COMPETITION AND THE MARKETPLACE
The Mall: One
of the markets where buyers meet sellers
Unit
Overview
One
of the most important characteristics of a market economy is competition. In markets, producers compete with each other
to meet demand and to make profits. At
the same time, consumers compete for goods and services at prices that they are
willing and able to pay. The degree of
competition among rival firms has led economists to divide market structures
into four major categories: perfect
competition, monopoly, oligopoly and monopolistic competition. Let's see how it all works.
The
Invisible Hand
According
to most economists, one of the key elements in keeping a market economy
functioning smoothly is competition. One of the first people to explain the
importance of this characteristic was Adam
Smith, a Scottish philosophy professor. In his book titled The
Wealth of Nations, Smith emphasizes that a country's economy works best
and acquires its greatest wealth when individuals are free to pursue their own
self-interests without government interference.
While he notes that government should protect private property and
enforce contracts, Smith stresses that it should not attempt to control prices
or to bailout failing businesses. This
philosophy is called laissez-faire, a French term which
means let them do as they please.
According
to Adam Smith, self-interest acts as an invisible
hand that guides the decision-making process of producers and
consumers. This leads to choices which make
the best use of scarce resources. With
the goal of making a profit, producers become rivals and challenge one another
to meet consumer demand. The competition
heats up when sellers employ tactics, such as advertising, offering promotions
and producing more efficiently. As profits convince sellers to create more of
what buyers are willing and able to purchase, competition among sellers
encourages new businesses to enter the market.
This increases supply, improves quality and eventually lowers
prices. Consumers also compete against
each other in the marketplace. Competition
among buyers impacts demand and, in turn, prices. It also allocates goods and services among the
people who are most able to pay for them. All of this is best accomplished
without laws or government regulation.
Remember—if left alone, the market will reach equilibrium. Smith's ideas
became the foundation of many European economies and continue to provide the
financial principles of countries around the globe today.
Go to Questions 1
through 3.
Market
Structures
When
Adam Smith published The Wealth of
Nations in 1776, businesses were competitive because most factories were
small. By the end of the nineteenth
century, however, conditions had changed.
Many small firms had combined to form large companies through
acquisitions and mergers. This resulted
in the rise of industries that weakened the power of competition and created
markets that were dominated by a few, influential firms. Economists use the term industry to represent all
of the producers of an identical or similar good or service. For example, the U.S. steel industry refers
to all companies that manufacture steel in the United States. Today, economists group industries into four,
major categories known as market structures.
They include perfect competition, monopoly, oligopoly and monopolistic
competition. An industry's market
structure depends on the number of businesses within the industry and the ways
that they compete in the market.
Go to Questions 4
and 5.
Perfect
Competition
The
simplest market structure is called perfect,
or pure, competition. As you may
have guessed when you saw the word perfect,
it refers to a very small number of industries that come close to reflecting this
model. Although perfect competition is
more theoretical than realistic, it is used by economists to evaluate the other
market structures. The conditions listed
below must be present for a perfectly competitive market to exist:
Ř Large numbers of buyers and sellers: Perfect competition requires many buyers and
sellers for a particular good or service.
A large number of independent producers and consumers means that no
single company or individual is powerful enough to sway the total market supply
or the market price. It also makes it
more difficult for groups of buyers or sellers to control prices by working
together. The market itself determines
the price without any influence from individual producers or consumers. Perfectly competitive markets operate
efficiently. Because it keeps prices and
production costs low, perfect competition benefits producers and
consumers.
Ř Identical Products:
There
are no differences among the items sold by the various producers in a perfectly
competitive market. This is certainly
true of commodities, such as milk, fuel oil, notebook paper and sugar. A commodity
is a product that is basically the same regardless of who makes it. For example, if a grocer is buying cauliflower
to sell in his store, he or she has no interest in who grew it as long as every
farm is willing to deliver it for the same price. This is based on the simple fact that one
head of cauliflower is very much like another. The buyer chooses the cheapest
supplier for cauliflower and does not pay extra for an identical product from
one, particular farmer.
Milk: An Example of a Commodity
Ř Well-informed buyers and sellers: When a market is purely competitive, buyers
and sellers are knowledgeable about an industry's goods and services. This encourages both sides of the market to search
for the best deals possible. Information concerning prices, products and
technological improvements is readily available with no lag time. For example, if a company is planning on
implementing a new production technique to streamline its manufacturing
process, the news is made public immediately to benefit both producers and
consumers.
Ř Free entry and exit from the market: If one firm can keep other companies out of
the market, it can sell its product at a higher price. For this reason, producers must be able to
enter and exit a purely competitive market structure freely and easily. In other words, companies enter the market
when they can make money and leave when they cannot. This helps to keep prices low because new
firms take business away from older firms that do not keep their pricing
competitive. It also makes it more
difficult for a few large companies to dominate the market.
Just
like everything else, perfect competition has advantages and
disadvantages. In this situation, both
buyers and sellers are what economists call price takers. They accept,
or take, the market price. Since
producers in this market structure cannot control prices, there is little
opportunity to exploit the consumer.
This benefits buyers because they receive a standard-quality good or
service at a price determined by the market no matter where it is
purchased. At the same time, the system offers sellers
the advantage of spending little or no money on advertising. This is unnecessary since each firm's version
of the product is identical. However,
suppliers have little incentive to improve their products or to add new
features. If they charge more than the
market price, their customers are likely to shift their business to another
company. There is no reason to charge
less since firms can sell as much as they can produce at the market price.
Go to Questions 6
through 10.
Monopoly
The
remaining market structures are all examples of imperfect competition. When
compared to perfect competition, a monopoly is at the opposite end of the
market structure spectrum. A monopoly
only has one seller for a particular good or service, but there may be any
number of buyers. As with perfect
competition, the U.S. economy offers few examples. This is because Americans have traditionally
disapproved of monopolies and have encouraged Congress to pass anti-trust
legislation opposing them. The
development of new technology also places limitations on monopolies. For example, email now competes with the U.S.
Postal Service, a federal agency that once was the sole supplier for mail
delivery.
In a
market structure controlled by a monopoly, there is one large firm supplying
the product rather than thousands of smaller ones. This gives the monopolist market power. Since there are no other sellers, a single
firm can raise prices without losing sales.
Although higher prices normally pull more sellers into the market, this
is only possible if producers can easily enter as they do in perfectly
competitive markets. However, monopolies
form because certain barriers make it difficult or impossible for new firms to
come into the market. Start-up costs,
the inability to obtain necessary natural resources and a lack of access to
technology discourage entrepreneurs.
Licenses, patents, copyrights and franchises also keep some companies
out of the market. Without competition
and ease of entry, the seller in a monopoly becomes a price maker rather than a price taker.
Document
Issued by the United States Patent Office
Although
most people have a negative view of them, some monopolies do serve a constructive
purpose. This is true of natural monopolies. These are situations in which a good or a
service produced by a single firm actually lowers costs and promotes
efficiency. Public utilities fall into
this category. What would happen if more
than one company supplied water, natural gas or electricity to a small
area? In the case of electricity, each
company competing for customers would have to put up their own poles and lines.
Each firm providing water would have to run its own network of pipes. Because that would be wasteful and expensive,
utility companies often receive franchises,
or exclusive rights to do business in a specified area without
competition. Other beneficial monopolies
can be found in locations where sellers of similar products are not
present. This is known as a geographic monopoly. A single grocery store operating in a small town
that is unable to support other similar businesses is one example.
Go to Questions 11 through 15.
Oligopoly
An oligopoly is a market structure in
which a few large sellers dominant an industry.
It is a little more competitive than a monopoly but much less
competitive than perfect competition. Economists
usually define an industry as an oligopoly if its four largest companies supply
between 70% and 80% of the total product.
Goods or services created by an oligopoly are often standardized
products like gasoline, but they may also be differentiated. Product
differentiation refers to the differences between two competing goods
within the same industry. These
variations may be real or, thanks to advertising, imaginary. Automobiles and smart phones are two
examples. Both offer products that serve
the same purpose but come in a wide variety of models, styles and brands. This category of market structures also
includes the soft-drink industry dominated by Coke and Pepsi as well as the
fast-food industry where McDonald's, Wendy's and Burger King maintain a large
percentage of the market.
Southwest Airlines: One of the
four carriers that dominate the U.S. airline industry
The
largest firms in an oligopoly tend to act as a team. Each of these companies knows that the others
have the power to affect price and to influence the choices made by
consumers. Therefore, whenever one
company raises its prices, the others soon follow. Because the companies within the oligopoly
act together when changing prices, firms tend to compete in areas other than
price. They do this through advertising
campaigns and by adding new features to their products. Although changes in price can be implemented
quickly, advertising gimmicks and product upgrades take more time to counteract
and put opposing firms at a disadvantage.
Within
an oligopoly, the major firms act as price makers and seldom protest the price
hikes of their rivals. When they choose
not to support a higher price, however, the company that initiated the increase
usually backs down to avoid losing customers.
Companies in oligopolies seldom lower prices. When they do, oligopolists may become caught
up in price wars in which firms slash
prices to draw more buyers. These brief
but intense clashes benefit consumers in the short-term. Overall, however, oligopolies result in
higher prices for buyers. As with
monopolies, patents, copyrights and licenses create barriers that make it
difficult for new firms to enter the market.
The
tendency of large firms within an oligopoly to work together sometimes leads to
illegal activities, such as collusion. Collusion is a formal agreement made by
firms to set prices and production levels.
Such arrangements often lead to price-fixing,
an action which commits companies to charge the same or similar price for a
product. These prices are almost always
higher than those determined through competition. Just as a monopoly does, this puts the
consumer at a disadvantage. The largest
firms in the oligopoly may also decide to divide the market among themselves,
an action that guarantees each of them a specific share and profit. Because collusion and price-fixing interferes
with free trade, the U.S. Congress has passed legislation to forbid these
practices. Nonetheless, some businesses
still risk engaging in these illegal activities for the sake of higher
profits.
Go to Questions 16 through 19.
Monopolistic
Competition
In
several ways, monopolistic competition
resembles perfect competition. Both
market structures consist of large numbers of sellers. This limits the ability of an individual
producer or a small group of them to control price or supply of an
industry. The presence of many sellers
also prevents some companies from working together to shut others out of the
marketplace. As a result, firms can
enter or exit the market with relative ease.
There is, however, one major difference between perfect competition and
monopolistic competition. One criteria
for perfect competition is the sale of identical products. Monopolistic competitors, on the other hand,
try to convince consumers to pay for goods and services that are similar but
slightly different from those offered by other sellers. As an economist would say, monopolistic
competition relies on differentiated products rather than identical ones.
Folded Jeans Waiting for Buyers in a Monopolistic Market
Monopolistic
competitors focus on making sure that the buying public is aware of the unique aspects
of their product. They use coupons,
giveaways and advertising in their promotional campaigns. Think about the choices that you have when
buying a pair of jeans. All jeans are a
type of pants made from a version of denim, but stores stock a wide variety of
this piece of clothing at an equally wide variety of prices. What makes us pay $49.99 as opposed to $17.99
for something that is made from similar material and serves the same
purpose? Advertising convinces consumers
that a particular brand, store or restaurant is better than another. Unlike firms that engage in perfect
competition, companies operating in a monopolistic market structure are willing
to spend large sums of money to create a certain image or status for their
products.
Under
monopolistic competition, similar products usually sell within a narrow price
range. If a firm can convince the buying public that its brand is better, the company
can charge a higher price. If a company
cannot convince buyers that there are advantages to purchasing its brand, it
cannot charge as much. Although the
seller does have some leeway to raise and lower prices, this decision requires
caution. If producers raise the price
too much, consumers will lose interest.
Since most differences that separate a similar good or service from
another are minor, buyers will simply refuse to pay the extra cost and change
brands.
Go to Questions 20 through 22.
What's
next?
Even
though economists maintain that a free enterprise economy works best without
government interference, the rise of large corporations in some markets has
limited the number of sellers. It has
also encouraged the formation of monopolies and oligopolies. To keep these market structures from controlling
price and supply, the federal government has used its authority to block
mergers and to prevent unfair competition.
As you will see in the next unit, this has had both intended and unintended
consequences. Before moving on, review
the terms found in this Unit 7; then, complete Questions 23 through 32.
Go to Questions 23
through 32.
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| Unit 7 Main Points Worksheet |
| Unit 7 Adam Smith |