The extreme conditions required for perfectly competitive markets to exist are rarely found in the real world. In actuality, minimal competition does exist, however, in a unique form. Firms within perfectly competitive markets have to compete to sustain market share. The threat posed by the possibility of new firms entering the market is taken to be a key determinant of the behaviour of existing firms in a market. Moreover, perfectly competitive markets are highly contestable which allows for “hit and run entry” as exemplified above in Figure 2. Thus, firms have to compete to obtain the abnormal profits that can only be made when the supply of products contracts and price is at a higher equilibrium. Firms within a market have to compete to gain a large proportion of market share. The market is so competitive that any individual buyer or seller has a negligible impact on the market price. The nature of perfectly competitive markets often creates problems for developing countries. For example, agriculturally producing countries often face little competition. As a result firms within such a market are only able to make normal profits or many firms are unable to sustain market share as a few large firms dominate the market.
An oligopoly occurs when a few firms dominate a market; for example the newspaper industry or the supermarkets, thus creating high barriers to entry to maintain their dominance. Because there are only a few firms, the actions of one of them can have a significant effect on the behaviour of the others. There is no one price and output outcome in oligopoly. Firms are interdependent and a firm’s behaviour will depend on what it predicts the other firms are going to do.
One theory that gives a reasoned analysis of price rigidity and non-price competition is known as the kinked demand curve. See Figure. 4.
- If the firm increase its price other firms do not follow so demand is price elastic.
- If the firm decreases its price the other firms do follow so demand is inelastic.
This model explains why prices do not change very much and firms tend to compete via non-price competition.
- If the price is increased, demand is price elastic and revenue falls; if price is cut, demand is price inelastic and revenue falls, i.e. any price change leads to a fall in revenue, and so the firm leaves price unchanged.
- The kinked demand curve causes a discontinuity in the marginal revenue curve; changes in marginal costs between MC1 and MC3 do not change the profit maximizing price and output i.e. prices are like to be relatively fixed despite cost changes.
This model suggests that inter-firm competition is often very fierce, and is often based on factors other than price. If two giant companies were to have a price war, they would be aware that they both might end up worse off. (footnote) In effect, oligopoly firms have two conflicting aims:
- To collude with other firms to maximize their combined profits, behaving as if they were a single monopoly (perhaps by forming a cartel), and;
- To compete with other firms to take business away from them and make more profit independently, by preferring gentle non-price competition rather than an aggressive price war.
If they were to collude, this would result in little or no competition. If they worked individually, this would result in intense inter-firm competition. As a result, oligopolies tend to compete through non-price competition, which involves strong branding of goods, advertising, free offers, competitions, emphasis on quality or service, in fact, anything but price.
Monopolistic Competition is the name given to highly competitive markets with the following characteristics: many sellers, many buyers, low barriers to entry, differentiated products with a proliferation of brand names and product advertising. It is also called imperfect competition and more often than not describes more real-life markets. Firms have a ‘monopoly’ over their own brand and thus some price control. Each firm within a market can influence its market share to some extent by changing its price relative to its competitors. There are many close substitutes; however, like brand loyalty that gives only very limited price. Hence, a firm faces a downwards sloping but very elastic demand curve.
The firms equilibrium or short-run industry equilibrium is where MR=MC. At this point supernormal profits of cabp are earned, attracting new entrants.
The firm’s long equilibrium, or the industry equilibrium, is where MR=MC, p=ATC, and TR=TC. Normal profit is being earned in this situation.
The characteristics of a monopolistic market unavoidably results in a high degree of competition between firms. The features of this market allow firms within its market to charge a slightly different price from other firms without losing their customers. However, this competition often takes place through forms other than price competition. For example, a florist may wish to construct an effective advertising campaign that promotes the freshness and quality of his flowers while another florist may advocate his prompt delivery service.
Barriers to entry are factors that deter new firms from entering a market. As such, they protect the market of existing firms and can influence the way firms behave to a great degree. The nature and size of barriers to entry vary enormously from one market to another.
In some markets, market entry requires a large initial investment in capital. This is true of the oil business, for example, but where the expertise of existing companies also constitutes a barrier. If the cost of the capital equipment cannot be recouped should the firm wish to leave the industry in the future, then market entry is less likely due to the high risk associated with failure. Such sunk costs create a barrier to exit. Markets where existing firms benefit from substantial economies of scale, a new company will need to be of similar size in order to compete on an equal footing. Where available economies of scale are so large that a natural monopoly exists, an almost insurmountable entry barrier is present. The average costs of the established firms are so low that it is unlikely that any rival could threaten its position. Barriers to entry such as the preceding two assist in controlling the level of competition within a market as they control the number of firms that exist within a market.
The government sometimes gains control of industries characterized by a lack of competition in the market. Such industries are more often than not of essence to the market, but the high risks of entry and exit defer most private firms from gaining a foothold. High operating costs also exist in such industries, and to prevent market failure, governments sometimes remedy this by taking over the sector. Traditional national monopolies can be illustrated by the ownership of a country’s electricity authority, entitling the government to set electricity prices at their own discretion. Government-owned businesses often benefit from a legally protected monopoly and this lack of competition means the firms (such as the Electricity Company) face little or no pressure to be efficient. The performance of nationalized firms are often poor compared to their private-sector counterparts, who are largely market-driven.
Deregulation usually refers to attempts to reduce entry barriers to industries and the reduction of control on prices in order to stimulate greater competition. Many governments that are committed to the free market (globalization) pursue policies of liberalization based on substantial amounts of deregulation working together with the privatization of industries previously owned by the government. Effective de-regulation usually involves some re-regulation such as this. The aim is to decrease the role of government in the economy and hence increase competition.
The idea behind a planned economy is an economy in which most decisions about resource allocation are made by the government. It is a policy measure to ensure the production of necessary goods - one that would not rely on the vagaries of free markets. Here, the government allocates resources (land, labor and capital) in favor of greater investment in capital investment for economic development channeled into desired pattern, rather than focus on consumer demand alone. Many modern societies fail to develop certain medicines and vaccines that are seen by medical companies as being unprofitable, but by social activists as being necessary for public health. Thus a planned economy can continue to manufacture and distribution of the drug to its people. However, there is no competition in a planned economy. There is no price competition and demand is not the ultimate variable of supply. This creates a flaw in the above example. A planned economy would not take into account the demand and supply in the market, and this could thus create shortages in other areas. The planned economy concept has been abandoned in recent times in favor of more market liberalization.
Some markets are more competitive than others because of policies undertaken by the governments and industries. There is absolute theory governing the control of competition, and there is no perfect model to advocate the market. Different economic theories are viable for different markets in different micro and macro environmental settings. A more competitive market might not be the best antidote to a less competitive one.