Friday, December 18, 2009

What is competition?

In economics, the standard assumptions we use to define a competitive market are straightforward. We say that a market is competitive if the following conditions are satisfied:

  • There are enough buyers and sellers so that no individual participant can exert significant influence on price. 
  • Products are not differentiated: This does not mean there are no physical differences among products but that consumers consider the products of all firms to be very close substitutes. 
  • There is perfect information about prices. In a competitive industry, buyers and sellers are always looking for the best deal. If they do not have good information about prices, some mutually beneficial transactions may fail to occur.
  •  Free entry and exit: Firms are free to enter and exit the industry as they see fit.
In my experience, students tend to get hung up on phrases like "perfect information": They, correctly, realize that, in the real world, no one has perfect information about anything. They also realize, in the real world, products are differentiated: A generic MP3 player is no iPod.

Those conditions, however, matter very little for the actual most desirable aspects of free competitive markets: To provide the greatest amount of satisfaction to the largest number of people at the least possible cost.

After all, if information has value, someone will be able to smooth out the kinks and provide it to people who desire it. Have you ever wondered where Mayor Bloomberg made his fortune?

If someone is making a boat load of money selling a special product, others will be motivated to provide other products that provide similar functionality or solve similar problems for their users. The fact that they are not identical usually does not matter. Have you ever wondered why all sorts of products from cars to candy bars of similar specs and quality tend to sell for a narrow price band?

Yes, unfortunately, most people miss the fact that free entry and exit is the condicio sine qua non of competition.

Industries can be close to perfect competition even if the first three conditions are not satisfied. But, without free entry and exit, there can be no real competition.

Free entry means any firm which perceives a profit opportunity can set up shop and start selling the product. Free entry is what drives prices down in markets (making consumers better off because now they can afford more of what they want).

Free exit means any firm that is no longer profitable can leave the industry. This is the mechanism that frees up resources in industries whose products are no longer in demand and allows them to shift into industries whose products are in greater demand.

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