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What Are Imperfect Markets? Definition, Types, and Consequences

Investopedia / Mira Norian

What Is an Imperfect Market?

An imperfect market refers to any economic market that does not meet the rigorous standards of the hypothetical perfectly—or purely—competitive market. Pure or perfect competition is an abstract, theoretical market structure in which a series of criteria are met. Since all real markets exist outside of the spectrum of the perfect competition model, all real markets can be classified as imperfect markets.

In an imperfect market , individual buyers and sellers can influence prices and production, there is no full disclosure of information about products and prices, and there are high barriers to entry or exit in the market.

A perfect market is characterized by perfect competition, market equilibrium, and an unlimited number of buyers and sellers.

Key Takeaways

• Imperfect markets do not meet the rigorous standards of a hypothetical perfectly or purely competitive market.
• Imperfect markets are characterized by having competition for market share, high barriers to entry and exit, different products and services, and a small number of buyers and sellers.
• Perfect markets are theoretical and cannot exist in the real world; all real-world markets are imperfect markets.
• Market structures that are categorized as imperfect include monopolies, oligopolies, monopolistic competition, monopsonies, and oligopsonies.

Understanding Imperfect Markets

All real-world markets are imperfect. Thus, the study of real markets is always influenced by competition for market share, high barriers to entry and exit, different products and services, prices set by price makers rather than by supply and demand, imperfect or incomplete information about products and prices, and a small number of buyers and sellers.

For example, traders in the financial market do not possess perfect or even identical knowledge about financial products. The traders and assets in a financial market are not perfectly homogeneous. New information is not instantaneously transmitted, and there is a limited velocity of reactions.

When considering the implication of economic activity, economists only use perfect competition models. A such, the term imperfect market is somewhat misleading. Most people will assume an imperfect market is deeply flawed or undesirable. However, this is not always the case. The range of market imperfections is as wide as the range of all real-world markets—some are much or less efficient than others.

Consequences of Imperfect Markets

Not all market imperfections are harmless or natural. Situations can arise in which too few sellers control too much of a single market, or when prices fail to adequately adjust to material changes in market conditions. It is from these instances that the majority of economic debate originates.

Some economists argue that any deviation from perfect competition models justifies government intervention, in order to promote increased efficiency in production or distribution. Such interventions may come in the form of monetary policy , fiscal policy, or market regulation. One common example of such interventionism is anti-trust law, which is explicitly derived from perfect competition theory.

Governments may also use taxation, quotas, licenses, and tariffs to help regulate so-called perfect markets.

Other economists argue that government intervention may not always be necessary to correct imperfect markets. This is because government policy is also imperfect, and government actors may not possess the right incentives or information to interfere correctly. Finally, many economists argue government intervention is rarely, if ever, justified in markets. The Austrian and Chicago schools notably blame many market imperfections on erroneous government intervention.

Types of Imperfect Markets

When at least one condition of a perfect market is not met, it can lead to an imperfect market. Every industry has some form of imperfection. Imperfect competition can be found in the following structures:

This is a structure in which there is only one (dominant) seller. Products offered by this entity have no substitutes. These markets have high barriers to entry and a single seller who sets the prices on goods and services. Prices can change without notice to consumers.

This structure has many buyers but few sellers. These few players in the market may bar others from entering. They may set prices together or, in the case of a cartel, only one takes the lead to determine the price for goods and services while the others follow.

Monopolistic Competition

In monopolistic competition, there are many sellers who offer similar products that can't be substituted. Businesses compete with one another and are price makers, but their individual decisions do not affect the other.

Monopsony and Oligopsony

These structures have many sellers, but few buyers. In both cases, the buyer is the one who manipulates market prices by playing firms against one another.

Imperfect Markets vs. Perfect Markets

Perfect markets are characterized by having the following:

• An unlimited number of buyers and sellers.
• Identical or substitutable products.
• No barriers to entry or exit.
• Buyers have complete information on products and prices.
• Companies are price takers meaning have no power to set prices.

In reality, no market can ever have an unlimited number of buyers and sellers. Economic goods in every market are heterogeneous, not homogeneous, as long as more than one producer exists. A diverse range of goods and tastes are preferred in an imperfect market.

Perfect markets, though impossible to achieve, are useful because they help us think through the logic of prices and economic incentives. It is a mistake, however, to try extrapolating the rules of perfect competition into a real-world scenario. Logical problems arise from the start, especially the fact that it is impossible for any purely competitive industry to conceivably attain a state of equilibrium from any other position. Perfect competition can thus only be theoretically assumed—it can never be dynamically reached.

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Perfect Markets in General Essay

Perfect market is a situational market that is rare in real life (Rittenberg & Tregarthen, 2011). Perfect competition in the market occurs in a way that it is difficult for any stakeholder to influence the price of commodities. In this case, automobile, beer and corn markets are examples of perfect market models.

A perfect competition market is, therefore, an imaginary situation that is characterized by large number of buyers and sellers. The buyers and sellers are many, but their individual consumer behavior has no impact on the market (Rittenberg & Tregarthen, 2011).

Similarly, the demand of one buyer is so insignificant compared to the total demand in the market and, therefore, no individual behavior can influence the prices. There are few competitive perfect markets in existence where the conditions of the perfect market are strict. (Salemi, & Hansen, 2005, p.29)

In this case, the automobile, beer and corn industries have influenced the buyer selection in their products so that products can be bought at different prices. A good example of perfect competitive market is where many farmers are producing corn.

Moreover, in the automobile industry, many dealers sell similar models of cars that one can barely differentiate. “The firms in these markets are price takers and are characterized by perfect knowledge, freedom of entry and exit of the market” (Salemi, & Hansen, 2005, p.29). There is also non-governmental interference in their activities, lack of excess supply and demand, and less transport costs.

In the beer and automobile industries, the seller has perfect knowledge about the market. Therefore, no one would conduct business at their preferred price other than the equilibrium price. For example, today a person could be assembling cars and then he or she can decide to clear the stock and start something else.

In these market models, all buyers are identical in the eyes of sellers. There are also no advantages of selling products to particular buyers (Salemi, & Hansen, 2005). The beer and the automobile companies have no personal recognition or preference of their buyers.

The prices in these markets are determined strictly by the interplay demand and supply. There is no government intervention in the form of taxes or subsidies, quotas, price controls among other regulations (Salemi, & Hansen, 2005). This factor makes the automobile and beer industries sell all what they supply in the market.

The buyers are able to buy all what they require because there is no deficit in supply. The other conditions that place these products under perfect mobility are factors of production. All factors of production including land, capital, labor, and entrepreneurship can be easily switched from one use to another. In beer, automobile, and corn market, factors of production are assumed to be perfectly mobile.

Further, it is assumed that buyers and sellers are located in one area. As such, they do not incur any costs in transporting their goods. The sellers in these markets cannot, therefore, charge higher prices to cover the cost of transport.

In the perfect markets, the buyers have perfect knowledge of the prices offered by different firms on certain products. The products sold have homogeneity. Perfect competition is advantageous to the society because the price equals the marginal cost of production in each firm. The price offered is reasonable and no single firm monopolizes the market.

Rittenberg, L., & Tregarthen, T. (2011). Principles of economics . Irvington, NY: Flat World Knowledge.

Salemi, M. K., & Hansen, W. L. (2005). Discussing economics: A classroom guide to preparing discussion questions and leading discussion . Cheltenham: Edward Elgar.

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Perfectly and Imperfectly Competitive Markets

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In the competition between economic models, the theory of perfect competition holds a dominant market share: no set of ideas is so widely and successfully used by economists as is the logic of perfectly competitive markets. Correspondingly, all other market models (collectively labelled ‘imperfectly competitive’ and including monopoly, monopolistic competition, dominant-firm price leadership, bilateral monopoly and other situations of bargaining, and all the varieties of oligopoly theory) are little more than fringe competitors.

• Nash Equilibrium
• Competitive Market
• Competitive Equilibrium
• Imperfect Competition
• Price Formation

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Roberts, J. (1989). Perfectly and Imperfectly Competitive Markets. In: Eatwell, J., Milgate, M., Newman, P. (eds) Allocation, Information and Markets. The New Palgrave. Palgrave Macmillan, London. https://doi.org/10.1007/978-1-349-20215-7_24

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Video transcript

Characteristics Of Perfect And Imperfect Markets

Market is a place where the buyers and sellers make transactions regarding goods and services. Depending on time, competition and extent of area, markets are classified into several types. On the basis of competition markets are classified into perfect markets and imperfect markets.

Perfectly competitive Markets:

Perfectly competitive market is one which consists of large number of buyers and sellers, uniform price and homogeneous commodities. No single buyer or seller is able to exercise control over the price of a commodity. The price of a commodity is same throughout the market. The following are the characteristics of perfect markets or perfectly competitive markets.

Characteristics of perfect markets:

1) There exists a large number of buyers and sellers. Each buyer buys a main portion of the whole stock of commodities. Similarity each seller sells a negligible portion of the whole stock of commodities. They have no influence over the determination of the price.

2) There prevails homogeneous commodities. The quantity and quality of commodities available in the market are the same. No differences are observed in the size, quality, taste of the Commodities.

3) Both the buyers and sellers will know the prices prevalent in the market. Neither of them can increase or decrease the price of a commodity. So the price line of a perfectly competitive market runs parallel to OX axis.

4) There exists no obstacles for the firms to enter or leave the industry. New firms enter the industry when there are huge profits. Old firms leave the industry when there are huge losses.

5) There exists no transport costs. As a result the price of the commodity is same at any place in the market.

6) Factors of production are freely mobile. They move from one industry to the other until they get higher remunerative prices for their services.

Distinction between pure competition and perfect competition:

‘Pure’ competition is a word introduced by Prof. Chamberlain. Pure competition is said to prevail when there exists large number of buyers and sellers, homogeneous commodities and freedom of admission into and exit of firms from an industry. In addition to these features perfect competition includes perfect knowledge of prices, free mobility of factors of production, absence of transport costs and uniform price as its features.

Both pure and perfect competitions are the two ideal concepts which can’t be found in real world. What we observe in reality is the prevalence of imperfect competition.

Imperfect Competition:

Imperfect competition consists of the features which are opposite to perfect competition. It has some special features.

Characteristics of imperfect markets:

1) There exists a small number of sellers in ‘this market. This enables the sellers to charge the prices as they like.

2) The number of buyers is also small. But its does not mean that buyers are few. The buyers in this market system are divided into several groups. Each group buys goods and services from different sellers.

3) The commodities bought and sold in this market are heterogeneous. They differ in their size, quality, appearance, tastes and durability.

4) The sellers adopt product differentiation and price discrimination. They collect different prices for the same commodity from different buyers.

5) There exists transport costs and selling costs in this market.

6) The consumers may not know the prevailing prices of the commodities in the market.

7) The factors of production are not freely mobile.

8) There prevails different prices for the same commodity in the same region.

Thus, imperfect competition consists of the features which are quite opposite to the perfect competition.

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THE DYNAMICS OF PERFECT MARKETS GRADE 12 NOTES - ECONOMICS STUDY GUIDES

• Key concepts
• Review of production, costs and revenue
• Perfect competition
• The individual business and the industry
• Market structures
• Output, profit, losses and supply
• How to draw graphs to show various equilibrium positions
• Competition policies

A perfect market is characterised by perfect competition. The conditions that result in perfect competition include:

• Equal access to the technology required for production
• No barriers to entry or exit from the marketplace
• Accurate and available market information
• No participant with the power to set the market price
• According to equilibrium theory, a perfect market will reach an equilibrium where the quantity supplied equals the quantity demanded at the market price

6.1 Key concepts

These definitions will help you understand the meaning of key Economics concepts that are used in this study guide. Understand these concepts well.

Use mobile notes to help you learn these concepts. Instructions for making them are on page xiv in the introduction.

6.2 Review of production, costs and revenue

Production takes place in the short run and the long run

• Short run The short run is the period of production where only the variable factors of production can change. The time period is too short to permit the number of firms in the industry to change.
• Long run The long run is the period of production where all factors can change. The time is long enough for variable and fixed factors to change. It allows enough time for new firms to enter the industry and/or existing firms to exit.

Table 6.1: Review of production, costs and revenue It is important to review production, cost and revenue concepts covered in Grade 11. This is vitally important for the understanding of cost and revenue curves for the different market structures which you will study in this section. Summary of costs

• The difference between the total cost and variable cost is the fixed cost
• TVC curve starts from 0 and TC starts from the fixed cost curve on the Y- axis.
• The gap between the AC curve and the AVC curve gets smaller as output increases.
• The MC Curve will always cut the AC and AVC curves at their minimum points.

6.3 Perfect competition

Perfect competition occurs in a market structure with a large number of participants who have access to all required information about the market place and are all price-takers. Prices are determined by demand and supply. Examples of market structures demonstrating most conditions of a perfect competition include the stock exchange, the foreign exchange market, the central grain exchange, and agricultural produce markets. A perfect market is a market where no single buyer or seller has a noticeable influence on the price of a good. This gives a true reflection of the scarcity value of goods and services. 6.3.1 Characteristics/conditions of a perfect market Products must be homogenous (i.e. identical)

• Products must be identical. There should be no differences in style, design and quality.
• In this way products compete solely on the basis of price and can be purchased anywhere.

There should be a large number of buyers and sellers

• It should not be possible for one buyer or seller to influence the price.
• When there are many sellers the share of each seller in the market is so small that the seller cannot influence the price.
• Sellers are price takers, they accept the prevailing market price. If they increase prices above the market price, they will lose customers.

No preferential treatment/discrimination

• Collusion occurs when buyers and sellers make an agreement to limit competition. In a perfect market no collusion takes place.
• Buyers and sellers base their actions solely on price, homogenous products fetch the same price and therefore no preference is shown for buying from or selling to any particular person.

Free competition

• Buyers must be free to buy whatever they want from any firm and in any quantity.
• Sellers must be free to sell what, how much and where they wish.
• There should be no State interference and no price control.
• Buyers should not form groups to obtain lower prices, nor should sellers combine to enforce higher prices.

Efficient transport and communication

• Efficient transport ensures that products are made available everywhere.
• In this way changes in demand and supply in one part of the market will influence the price in the entire market.
• Efficient communication keeps buyers and sellers informed about market conditions.

All participants must have perfect knowledge of market conditions

• All buyers and sellers must be fully aware of what is happening in any part of the market.
• Technology has increased competition as information is easily obtained via the internet.

Free access to and from markets

• Producers may enter and leave a market with little interference.
• Entering and leaving a perfect market is easy as less capital is required and there are fewer legal restrictions.

The factors of production are completely mobile

• They can move freely between markets.

In reality there are few perfect markets, however there are some sectors such as mining (e.g. gold) and agriculture (e.g. maize) where many of the conditions are met. These sectors illustrate the way in which the market mechanism works.

6.4 The individual business and the industry

6.4.1 Determining the market price To determine the market price for a firm under perfect competition you need to draw two graphs next to each other. On the left is the graph for the industry and on the right is the graph for the firm (individual producer).

• Figure 6.2 a) (the industry) shows the interaction of demand and supply (market forces).
• The market forces are in equilibrium at the point of intersection of the demand and supply curves, at “e”.
• At equilibrium the quantity demanded is equal to the quantity supplied. This determines the market price.
• Now look at Figure 6.2 b) (firm or individual producer). One producer will not be able to influence the market price and has to accept the market price (P1), he is a price taker.
• Because this is the only price the producer can charge, the demand curve for the producer is a straight line drawn at price P1.
• This horizontal line at the market price (P1) is the demand curve (DD), the average revenue (AR) curve and the marginal revenue (MR) curve.

Read this section on graphs through five times, and redraw each graph each time. 6.4.2 Demand curve for an individual producer The individual producer is a price taker and sells goods at the market price. At this price, demand remains constant. A higher price such as P2 cannot be charged as customers will be lost to other producers. A lower price such as P3 cannot be charged as a small profit or a loss will be made.

• At all pionts where MR is above MC, the firm is adding to profit. From unit 1-3, the firm is increasing its profit.
• At all points where MC is above MR, the firm is decreasing profit. From unit 5-7, the firm’s profit will decrease.
• The firm maximises profit where MR = MC. The firm maximises its profits at unit 4.

Table 6.5: Depicting Profit Maximisation

• If TC > TR the business makes a loss. If TR > TC it makes a profit.
• Maximum profit is achieved at units 3 and 4.
• Once the maximum profit is achieved, profits start to decrease with the next unit of output.
• Therefore the firm will not produce more than 4 units.
• At all points where TR is above TC, the firm is making a profit.
• At all points where TC is above TR, the firm is making a loss.
• The gap between TR and TC represents profit.
• Profit is maximised when the gap between TR and TC is the greatest. This is occurs at between 3 and 4 units.

6.5 Market structures

There are FOUR different market structures:

• Monopolistic competition

Table 6.6 shows the 5 broad characteristics which distinguish the four market structures: As you study each market structure in detail, you will be able to identify more distinguishing characteristics.

6.6 Output, profit, losses and supply

• Given a market price of P3, profit is maximised where MR = MC = P 3.
• This occurs at a quantity of Q 3 .
• At Q 3 the firm’s average revenue (AR) per unit of production is P 3,
• The average cost per unit is C 1 which is lower than the price of P 3.
• The firm is making an economic profit per unit of production of P 3 – C 1.

Another explanation

• Total revenue equals P 3 × Q 3, therefore total revenue is represented by the area 0P 3 E 3 Q 3 .
• Total cost equals C 1 × Q 3, this is represented by the area 0C 1 MQ 3.
• The difference between these two areas is the economic profit which is represented by the light grey shaded area C 1 P 3 E 3 M.

When Average Revenue is above Average cost the firm makes an ECONOMIC PROFIT.

• Given a market price of P 3, profit is maximised where MR = MC at point E 3.
• This occurs at a quantity of Q 3.
• At Q3 the firm’s average revenue (AR) per unit of production is P 3,
• The average cost per unit is C 3 which is higher than the price of P 3.
• The firm is making an economic loss per unit of production which is equal to the difference between C 3 and P 3.

Another explanation.

• Total revenue equals P 3 × Q 3, therefore total revenue is represented by the area 0P 3 E 3 Q 3.
• Total cost equals C 3 × Q 3, this is represented by the area 0C 3 MQ 3.
• The difference between these two areas is the economic loss which is represented by the light grey shaded area C 3 P 3 E 3 M.
• Whether the firm should continue production would depend on the level of AR (that is P3) relative to the firm’s average variable cost.

3. Normal profits

• A firm makes normal profits when total revenue (TR) equals total costs or when average revenue (AR) equals average cost (AC).
• Normal profit is the maximum return the owner of a firm expects to receive to keep on operating in the industry.
• Given a market price of P 2, profit is maximised where MR = MC = P 2.
• This occurs at a quantity of Q 2.
• At Q2 the firm’s average revenue (AR) per unit of production is P2, which is also equal to the average cost per unit C 2 (AC).
• Since AR = AC, the firm earns a normal profit since all its costs are fully covered.
• Point E 2 is usually called the break-even point.
• Total revenue equals P2 x Q2, therefore total revenue is represented by the area 0P2E2Q2.
• Total cost equals C2 × Q2, this is represented by the area 0P2E2Q2.
• Since Total revenue equals Total Cost the producer makes a normal profit.

The individual business can make an economic profit, economic loss or normal profit in the Short Run. They are referred to as short run equilibrium positions. In the long run the individual business will always make normal profit. 6.6.2 The industry The long term equilibrium for the industry and the individual firm The impact of entry and exit on the equilibrium of the firm and industry

• Profits are a signal for the entry of new businesses.
• Losses are a signal for businesses to leave the market.
• The long-term equilibrium in the perfect market will be influenced by the entry or exit of individual businesses.
• If individual farmers are earning an economic profit at P 1.
• New farmers will enter the market, more apples will be supplied.
• The market supply curve will shift to the right from S 1 to S 2.
• The Equilibrium price will drop from P 1 to P 2.
• Individual farmers will then earn normal profits. There will be no further reason for new farmers to enter the market. The industry is in equilibrium.
• If individual farmers are making economic losses, some farmers may leave the industry.
• When a few farmers leave the market, fewer apples will be supplied.
• The market supply curve will shift to the left from S 1 S 1 to S 2 S 2.
• The equilibrium price will increase from P 1 to P 2. Individual farmers will then earn normal profits. There will be no reason for individual farmers to leave the market.
• Therefore in a perfect market the long term equilibrium is achieved when individual firms earn a normal profit.
• Point a: a firm will not produce here because AR < AVC
• Point b: it is the lowest price that the firm will charge (shut-down point). It represents the beginning of the supply curve.
• Point c: the firm is making an economic loss. Because AR < AC. The loss is minimised because the firm produces where MR = MC.
• Point d: the firm is making normal profit (breaking even) because AR = AC.
• Point e: the firm is making economic (supernormal) profits because AR > AC.

6.7 How to draw graphs to show various equilibrium positions

First draw your TWO axes: Price (P) on the vertical axis and Quantity (Q) on the horizontal axis. Remember, they meet at the origin (0). Note that the labelling of the axes is not the same for all graphs. In showing the various equilibrium positions the following sequence should be followed.

• Draw the demand curve followed by the Marginal revenue curve, (in a perfect market D = MR = AR).
• Then draw the AC curve.
• Then draw the MC curve which must cut the AC curve at its minimum point.
• Identify profit maximising point. MC = MR
• Determine quantity (drop a line from the profit maximizing point to the x-axis).
• Determine price (extend line upwards from the profit maximizing point to the demand curve) and then extend the line horizontal to the y-axis.
• Compare AR/price to AC to determine profit or loss.

Everything is important – do not leave out anything! Each step counts for marks. Label all axes, curves and graphs. Note the following:

• To show economic profit the AC curve must cut the demand curve.
• To show normal profit the minimum point on AC curve must be at a tangent to the demand curve.
• To show economic loss the AC curve must not touch demand curve.

6.8 Competition policies

6.8.1 Description Competition refers to the existence of free entry into and exit from markets. This ensures that markets are not dominated by certain businesses. 6.8.2 Goals of competition policy

• To prevent monopolies and other powerful businesses from abusing their power.
• To regulate the formation of mergers and acquisitions who wish to exercise market power.
• To stop firms from using restrictive practices like fixing prices, dividing markets etc.

6.8.3 The Competition Act in South Africa The government introduced the Competition Act 89 of 1998 to promote competition in South Africa in order to achieve the following objectives:

• promote the efficiency of the economy (its primary aim)
• provide consumers with competitive prices and a variety of products
• promote employment
• encourage South Africa to participate in world markets and accept foreign competition in South Africa
• enable SMMEs to participate in the economy
• to allow the previously disadvantaged to increase their ownership of businesses
• Define the concept market structure. (2)
• How many sellers will one find in a monopoly market? (2)
• In what market are all participants price-takers? Motivate your answer. (4)
• Explain the shape of the individual demand curve under perfect competition. (4)
• Vodacom (6)
• Explain in your own words the message behind the pie-charts shown above. (4)

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Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information

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Michael Rothschild, Joseph Stiglitz, Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information, The Quarterly Journal of Economics , Volume 90, Issue 4, November 1976, Pages 629–649, https://doi.org/10.2307/1885326

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Introduction, 629.—I. The basic model, 630.—II. Robustness, 638—III. Conclusion, 648.

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