Definition of Competition
Competition is a situation in which someone is trying to win something or be more successful than someone else.
In economics, it is defined as an activity involving two or more firms, in which each firm tries to get people to buy its own goods in preference to the other firm’s goods. For example, by offering different products, better deals or by other means.
In other words, it is simply the effort of enterprises to be leaders in their industry and increase their market share.
What is Competition in Economics?
When a market has a sufficient number of buyers and sellers to keep prices at low level, competition in economics exists. Having a large number of sellers gives consumers many options, which means companies have to compete to offer the best prices, value and service. Otherwise, consumers will go to the competition.
When consumers enjoy many choices, businesses must continue to offer the best prices. In this way, competition self-regulates the supply and demand of markets, keeping goods affordable for consumers. This is called the invisible hand theory.
Under a truly competitive market, no one company is able to exploit prices because consumers always have a choice to go somewhere else. There must be a healthy amount of competition in a market for this to work. Certain markets may not have as much competition, thus causing prices to go up.
Types of Competition
Several different types of competition in economics are largely defined by the number of sellers existing in a market.
1. Perfect Competition
Perfect competition is a theoretical market structure where many firms sell an identical product (the product is a “commodity” or “homogenous”). Because of so many companies selling similar products, consumers have available substitutes and thus, prices are controlled by supply and demand, and are generally low for consumers.
In addition to the existence of many companies that sell homogenous product, a perfect competition also assumes that:
- All firms are price-takers. It means that an individual or company must accept prevailing prices in a market, lacking the market share to influence the market price on its own.
- Market share has no influence on prices.
- Buyers have complete or “perfect” information – in the past, present and future – about the product being sold and the prices charged by each firm.
- Firms to enter or exit the market with zero cost.
- There is no price and government intervention.
- There is free movement of factors of production.
- There are companies seeking for profit maximization.
How Perfect Competition Works
Perfect competition is a benchmark, or “ideal type,” to which a real-life market structures can be compared. Under a perfect competition, there are many buyers and sellers and prices reflect supply and demand.
Companies earn just enough profit to stay in business and no more. If they were to earn an excess profit, other companies would enter the market and drive profits down.
A Large and Homogenous Market
There are a large number of buyers and sellers in a perfectly competitive market. The sellers are small firms, instead of large corporations capable of controlling prices through supply adjustments. They sell products with minimal differences in capabilities, features and pricing. This ensures that buyers cannot distinguish between products based on physical attributes, such as size or color, or intangible values, such as branding.
A large population of both buyers and sellers ensures that supply and demand remain constant in this market. As such, buyers can easily substitute products made by one firm for another.
Perfect Information Availability
In a perfectly competitive market, information is freely and equally available to all market participants. This ensures that each firm can produce its goods or services at exactly the same rate and with the same production techniques as another one in the market.
Absence of Controls
Governments play a vital role in market formation for products by imposing regulation and price controls. They can control the entry and exit of firms into a market by setting up rules to function in the market.
For example, the pharmaceutical industry has to contend with a roster of rules pertaining to research, production, and sale of drugs.
In turn, these rules require big capital investments in the form of employees, such as lawyers and quality assurance personnel, and infrastructure, such as machinery to manufacture medicines. The cumulative costs add up and make it extremely expensive for companies to bring a drug to the market.
In comparison, the technology industry functions with relatively less oversight as compared to its pharma counterpart. Thus, entrepreneurs in this industry can start firms with less to zero capital, making it easy for individuals to start a company in the industry.
Such controls do not exist in a perfectly competitive market. The entry and exit of firms in such a market are unregulated, and this frees them up to spend on labor and capital assets without restrictions and adjust their output in relation to market demands.
Cheap and Efficient Transportation
In this type of market, companies do not incur significant costs to transport goods. This helps reduce the product’s price and cuts back on delays in transporting goods.
2. Monopolistic Competition
Monopolistic competition is a market structure which combines elements of monopoly and competitive markets. It happens when there are many competitors in a market but each company sells a slightly different product.
In monopolistic competition, there is a relatively low barrier of entry for businesses. This means there will be many companies entering the competition. They must each use marketing to differentiate their products and convince consumers of why their company’s product should be chosen over all the others.
A central feature of monopolistic competition is that products are differentiated.
There are four main types of differentiation:
- Physical product differentiation. Firms use size, design, color, shape, performance and features to make their products different. (e.g. consumer electronics can be differentiated physically.)
- Marketing differentiation. Firms use distinctive packaging and other promotional techniques. (e.g. breakfast cereals packaging can be differentiated easily.)
- Human capital differentiation. Firms create differences through the skills, level of training received, distinctive uniforms and so on of its employees.
- Distribution differentiation. Distribution via mail order or through internet shopping, such as Amazon, differentiates from traditional selling online by bookstores.
Because of the abundance of competition, demand is elastic. If a company significantly raises their prices, many consumers will likely go elsewhere.
Examples of Monopolistic Competition
- Restaurants. Compete on quality of food as much as price.
- Hairdressers. Compete on the quality of service, i.e. hair-cutting.
- Clothing. Compete on the quality, label and branding of clothes.
- TV Programs. Globalization has increased the variety TV programs from networks around the world. Consumers can choose between domestic channels but also imports from other countries and new services, such as Netflix, etc.
Limitation of the Model of Monopolistic Competition
There are some limitations of this model as observed in the market. Many industries, described as monopolistically competitive are very profitable, so the assumption of normal profits would be too basic. Some firms will be better at brand differentiation, and thus, are able to make supernormal profit.
If a business has strong brand loyalty and product differentiation, this becomes a barrier to entry. Which means a new firm cannot easily capture the brand loyalty. Accordingly, new companies will not be seen as close substitute.
3. Monopoly
A monopoly exists when there is only one company covering an entire market.
In the most extreme sense, a monopoly is a single supplier that controls a market for a product or service, and thus can set prices without any competition.
This lack of consumer choice usually leads to high prices. Sometimes a business is considered a monopoly because the barrier to entry is too high for other firms to compete with the market.
When a government is the sole controller of a product or service, such as electricity, mail delivery or gas, in those times, a monopoly is artificially formed.
Antitrust laws are intended to prevent monopolies and protect consumers from their effects. Markets must continue to be open to new competitors if prices are to stay low and goods are to remain affordable.
Characteristics of Monopolies
Since they are either the sole provider of a product or service, thus control most of the market share or customers for their product, monopolies naturally have an unfair advantage over their competition. Although monopolies might vary from industry-to-industry, they tend to share comparable characteristics that include:
- High or no barriers to entry. By acquiring the competition, the monopoly can easily prevent competition from developing their position in an industry. Competitors cannot easily enter the market.
- Single seller in the market. The company becomes the same as the industry it attends.
- Price maker. The company that operates the monopoly decides the price of the product that it will sell without any competition keeping their prices in check. So, monopolies can raise prices at their option.
- Economies of scale. Given that monopolies can buy huge quantities of inventory, usually at a discount, they also often produce at a lower cost, compared to smaller companies. This means, a monopoly can lower its prices so much that smaller competitors can’t manage to survive.
4. Oligopoly
Oligopoly is a market structure where there are more than two competitors, but no more than a handful. Usually, oligopoly markets have a high barrier to entry.
While monopoly is one firm, duopoly is two firms, an oligopoly is two or more firms.
There is no exact upper limit as to the number of businesses in an oligopoly, but the number must be low enough that the actions of one firm significantly impact that of the others.
Generally, governments set laws that prohibit oligopolies from engaging in price fixing or collusion. Unfortunately, the practice is not unprecedented. OPEC has famously found ways around laws to continue fixing prices on oil. Further, companies competing in an oligopoly tend to follow price leaders – when one price leader business raises prices, the others follow suit, raising prices overall for consumers.
Examples of Oligopolies
Historically, oligopolies include steel manufacturers, oil companies, rail roads, tire manufacturing, grocery store chains, and wireless carriers. The economic and legal concern is that an oligopoly can block new entrants, slow innovation, and increase prices, all of which harm consumers.
Businesses in an oligopoly tend to set prices rather than taking prices from the market. Thus, returns are higher than they would be in a more competitive market.
Business Impact of Competition in Economics
Competition disturbs several aspects of a business. This includes:
- Barrier entry for a business.
For more competitive industries, the barrier to entry is relatively low. Many competitors can enter the marketplace and afford to do business.
In less competitive markets, it is difficult to enter the market and compete with the existing entities. This could be due to cost or legal difficulties.
For example, if you want to build a railroad, you are going to be in for a difficult undertaking. Building new railroad tracks requires government approval, which is not easily given. Further, the amount of money needed for such a project is not available to most.
- Price-setting.
In competitive industries, a business must always be conscious of its pricing when placed next to comparable companies.
For example, if you are opening a bar, you must be aware of what other bars in the area are charging for drinks. You may be able to convince your customers to pay $10 for a Bud Light when the bar next door charges $5 if you offer entertainment or some other valuable service.
But in the end, you will always be fairly bound to the prices your competition charges. That is, unless you are able to differentiate yourself substantially from what other firms are offering.
- Business profits.
Suppose you’re in the car-washing business. You have relatively limited competitors, and thus, you are making high profit margins. Now some other entrepreneurs hear that your business is making great returns. This induces five new car washers to join the market.
Accordingly, the entry of new businesses may compel you to lower prices or offer higher value to your customers. This shows that the competition will surely have impact on your expected returns.
Typically, competition is fast to enter high profit businesses, resulting to a lower profit for everyone.
FAQs
1. What is a competition?
Competition is an activity involving two or more firms striving to gain an advantage over each other. In other words, it is a showdown between businesses to see who can come out on top.
2. What are the benefits of competition?
There are several benefits of competition, including:
1) Lower prices - In a competitive market, businesses are constantly trying to undercut each other's prices in order to gain market share. This drives prices down for consumers.
2) Greater innovation - In a competitive market, businesses are always trying to come up with new products and services in order to stay ahead of the competition.
3) Higher quality - In a competitive market, businesses are forced to provide high-quality products and services in order to stay ahead of the competition. If they don't, consumers will quickly switch to a competitor.
3. What are the types of competition?
There are four types of competition:
1) Perfect Competition - This is a theoretical market structure where there are a large number of small firms, each selling identical products. There is free entry and exit, and perfect information.
2) Monopolistic Competition - This is a market structure where there are many firms selling similar but not identical products. Firms have some power to set prices, but there is still free entry and exit.
3) Oligopoly - This is a market structure where there are more than two firms. Businesses in an oligopoly tend to set prices rather than take prices from the market. Thus, returns are higher than they would be in a more competitive market.
4) Monopoly - This is a market structure where there is only one firm in the market. The firm has total control over the price and quantity of the product.
4. Does competition affect bank risk?
Yes, competition affects bank risk. In a competitive market, banks are constantly trying to undercut each other's rates in order to gain market share. This drives rates down for consumers, but it also means that banks are taking on more risk. This is because they are lending money at a lower rate, which means they are not making as much money on each loan. As a result, they are more likely to suffer losses if a large number of borrowers default on their loans.
5. How does the level of competition affects the cash flow?
The level of competition in a market affects the cash flow for two reasons. First, in a more competitive market, businesses distribute less dividends to their shareholders because they are reinvesting the profits back into the business in order to stay competitive.
Second, in a more competitive market, businesses are forced to offer lower prices, which reduces the amount of cash flow that they receive from customers. This means that businesses in a more competitive market have less money to work with, which affects their ability to grow and expand.
