Is there a resolution to the perfect market dilemma?

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Question: 

I read a summary of perfect competition which said that:
1. All market participants have perfect knowledge.
2. Excess profit is only possible in the short run.

If all participants have perfect knowledge, wouldn't all producers instantly know about excess profit opportunities, causing all of them to switch to producing that product at the same time, causing the price to crash and all of them to experience losses? Or, with second-order knowledge, wouldn't they all know that they all knew about the opportunity, and none of them would switch?

Is there a resolution to this perfect market dilemma?

Answer: 

"I read a summary of perfect competition which said that: 1. All market participants have perfect knowledge."

An assumption that a market M for a good Q is a "perfectly competitive market" is not a presumption of perfect knowledge on the part of the market participants. Rather, it is an assumption that participants in M are (or perceive themselves to be) too small relative to the market as a whole to have any impact on the market price. Consequently, they are "price takers" in the sense that they condition their market demands for Q (i.e., their bids to buy units of Q) and their market supplies of Q (i.e., their offers to sell units of Q) on the possible market price P. Thus, the total demand for Q is a function D(P) of P, and the total supply of Q is a function S(P) of P. The market M (modeled as some kind of auction process) then sets the actual market price for units of Q at a level P* at which D(P*) = S(P*). The resulting price P* is called the competitive price solution for M and the resulting output Q* = D(P*) = S(P*) is called the competitive quantity solution for M. The pairing (Q*, P*) is also referred to as the competitive market solution for M.

"2. Excess profit is only possible in the short run."

In the "short run", meaning (by definition in economics) a period of time during which some inputs to production are fixed, the revenues received by the suppliers of the competitive output Q* can exceed C*, the total avoidable cost of producing Q*. That is, the short-run net earnings P*Q* - C* can be positive. ("Profit" is a more comprehensive measure of net earnings that also accounts for the costs of the fixed inputs.) In the longer run, however, the presumption under perfect competition is that fixed inputs will be adjusted and/or firms can and will enter the market until all of these "excess" net earnings disappear.

"If all participants have perfect knowledge, wouldn't all producers instantly know about excess profit opportunities, causing all of them to switch to producing that product at the same time, causing the price to crash and all of them to experience losses? Or, with second-order knowledge, wouldn't they all know that they all knew > about the opportunity, and none of them would switch? Is there a resolution to this perfect market dilemma?"

Your above statement is based on the presumption of perfect knowledge and instantaneous possible adjustment of all factors of production. However, for perfectly competitive markets, perfect knowledge is not assumed at any time, and instantaneous adjustment of all factors of production is only assumed to hold "in the longer run."

Answered by:
Professor Emerita of Economics
Courtesy Research Professor of Electrical & Computer Engineering
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