Competition and Market Structures
A College Economics Guide
Supplementary resources for college students
Competition is a familiar activity for every school child who plays games, from schoolyard games like tag, to board games like checkers, to organized sports like soccer. Two or more people independently strive for a single goal, such as evading the person who is “It” in tag, being the last person with a piece on the board in checkers, or winning the most points in a given amount of time in soccer.
To economists, the word “competition” usually refers something more specific. In particular, businesses are said to compete or to be competitive if they and other businesses selling similar goods or services all act independently to strive for survival as firms.
Unlike in many childhood games, survival as a firm does not necessarily mean being the only survivor, a sole winner. It does not mean driving everyone else out of business. It only means that you, the business owner, are running a viable business that makes it worth it for you–in terms of money and personal satisfaction–to continue. Can you pay your employees? Can you pay your business debts? Can you expand and invest for a future so you can do that in the coming years? And can you also pay your own self enough to make it worth it to you?
In competitions–be they childhood games or business survival–humans have a strong, innate sense of fairness and of the importance of having a clear advance sense of the rules. Cheating, being granted special privileges, or someone else stacking the deck are viewed with indignation and hurt even in childhood games. In business, these outside-the-rules activities not only give rise to indignation and hurt, but also often to lawsuits or criminal charges.
One outside determiner of the rules for businesses is government. Governments often grant special privileges to certain firms. They may do so for the most high-minded of reasons. But also, governments may make rules for the most low-minded reasons–granting favors for friends, political payoffs, corruption, etc. Even the most high-minded of reasons can later go awry because the firms themselves naturally exploit any special privileges they are granted. Often governments make policies or rules that have unexpected side-effects that benefit certain businesses at the expense of others.
In economics, the terms Market Structures or Organization of Industry are used to summarize the background customs or laws in which competition functions. What are the background laws, rules, or societal customs that guide or encourage private business competition? Can anyone start a business in some particular field or industry? What are the government-supported privileges awarded to individual industries, businesses, or firms? So, for example, if a law is crafted by legislators such that there is only one dairy farm that happens to pass muster in a state with thousands of dairy farms, that’s obviously unfair, though it may be difficult to prove. If only one company or a few companies receive permission to continue legally–such as by requiring licenses whereby any firm allowed to be in business first has to pay the state a fee–is that fair? Or is it consumer protection–which is often what a government claims when it lays down stringent regulations? Should government itself start its own business and compete with or put out of business private businesses?
Definitions and Basics
Competition, from the Concise Encyclopedia of Economics, 1st ed.
“Competition,” wrote Samuel Johnson, “is the act of endeavoring to gain what another endeavors to gain at the same time.” We are all familiar with competition—from childhood games, from sporting contests, from trying to get ahead in our jobs. But our firsthand familiarity does not tell us how vitally important competition is to the study of economic life. Competition for scarce resources is the core concept around which all modern economics is built….
Competition, from the Concise Encyclopedia of Economics, 2nd ed.
Economic competition takes place in markets–meeting grounds of intending suppliers and buyers. Typically, a few sellers compete to attract favorable offers from prospective buyers. Similarly, intending buyers compete to obtain good offers from suppliers. When a contract is concluded, the buyer and seller exchange property rights in a good, service, or asset. Everyone interacts voluntarily, motivated by self-interest.
In the process of such interactions, much information is signaled through prices. Keen sellers cut prices to attract buyers, and buyers reveal their preferences by raising their offers to outcompete other buyers. When a deal is done, no one may be entirely happy with the agreed price, but both contract partners feel better off. If prices exceed costs, sellers make a profit, an inducement to supply more. When other competitors learn what actions lead to profits, they may emulate the original supplier. Conversely, losses tell suppliers what to abandon or modify….
Competition and Market Structures (Industrial Organization), an Economics Topics Detail.
Market structures, or industrial organization, describe the extent to which markets are competitive. At one extreme, pure monopoly means that there is only one firm in an industry. At the other extreme, economists describe a theoretical possibility termed perfect competition. In between are the market structures found most often in the real world, which are oligopoly and monopolistic competition….
Monopoly, from the Concise Encyclopedia of Economics
A monopoly is an enterprise that is the only seller of a good or service. In the absence of government intervention, a monopoly is free to set any price it chooses and will usually set the price that yields the largest possible profit. Just being a monopoly need not make an enterprise more profitable than other enterprises that face competition: the market may be so small that it barely supports one enterprise. But if the monopoly is in fact more profitable than competitive enterprises, economists expect that other entrepreneurs will enter the business to capture some of the higher returns. If enough rivals enter, their competition will drive prices down and eliminate monopoly power….
[Box: Natural Monopoly] The main kind of monopoly that is both persistent and not caused by the government is what economists call a “natural” monopoly. A natural monopoly comes about due to economies of scale—that is, due to unit costs that fall as a firm’s production increases. When economies of scale are extensive relative to the size of the market, one firm can produce the industry’s whole output at a lower unit cost than two or more firms could. The reason is that multiple firms cannot fully exploit these economies of scale. Many economists believe that the distribution of electric power (but not the production of it) is an example of a natural monopoly. The economies of scale exist because another firm that entered would need to duplicate existing power lines, whereas if only one firm existed, this duplication would not be necessary. And one firm that serves everyone would have a lower cost per customer than two or more firms.
Cartels, from the Concise Encyclopedia of Economics
Public policy’s traditional hostility to cartels is rooted in the view, summarized by eighteenth-century economist Adam Smith, that rival sellers will almost always prefer to raise their prices in unison than to aggressively compete for customers by undercutting each other’s prices. But this statement tells only half the story. The same profit motive that entices sellers to want to collude also creates strong and sometimes uncontrollable temptations to “cheat” on a cartel. This is because any individual seller can usually garner a larger share of the market and earn larger profits by undercutting the cartel’s price. If enough other sellers behave in this way, however, then attempts to raise prices artificially will fail under the collective weight of cheating.
Industrial Concentration, from the Concise Encyclopedia of Economics
“Industrial concentration” refers to a structural characteristic of the business sector. It is the degree to which production in an industry–or in the economy as a whole–is dominated by a few large firms. Once assumed to be a symptom of “market failure,” concentration is, for the most part, seen nowadays as an indicator of superior economic performance. In the early 1970s, Yale Brozen, a key contributor to the new thinking, called the profession’s about-face on this issue “a revolution in economics.” Industrial concentration remains a matter of public policy concern even so.
Antitrust, from the Concise Encyclopedia of Economics
Before 1890 the only “antitrust” law was the common law. Contracts that allegedly restrained trade (price-fixing agreements, for example) often were not legally enforceable, but such contracts did not subject the parties to any legal sanctions. Nor were monopolies generally illegal. Economists generally believe that monopolies and other restraints of trade are bad because they usually have the effect of reducing total output and, therefore, aggregate economic welfare (see Monopoly). Indeed, the term “restraint” of trade indicates exactly why economists dislike monopolies and cartels. But the law itself did not penalize monopolies. The Sherman Act of 1890 changed all that. It outlawed cartelization (every “contract, combination… or conspiracy” that was “in restraint of trade”) and monopolization (including attempts to monopolize)….
Should Government Regulate Monopolies?, a LearnLiberty video.
Prof. Lynne Kiesling highlights some of the regulation that markets naturally provide against monopoly.
In the News and Examples
Postrel on Style. Podcast at EconTalk
Author and journalist Virginia Postrel talks about how business competes for customers using style and beauty, going beyond price and the standard measures of quality. She looks at the role of appearance in our daily lives and the change from earlier times when style and beauty were luxuries accessible only to the wealthy….
“In Defense of Apple”, by Richard B. McKenzie. Econlib, July 2, 2012.
Microsoft has long been the poster child for targeted antitrust enforcement. One of its presumed antitrust violations was, according to the U.S. Justice Department in the late 1990s, zero pricing of its browser, Internet Explorer, which could enable Microsoft to increase its sales of Windows (the exact opposite of what monopolists are supposed to do, according to antitrust convention).
Now Apple has become the bull’s eye of antitrust enforcers, with their formal complaint filed in early April 2012. Apple’s violation, according to Justice Department lawyers? Seeking to make inroads into the Amazon-dominated e-book market by “conspiring” with major publishers to devise an innovative pricing strategy–the so-called “agency model”–under which the publishers agreed to a set of selling prices for their e-books sold on Apple’s iBook portal and to give Apple a percentage of the take. The selling prices would also be applied to all other e-book download sites, including Amazon’s….
Airline Deregulation, from the Concise Encyclopedia of Economics
Under CAB regulation, investment and operating decisions were highly constrained. CAB rules limiting routes and entry and controlling prices meant that airlines were limited to competing only on food, cabin crew quality, and frequency. As a result, both prices and frequency were high, and load factors–the percentage of the seats that were filled–were low. Indeed, in the early 1970s load factors were only about 50 percent. The air transport market today is remarkably different. Because airlines compete on price, fares are much lower. Many more people fly, allowing high frequency today also, but with much higher load factors–74 percent in 2003, for example….
OPEC, from the Concise Encyclopedia of Economics
OPEC is a cartel—a group of producers that attempts to restrict output in order to keep prices higher than the competitive level. The heart of OPEC is the Conference, which comprises national delegations, usually at the level of oil minister. The Conference meets twice each year to assign output quotas, which are upper limits on the amount of oil each member is allowed to produce. The Conference may also meet in special sessions when deemed necessary, particularly when downward pressure on prices becomes acute.
OPEC faces the classic problem of all cartels: overproduction and cheating by members. At the higher cartel price, less oil is demanded. That is why OPEC assigns output quotas. Each member of the OPEC cartel has an incentive to produce more than its quota and “shave” (cut) this price because the cost of producing an additional barrel of crude is typically well below the cartel price. The methods available to shave official OPEC prices are numerous. Credit can be extended to buyers for periods longer than the standard thirty days. Higher grades (or blends) of oil can be sold for prices applicable to lower grades. Transportation credits can be given. Buyers can be offered side payments or rebates….
Don Boudreaux on Market Failure, Government Failure and the Economics of Antitrust Regulation. EconTalk podcast, October 1, 2007.
Don Boudreaux of George Mason University talks with EconTalk host Russ Roberts about when market failure can be improved by government intervention. After discussing the evolution of economic thinking about externalities and public goods, the conversation turns to the case for government’s role in promoting competition via antitrust regulation. Boudreaux argues that the origins of antitrust had nothing to do with protecting consumers from greedy monopolists. The source of political demand for antitrust regulation came from competitors looking for relief from more successful rivals.
Natural Gas: Markets and Regulation, from the Concise Encyclopedia of Economics
Natural gas is the commercial name for methane, a hydrocarbon produced by the same geological processes that produce oil. Relatively abundant in North America, its production and combustion have fewer adverse environmental effects than those of coal or oil….
Before high-pressure pipelines were developed in the 1920s, gas was either consumed in the vicinity of its production or flared off as hazardous. Today, producers and marketers use interstate pipelines for deliveries to distributors and large consumers. The Federal Energy Regulatory Commission (FERC) determines cost-based pipeline rates, but pipelines are free to discount these (which they often do) in order to attract business. The rates of most local distribution companies (LDCs) that deliver and sell gas to final users are under state regulation, and the remainder are operated by municipal governments. Thus, gas is a vertically unintegrated industry in which dependable product flows require coordination among producers, pipelines, and LDCs. Since the 1970s, the industry has relied more heavily on coordination by market forces and less heavily on regulation, although the latter still plays a large role. Somewhat unusually, regulators themselves took major initiatives to bring competition to the industry, rather than protecting the status quo or imposing heavier regulations. The industry’s evolution is a case study in the replacement of inefficient economic institutions by efficient ones and the replacement of localized markets by national and global ones.
A Little History: Primary Sources and References
Adam Smith on collusion: Of Competition and Custom, by Adam Smith. Book I, Chap. 10 from the Wealth of Nations.
People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. It is impossible indeed to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and justice. But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies; much less to render them necessary.
Of Competition and Custom, by John Stuart Mill. Book II, Chap. 4 from Principles of Political Economy
Under the rule of individual property, the division of the produce is the result of two determining agencies: Competition, and Custom. It is important to ascertain the amount of influence which belongs to each of these causes, and in what manner the operation of one is modified by the other.
Political economists generally, and English political economists above others, have been accustomed to lay almost exclusive stress upon the first of these agencies; to exaggerate the effect of competition, and to take into little account the other and conflicting principle. They are apt to express themselves as if they thought that competition actually does, in all cases, whatever it can be shown to be the tendency of competition to do. This is partly intelligible, if we consider that only through the principle of competition has political economy any pretension to the character of a science….
Non-market activity within the family: Gary Becker, biography from the Concise Encyclopedia of Economics
One of Becker’s insights was that a major cost of investing in education is one’s time. Possibly that insight led him to his next major area, the study of the allocation of time within a family. Applying the economist’s concept of opportunity cost, Becker showed that as market wages rose, the cost to married women of staying home would rise. They would want to work outside the home and economize on household tasks by buying more appliances and fast food….
Supply and Demand, Markets and Prices
Roles of Government