been conducted on the assumption of perfect competition. Perfect or pure competition pre-supposes the following conditions:
(i) Large Number of Buyers and Sellers:
The first condition of perfect competition is that there should be a large number of buyers and sellers in the market. If this be so, no single seller or buyer will be able to influence the market price.
The output of a single firm is only a small portion of the total output and the demand of any single buyer is only a small portion of the total demand.
Hence the market price has to be taken as given and no single firm is in a position to affect the market price by varying its own output. In other words, the individual seller is a price-taker and not a price-maker.
The price taker cannot charge a price higher than his competitors; otherwise no one would buy from him. Although he can charge a price lower than the prevailing price, he accepts the prevailing price in order to maximize profits. This leads to the perfectly elastic demand curve of the purely competitive firm.
(ii) Homogeneous Products:
The second condition of perfect competition is that the products produced by all firms are homogeneous and identical. It means that the products of various firms are indistinguishable from each other; they are perfect substitutes for one another.
Here the trade marks, patents, special brand labels etc. do not exist since these things make the products differentiated. In case the output is not standardised, each individual firm will be in a position to influence the market price.
(iii) Free Entry and Exit:
The third essential condition of perfect competition is that there should be no restrictions on the firm’s entry into or exit from that industry. This will happen when all the firms are making just normal profits.
If the profit is more than normal, new firms will enter and extra profit will be competed away; and if, on the other hand, profit is less, some firm will exit, raising the profits for the remaining firms.
But if there are restrictions on the entry of firms, the existing firms may enjoy supernormal profits. Only when there are no restrictions on the entry of new firms or exit of the existing firms will they enjoy normal profits.
(iv) Perfect Knowledge of the Market:
Another condition for perfect competition is that both the buyers and sellers are fully aware of prevailing price in the market. Because all buyers know fully the current price of the products in the market, sellers cannot charge more than the going price.
If any seller tries to charge a price higher than the buyers will shift to some other sellers and buy the products at the prevailing price since it is assumed that they know what the prevailing price in the market is.
Similarly, all the sellers are also aware of the prevailing price in the market and no one will charge less price than this since his objective is to maximize profits.
No buyer has a preference to buy from a particular seller and no seller has a preference to sell the products to a particular buyer.
Although in the real world we rarely find instances where all the conditions for pure competition are met, the commodity markets and securities exchanges approximate to these conditions.
A firm under perfect competition may either make profits or operate at a loss in the short run. In the long run, all firms will operate at an equilibrium output where all profits and losses have disappeared.
If some firms earn excessive profits, more firms enter the industry in the long run, supply will increase and the market price will be driven downward, thereby helping to eliminate excessive profits for the remaining firms.
In the converse case, if some firms are operating at a loss, some firms leave the industry in the long run, supply will decrease and the market price will be driven upward, thereby helping to eliminate losses for the remaining firms.
In addition to price changes which occur in the long run, as firms enter and leave the industry, another force also drives all firms towards equilibrium. In equilibrium all firms will also have identical costs, even though they may use different production techniques.