Competition refers to the set of actions that sellers take against each other as they each try to increase their own profits. In actual competition, sellers alter the prices and quality of their products as they try to win larger shares of the market for a good or service from each other. In contrast, cooperation between sellers is the set of actions that sellers take in concert as they seek greater overall profits. Sellers sometimes conspire against buyers to set prices above competitive levels, but at other times they cooperate in the development of new products and technologies.
Our understanding of competition has changed over time. Most early economists agreed that competition was a combative and open-ended process. However, modern economists disagree over competition’s exact nature. Adam Smith argued that competition in free markets causes self-interested individuals to promote the welfare of others. He argued that individuals who wish to gain something for themselves by trading with others could only do so by agreeing to terms that also benefited their trading partners. Smith saw competition among buyers and sellers as a means of reconciling interests between the two groups. Smith also recognized the potential for sellers to conspire together with the government to raise prices above competitive levels.
In the 19th century, Antoine Cournot argued that sellers could first agree to divide market share among themselves and at that point act collectively to increase prices above competitive levels. However, some time later, Joseph Bertrand argued that because sellers could dramatically increase market share by cheating on their agreements, efforts between sellers to cooperate in setting prices above competitive levels would invariably end in failure. This argument is consistent with Smith’s view that monopolies were nothing more than government-granted privileges.
During the early 20th century, the concept of perfect competition was put forward by economists; it referred to competition as it would exist under the following five conditions: first, that there were a large number of buyers and sellers trading a uniform product; second, that the market had free entry and exit; third, that all market participants were fully informed regarding all opportunities for trade; fourth, that bargaining and price changes cost nothing; and fifth, that enforcing the terms of a transaction is costless. Under these conditions, individuals will engage in trades that bring about perfection in the allocation of existing resources. This static view of competition treats it as an end state or goal, rather than an ongoing process.
Some economists have used the theoretical results of perfect competition as a standard in judging the performance of real-world markets and found the market system lacking. In this view, private businesses wield “market power” to set prices above perfectly competitive levels. These economists argued that governments could improve upon actual competition with policies that bring about perfectly competitive results.
Harold Demsetz has countered these conclusions by arguing that perfect competition is too high a standard for either real-world markets or the government to meet. This argument is true because there is a positive cost to operating any economic system. Because both competitive market systems and planned economies cost something to operate, neither will allocate resources perfectly. These operating costs create imperfections in both private markets and the public sector. Demsetz maintained that economists who condemn the free market on these grounds fail to account for the possibility that government intervention aimed toward correcting market imperfections is imperfect. Thus, when the government intervenes to correct the market, there always exists the possibility that it might make matters worse. Demsetz further demonstrated that abnormally high profit rates tend to disappear over time, thus negating the purposes of government intervention.
Similarly, Friedrich Hayek argued that the concept of perfect competition misconstrues the true nature of competition. According to Hayek, perfect competition represents a situation where actual competition has ended. To Hayek, competition is a procedure in which competitors search for opportunities for profit. Competitors begin this procedure with relatively little knowledge of the situations that they face in the markets in which they sell. Competition between sellers then amounts to a discovery procedure as sellers learn how to increase their profits and buyers discover new opportunities for consumption. This analysis directly contradicts the assumptions of perfect competition, which are predicated on the presence of perfect information. Hayek stressed that competition is important precisely because it drives individuals to improve on the limited knowledge that they possess. Consequently, attempts to condemn the market system because sellers lack perfect information make no sense.
Because competition involves the discovery of new opportunities for trade, the assumption of perfect information means that “perfect competition” would exist only in situations where all competition is over. Israel Kirzner extended Hayek’s arguments in noting the crucial importance of alertness on the part of entrepreneurs in discovering new opportunities for profit.
Hayek and Kirzner emphasized that competition is an open-ended process and doubted the realism of perfectly competitive models. Under perfect competition, competition is an end state where all individuals know who their best potential trading partners are. By focusing on continuous discovery, Hayek and Kirzner demonstrated the importance of competition as a means of collecting the information that the perfect competition concept takes for granted.
The importance of advertising to competition was discussed by George Stigler and Lester Telser, who demonstrated that advertising acted as a means of reducing the costs of gathering information. To Stigler and Telser, advertising fosters competition by informing individuals about the opportunities that await them in markets.
Some economists have noted that in some markets natural barriers to entry and exit limit competition and may even result in the formation of private monopolies. Although this concern is legitimate, there are two important points to keep in mind. First, as economist William Baumol has argued, potential competition can work just as well as actual competition. In some cases, monopolies may form, although it is possible for other sellers to enter the market. In such instances, monopolists (in the sense of single sellers in the market) will price their products as if they in fact had competitors. In other words, monopolists who fear potential competition will charge competitive prices to prevent entry by competitors. Because the primary complaint about monopolies is that they charge prices above competitive levels, it makes little sense for anyone to worry about monopolies that use low prices as a barrier to entry.
Second, even if a monopolist secures another type of barrier to entry and sets prices above competitive levels, this fact does not imply that there is no competition. Instead, these situations generally imply that competition has moved to a different level. Barriers to market entry are seldom free and generally require maintenance. Demsetz points out that if some companies have higher profits than others, it may be because they have some uncapitalized asset, such as a trademark or goodwill. Some entrepreneurs create a barrier to entry through innovation. If an entrepreneur creates a new product or develops a new technology that reduces costs, then that entrepreneur is able to charge prices above competitive levels. Patent laws facilitate this process by enabling entrepreneurs to earn extra profits by patenting new products and technologies. Although itis true that these entrepreneurs can charge monopolistic prices, it also is true that they invest money in research and development (R&D). The money that entrepreneurs invest in R&D represents the cost of gaining monopoly status, and the extra profits they earn represent a return on the money that they invested in creating their monopoly. Because patents run out, these monopolists must reinvest in research and development to maintain their monopoly status over time. This reinvestment results in long-term technological progress and product innovation that Joseph Schumpeter described as creative destruction.
Edwin Chadwick distinguished between competition within a field and competition for a field. Chadwick’s research drew a clear line between competition between sellers for customers and competition between sellers for the means to exclude each other. Gordon Tullock revived this issue by arguing that entrepreneurs lobby governments to construct artificial barriers to entry as a means of gaining monopoly control over prices. Labor unions and professional associations like the American Medical Association are examples of resource market monopolies that derive benefits from artificial governmental barriers. These monopolists pay for their privileges; however, in these instances, the resources that the monopolist invests in constructing and maintaining barriers to entry do nothing to enhance long-term progress and prosperity.
In competitive markets, entrepreneurs compete with each other for customers. In monopolistic markets, entrepreneurs compete with each other to either win or maintain monopoly status. In the absence of government-granted privileges, competition enables individuals to benefit from gains from trade and innovation. However, competition does become onerous when individuals compete for special privileges from the government that enable them to charge monopolistic prices without improving the quality of their products or services.
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Demsetz, Harold. “Information and Efficiency, Another Viewpoint.” The Journal of Law and Economics 12 no. 1 (April 1969): 1–22.
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Originally published .