Basics of Competition

Today we’re talking about competition in economic markets. This follows from previous posts we’ve offered so far for Financial Literacy Month: the Basics of Trade and Basics of Supply & Demand.

Competition between sellers in a market is seen as a good thing for consumers. If there is only one restaurant in town, it’s free to charge higher prices (because as we learned earlier this month, demand for restaurants is greater than the supply). A second restaurant will typically cause prices to go down, as both establishments are competing for your business.

If you add too many restaurants, supply will be higher than demand. Competition means someone will likely go out of business—ultimately the market will leave your town with the right number of restaurants.

Price Signals

If prices are allowed to rise and fall as needed, signals are sent to buyers and sellers. If a location is paying far more than the surrounding area for a good, then savvy sellers know to move into the area and start providing that good. The more sellers enter, the lower the price gets, until everyone in that market is served.

This is part of what happens after a natural disaster—if a hurricane closes all of the stores, but local residents need things like gas, ice, fresh water, etc., then the price of those goods will go up. This inspires more sellers to bring trucks full of goods to the disaster area to sell. Critics call this “price gouging,” as the sellers are taking advantage of a disaster to make a profit. But without allowing the higher prices for those goods, there’s no incentive for sellers to bring goods to that area, and no one would have access to purchase anything they need.

These price signals aren’t perfect—most sellers would prefer to get more for their goods, and most buyers would prefer to pay less, but if the market is allowed to work, both parties will feel they are better off after the exchange.

Nonprice Competition

Lowering prices isn’t the only way sellers compete. They might increase the quality of their goods to stay ahead of the competition. Most adults in the US have a smartphone, and these smartphones get smarter every year. This is because firms like Apple and LG are competing to make phones better, but they’re not typically lowering their prices.

Advertising is another form of competition that suppliers use. They are competing for the attention of buyers. If they win the competition for “mind share”, then they may not have to lower their price. They create demand simply by making you aware of their product and its advantages.

Entrepreneurship

Entrepreneurs introduce something new to the market. That might be an entirely new product, or a new way of doing business. They’re hoping there is demand for their new goods, or that the way they are going to sell to people will be more efficient than existing sellers.

To start a new business, sellers need to do a lot of research to understand what the demand is for their goods, and whether people will pay enough for it to make it worthwhile to produce that good or service.

Anti-Competitive Practices

Some firms don’t want to engage in honest competition for buyers’ business. It is a lot of work, and it’s possible they might lose. So they engage in practices that are designed to give them the advantage.

• A monopoly is when there is only one seller for a good. This monopoly can set whatever price they want, since they have no competitors. It’s difficult to establish a monopoly—firms either buy up their competitors, or engage in unfair competition, or they take advantage of government regulations to maintain their monopoly position.
• Price-fixing is when groups of sellers get together and agree to charge a set price for their goods. They all want to earn more, so they get together and agree that no one will undercut the other when it comes to pricing a particular good. (A group of businesses colluding in this way is called a cartel.)
• Predatory pricing is when a large seller sells a popular good for an artificially low price in order to drive competitors out of business. A large chain of electronics stores might sell video game consoles at less than the wholesale price. They lose money on the sale of that console, but they make more money selling games and controllers than they do consoles anyway. And since their stores have the best prices on consoles, that’s where shoppers go. Consequently, small local game shops that can’t afford to lose money on console sales go out of business. The idea with predatory pricing is that the seller will be the only survivor in the market and can then raise prices after all of the competitors go out of business.
• Abuse of a dominant position involves various kinds of anti-competitive practices a business might take. If one firm is larger than all of the others, it can buy up all of the resources its competitors need, or it can tell retailers not to sell competitors’ products. These kinds of behaviors distort the market and give the large firm an unfair advantage.
• Other practices like tax avoidance, corporate espionage, or sabotaging competitors’ businesses are common anti-competitive practices. A business might try to inspire a competitor’s workers to unionize in order to disrupt their business and make it more expensive for them to operate, or they might accuse a competitor of some code violations to incur expensive inspections or legal sanctions.

Generally, anti-competitive practices that harm consumers are illegal, and often lead to prosecution. Firms have an easier time getting away with practices like predatory pricing that harm competitors but don’t immediately harm consumers.

While it seems like competition is unhealthy (it is certainly unpleasant for those who lose), it can result in innovation, lower prices, and higher quality goods for consumers.

We’re in the last week of Financial Literacy Month, and we hope we’ve helped inspire a greater sense of how economics works and how economic forces affect one’s finances. We’re also ready to help with one-on-one counseling that is confidential, free and available on demand.

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