Competition (economics)

Adjacent advertisements in an 1885 newspaper for the makers of two competing ore concentrators (machines that separate out valuable ores from undesired minerals). The lower ad touts that their price is lower, and that their machine's quality and efficiency was demonstrated to be higher, both of which are general means of economic competition.

In economics, competition is a scenario where different economic firms[Note 1] are in contention to obtain goods that are limited by varying the elements of the marketing mix: price, product, promotion and place. In classical economic thought, competition causes commercial firms to develop new products, services and technologies, which would give consumers greater selection and better products. The greater the selection of a good is in the market, prices are typically lower for the products, compared to what the price would be if there was no competition (monopoly) or little competition (oligopoly). This is because there is now no rivalry between firms to obtain the product as there is enough for everyone. The level of competition that exists within the market is dependant on a variety of factors both on the firm/ seller side; the number of firms, barriers to entry, information availability, availability/ accessibility of resources. The number of buyers within the market also factors into competition with each buyer having a willingness to pay, influencing overall demand for the product in the market.

The extent of the competition present within a particular market can measured by; the number of rivals, their similarity of size, and in particular the smaller the share of industry output possessed by the largest firm, the more vigorous competition is likely to be.[1]

Early economic research focused on the difference between price- and non-price-based competition, while modern economic theory has focused on the many-seller limit of general equilibrium.

Perfect Vs imperfect competition [ edit ]

Perfect competition [ edit ]

Neoclassical economic theory places importance in a theoretical market state, in which the firms and market are considered to be in perfect competition. Perfect competition exists when all criteria are met, which is rarely (if ever) observed in the real world. These criteria include; all firms contribute insignificantly to the market,[2] all firms sell an identical product, all firms are price takers, market share has no influence on price, both buyers and sellers have complete or "perfect" information, resources are perfectly mobile and firms can enter or exit the market without cost.[3] Under perfect competition, there are many buyers and sellers within the market and prices reflect the overall supply and demand. Another key feature of a perfectly competitive market is the variation in products being sold by firms. The firms within a perfectly competitive market are small, with no larger firms controlling a significant proportion of market share.[3] These firms sell almost identical products with minimal differences or in-cases perfect substitutes to another firms product.

The idea of perfectly competitive markets draws in other neoclassical theories of the buyer and seller. The buyer in a perfectly competitive market have identical tastes and preferences with respect to desired product features and characteristics (homogeneous within industries) and also have perfect information on the goods such as price, quality and production.[4] In this type of market, buyers are utility maximizers, in which they are purchasing a product that maximizes their own individual utility that they measure through their preferences. The firm, on the other hand, is aiming to maximize profits acting under the assumption of the criteria for perfect competition.

The firm in a perfectly competitive market will operate in two economic time horizons; the short-run and long-run. In the short-run the firm adjusts its quantity produced according to prices and costs. While in the long run the firm is adjusting its methods of production to ensure they produce at a level where marginal cost equals marginal revenue.[4] In a perfectly competitive market, firms/producers earn zero economic profit in the long run.[2]

Imperfect competition [ edit ]

Imperfectly competitive markets are the realistic markets that exist in the economy. Imperfect competition exist when; buyers might not have the complete information on the products sold, companies sell different products and services, set their own individual prices, fight for market share and are often protected by barriers to entry and exit, making it harder for new firms to challenge them.[5] An important differentiation from perfect competition is, in markets with imperfect competition, individual buyers and sellers have the ability to influence prices and production.[6] Under these circumstances, markets move away from the neoclassical economic definition of a perfectly competitive market, as the market fails the criteria and this inevitably leads to opportunities to generate more profit, unlike in a perfect competition environment, where firms earn zero economic profit in the long run.[5] These markets are also defined by the presence of monopolies, oligopolies and externalities within the market.

The measure of competition in accordance to the theory of perfect competition can be measured by either; the extent of influence of the firm's output on price (the elasticity of demand), or the relative excess of price over marginal cost.[1]

Types of imperfect competition [ edit ]

Monopoly [ edit ]

Monopoly is the opposite to perfect competition. Where perfect competition is defined by many small firms competition for market share in the economy, Monopolies are where one firm holds the entire market share. Instead of industry or market defining the firms, monopolies are the single firm that defines and dictates the entire market.[7] Monopolies exist where one of more of the criteria fail and make it difficult for new firms to enter the market with minimal costs. Monopoly companies use high barriers to entry to prevent and discourage other firms from entering the market to ensure they continue to be the single supplier within the market. A natural monopoly is a type of monopoly that exists due to the high start-up costs or powerful economies of scale of conducting a business in a specific industry.[8] These types of monopolies arise in industries that require unique raw materials, technology, or similar factors to operate.[8] Monopolies can form through both fair and unfair business tactics. These tactics include; collusion, mergers, acquisitions, and hostile takeovers. Collusion might involve two rival competitors conspiring together to gain an unfair market advantage through coordinated price fixing or increases.[8] Natural monopolies are formed through fair business practices where a firm takes advantage of an industry's high barriers. The high barriers to entry are often due to the significant amount of capital or cash needed to purchase fixed assets, which are physical assets a company needs to operate.[8] Natural monopolies are able to continue to operate as they typically can as they produce and sell at a lower cost to consumers than if there was competition in the market. Monopolies in this case use the resources efficiently in order to provide the product at a lower price. Similar to competitive firms, monopolists produces a quantity at that marginal revenue equals marginal cost. The difference here is that in a monopoly, marginal revenue does not equal to price because as a sole supplier in the market, monopolists have the freedom to set the price at which the buyers are willing to pay for to achieve profit-maximizing quantity.[9]

Oligopoly [ edit ]

Oligopolies are another form of imperfect competition market structures. An oligopoly is when a small number of firms collude, either explicitly or tacitly, to restrict output and/or fix prices, in order to achieve above normal market returns.[10] Oligopoly can be made up of two or more firms, however, it is a market structure that is very highly concentrated. Only a few firms dominate, for example, major airline companies like Delta and American Airlines operate with a few close competitors, but there are other smaller airlines that are competing in this industry too.[11] Similar factors that allow monopolies to exist also facilitate the formation of oligopolies. These include; high barriers to entry, legal privilege; government outsourcing to a few companies to build public infrastructure (e.g railroads) and access to limited resources, primarily seen with natural resources within a nation. Companies in an oligopoly benefit from price-fixing, setting prices collectively, or under the direction of one firm in the bunch, rather than relying on free-market forces to do so.[10] Oligopolies can form cartels in order to restrict entry of new firms into the market and ensure they hold market share. Governments usually heavily regulate markets that are susceptible to oligopolies to ensure that consumers are not being over charged and competition remains fair within that particular market.[12]

Monopolistic competition [ edit ]

Monopolistic competition characterises an industry in which many firms offer products or services that are similar, but not perfect substitutes. Barriers to entry and exit in a monopolistic competitive industry are low, and the decisions of any one firm do not directly affect those of its competitors.[13] Monopolistic competition exists in-between monopoly and perfect competition, as it combines elements of both market structures. Within monopolistic competition market structures all firms have the same, relatively low degree of market power; they are all price makers, rather than price takers. In the long run, demand is highly elastic, meaning that it is sensitive to price changes. In order to raise their prices, firms must be able to differentiate their products from their competitors in terms of quality, whether real or perceived. In the short run, economic profit is positive, but it approaches zero in the long run. Firms in monopolistic competition tend to advertise heavily because different firms need to distinguish similar products than others.[13] Examples of monopolistic competition include; restaurants, hair salons, clothing, and electronics.

Dominant firms [ edit ]

In several highly concentrated industries, a dominant firm serves a majority of the market. Dominant firms have a market share of 50% to over 90%, with no close rival. Similar to a monopoly market, it uses high entry barrier to prevent other firms from entering the market and competing with them. They have the ability to control pricing, to set systematic discriminatory prices, to influence innovation, and (usually) to earn rates of return well above the competitive rate of return.[12] This is similar to a monopoly, however there are other smaller firms present within the market that make up competition and restrict the ability of the dominant firm to control the entire market and choose their own prices. As there are other smaller firms present in the market, dominant firms must be careful not to raise prices too high as it will induce customers to begin to buy from firms in the fringe of small competitors.[14]

Effective competition [ edit ]

Effective competition exists when there are four firms with market share below 40% and flexible pricing. Low entry barriers, little collusion, and low profit rates.[12] The main goal of effective competition is to give competing firms the incentive to discover more efficient forms of production and to find out what consumers want so they are able to have specific areas to focus on.[15]

Competitive Equilibrium [ edit ]

Competitive equilibrium is a concept in which profit-maximising producers and utility-maximising consumers in competitive markets with freely determined prices arrive at an equilibrium price. At this equilibrium price, the quantity supplied is equal to the quantity demanded.[16] This implies that a fair deal has been reached between supplier and buyer, in-which all suppliers have been matched with a buyer that is willing to purchase the exact quantity the supplier is looking to sell and therefore, the market is in equilibrium.

The competitive equilibrium in economic theory is considered to be a part of game theory which deals with decision making of firms in large markets. The overall concept acts as a benchmark for evaluating efficiency in the market and how far off the market is from equilibrium.[16]

The competitive equilibrium has many applications for predicting both the price and total quality in a particular market. It can also be used to estimate the quantity consumed by each individual and the total output of each firm within a market. Furthermore, through the idea of a competitive equilibrium, particular government policies or events can be evaluated and decide whether they move the market towards or away from the competitive equilibrium.[16]

Role in market success [ edit ]

Competition is generally accepted as an essential component of markets, and results from scarcity—there is never enough to satisfy all conceivable human wants—and occurs "when people strive to meet the criteria that are being used to determine who gets what." In offering goods for exchange, buyers competitively bid to purchase specific quantities of specific goods which are available, or might be available if sellers were to choose to offer such goods. Similarly, sellers bid against other sellers in offering goods on the market, competing for the attention and exchange resources of buyers.[17]:105

The competitive process in a market economy exerts a sort of pressure that tends to move resources to where they are most needed, and to where they can be used most efficiently for the economy as a whole. For the competitive process to work however, it is "important that prices accurately signal costs and benefits." Where externalities occur, or monopolistic or oligopolistic conditions persist, or for the provision of certain goods such as public goods, the pressure of the competitive process is reduced.[18]

In any given market, the power structure will either be in favour of sellers or in favour of buyers. The former case is known as a seller's market; the latter is known as a buyer's market or consumer sovereignty.[19] In either case, the disadvantaged group is known as price-takers and the advantaged group known as price-setters.[20] Price takers must accept the prevailing price and sell their goods at the market price whereas price setters are able to influence market price and enjoy pricing power.

Competition bolsters product differentiation as businesses try to innovate and entice consumers to gain a higher market share and increase profit. It helps in improving the processes and productivity as businesses strive to perform better than competitors with limited resources. The Australian economy thrives on competition as it keeps the prices in check.[21]

Historical views [ edit ]

In his 1776 The Wealth of Nations, Adam Smith described it as the exercise of allocating productive resources to their most highly valued uses and encouraging efficiency, an explanation that quickly found support among liberal economists opposing the monopolistic practices of mercantilism, the dominant economic philosophy of the time.[22][23] Smith and other classical economists before Cournot were referring to price and non-price rivalry among producers to sell their goods on best terms by bidding of buyers, not necessarily to a large number of sellers nor to a market in final equilibrium.[24]

Later microeconomic theory distinguished between perfect competition and imperfect competition, concluding that perfect competition is Pareto efficient while imperfect competition is not. Conversely, by Edgeworth's limit theorem, the addition of more firms to an imperfect market will cause the market to tend towards Pareto efficiency.[25] Pareto efficiency, named after the Italian economist and political scientist Vilfredo Pareto (1848-1923), is an economic state where resources cannot be reallocated to make one individual better off without making at least one individual worse off. It implies that resources are allocated in the most economically efficient manner, however, it does not imply equality or fairness.

Appearance in real markets [ edit ]

Real markets are never perfect. Economists who believe that perfect competition is a useful approximation to real markets classify markets as ranging from close-to-perfect to very imperfect. Examples of close-to-perfect markets typically include share and foreign exchange markets while the real estate market is typically an example of a very imperfect market. In such markets, the theory of the second best proves that, even if one optimality condition in an economic model cannot be satisfied, the next-best solution can be achieved by changing other variables away from otherwise-optimal values.[26]:217

Time variation [ edit ]

Within competitive markets, markets are often defined by their sub-sectors, such as the "short term" / "long term", "seasonal" / "summer", or "broad" / "remainder" market. For example, in otherwise competitive market economies, a large majority of the commercial exchanges may be competitively determined by long-term contracts and therefore long-term clearing prices. In such a scenario, a “remainder market” is one where prices are determined by the small part of the market that deals with the availability of goods not cleared via long term transactions. For example, in the sugar industry, about 94-95% of the market clearing price is determined by long-term supply and purchase contracts. The balance of the market (and world sugar prices) are determined by the ad hoc demand for the remainder; quoted prices in the "remainder market" can be significantly higher or lower than the long-term market clearing price.[citation needed] Similarly, in the US real estate housing market, appraisal prices can be determined by both short-term or long-term characteristics, depending on short-term supply and demand factors. This can result in large price variations for a property at one location.[citation needed]

Anti-competitive pressures and practices [ edit ]

Competition requires the existing of multiple firms, so it duplicates fixed costs. In a small number of goods and services, the resulting cost structure means that producing enough firms to effect competition may itself be inefficient. These situations are known as natural monopolies and are usually publicly provided or tightly regulated.[27]

The printing equipment company American Type Founders explicitly states in its 1923 manual that its goal is to 'discourage unhealthy competition' in the printing industry.

International competition also differentially affects sectors of national economies. In order to protect political supporters, governments may introduce protectionist measures such as tariffs to reduce competition.[28]

Anti-competitive practices [ edit ]

A practice is anti-competitive if it unfairly distorts free and effective competition in the marketplace. Examples include cartelization and evergreening.[29]

Critiques of Perfect competition [ edit ]

Economists do not all agree to the practicability of perfect competition. There is debate surrounding how relevant it is to real world markets and whether it should be a market structure that should be used as a benchmark.

Neoclassical economists believe that perfect competition creates a perfect market structure, with the best possible economic outcomes for both consumers and society. In general, they do not claim that this model is representative of the real world. Neoclassical economists argue that perfect competition can be useful, and most of their analysis stems from its principles.[30]

Economists that are critical of the neoclassical reliance on perfect competition in their economic analysis believe that the assumptions built into the model are so unrealistic that the model cannot produce any meaningful insights. The second line of critic to perfect competition is the argument that it is not even a desirable theoretical outcome.[30] These economists believe that the criteria and outcomes of perfect competition do not achieve a efficient equilibrium in the market and other market structures are better used as a benchmark within the economy.

See also [ edit ]

Notes [ edit ]

  1. ^ This article follows the general economic convention of referring to all actors as firms; examples in include individuals and brands or divisions within the same (legal) firm.

References [ edit ]

  1. ^ a b Stigler, George J. (1972). "Economic Competition and Political Competition". Public Choice. 13: 91–106. ISSN 0048-5829.
  2. ^ a b "Perfect Competition | Boundless Economics". Retrieved 2020-11-29.
  3. ^ a b Hayes, Adam. "Understanding Perfect Competition". Investopedia. Retrieved 2020-10-28.
  4. ^ a b Hunt, Shelby (2000). A General Theory of Competition: Resources, Competences, Productivity, Economic Growth. California: SAGE Publications. doi:10.4135/9781452220321.
  5. ^ a b Liberto, Daniel. "Imperfect Competition Definition". Investopedia. Retrieved 2020-10-28.
  6. ^ Kenton, Will. "Imperfect Market: An Inside Look". Investopedia. Retrieved 2020-10-28.
  7. ^ McNulty, Paul J. (1968). "Economic Theory and the Meaning of Competition". The Quarterly Journal of Economics. 82 (4): 639–656. doi:10.2307/1879604. ISSN 0033-5533.
  8. ^ a b c d Staff, Investopedia. "Natural Monopoly Definition". Investopedia. Retrieved 2020-10-28.
  9. ^ "Profit Maximization for a Monopoly | Microeconomics". Retrieved 2020-11-29.
  10. ^ a b Staff, Investopedia. "Oligopoly". Investopedia. Retrieved 2020-10-28.
  11. ^ Krylovskiy, Nikolay. "Oligopoly". Economics Online. Retrieved 2020-11-29.
  12. ^ a b c Shepherd, William G. (1982). "Causes of Increased Competition in the U.S. Economy, 1939-1980". The Review of Economics and Statistics. 64 (4): 613–626. doi:10.2307/1923946. ISSN 0034-6535.
  13. ^ a b Staff, Investopedia. "Monopolistic Competition Definition". Investopedia. Retrieved 2020-10-28.
  14. ^ "Dominant Firm". Retrieved 2020-11-29.
  15. ^ Bender, Christian M.; Bijl, Paul W. J. de; Götz, Georg; Haus, Florian C.; Knieps, Günter; Littlechild, Stephen; Pakula, Benjamin; Schwarz, Anton (2011). ""Effective Competition" in Telecommunications, Rail and Energy Markets". Intereconomics. 2011 (1): 4–35.
  16. ^ a b c Liberto, Daniel. "Competitive Equilibrium Definition". Investopedia. Retrieved 2020-10-29.
  17. ^ Heyne, Paul; Boettke, Peter J.; Prychitko, David L. (2014). The Economic Way of Thinking (13th ed.). Pearson. pp. 102–06. ISBN 978-0-13-299129-2.
  18. ^ Cowen, Tyler; Tabarrok, Alex (2013). Modern Principles: Microeconomics (2nd ed.). New York: Worth Publishers. pp. 228–29. ISBN 978-1-4292-3999-8.
  19. ^ Hutt, William H. (March 1940). "The Concept of Consumers' Sovereignty". The Economic Journal. 50: 66–77. JSTOR 2225739.
  20. ^ "Price Taker - Learn More About Price Takers vs. Price Makers". Corporate Finance Institute. Retrieved 2020-11-29.
  21. ^ "Competition is the key to a brave new Australia".
  22. ^ Lanny Ebenstein, 2015. Chicagonomics: The Evolution of Chicago Free Market Economics Macmillan, pp. 13–17, 107.
  23. ^ George J. Stigler, 2008. ([1987] 2008,. "competition," The New Palgrave Dictionary of Economics. Abstract.
  24. ^ Mark Blaug, 2008. "invisible hand," The New Palgrave Dictionary of Economics, 2nd Edition, v. 4, p. 565. Abstract.
  25. ^ Staff, Investopedia. "Pareto Efficiency Definition". Investopedia. Retrieved 2020-11-29.
  26. ^ Lipsey, R. G.; Lancaster, Kelvin (1956). "The General Theory of Second Best". Review of Economic Studies. 24 (1): 11–32. doi:10.2307/2296233. JSTOR 2296233.
  27. ^ Perloff, J, 2012. Microeconomics, Pearson Education, England, p. 394.
  28. ^ Poole, William. "Free Trade: Why Are Economists and Noneconomists So Far Apart?". Retrieved 2018-02-27. One set of reservations concerns distributional effects of trade. Workers are not seen as benefiting from trade. Strong evidence exists indicating a perception that the benefits of trade flow to businesses and the wealthy, rather than to workers, and to those abroad rather than to those in the United States.
  29. ^ J. Gregory Sidak, The Deterrent Effect of Antitrust Enforcement, 89 J. POL. ECON. 429, 429 (1981).
  30. ^ a b Gallant, Chris. "Does Perfect Competition Exist in the Real World?". Investopedia. Retrieved 2020-10-29.

External links [ edit ]

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