Chapter 6 - Competition: Strategies and Structure

Chapter 6

COMPETITION:  STRATEGIES AND STRUCTURE

  
Competition: Two Meanings to the Idea of Competition

This tutorial discusses the supply side of a market. It introduces the specialized meaning of the concept of competition used in economics. 

The word “competition” is used in two ways.  One way is the common usage - the strategies or processes companies use to compete with each other.  But economists use the word in another way - to describe the structure of an industry or market.

Economists divide industries or markets into two groups - perfect competition and (not surprisingly) imperfect competition.  Imperfect competition is then subdivided into three types.  They are called monopoly, monopolistic competition, and oligopoly. Oligopoly is a market structure where a small number of companies account for a large percent of total sales. It is the dominant market structure for many large markets. A later tutorial will discuss a special version of oligopoly called bilateral oligopoly.

Competitors’ Business Strategies:  Eliminating All of Them Leads to Perfect Competition

What is the difference between perfect competition and imperfect competition? Perfect competition assumes away all strategies of competition except price competition. Besides all forms of marketing, perfect competition ignores:


  • ·      brand names, trademarks, and copyrights. 
  • ·      price discrimination and dynamic pricing (charging different groups of customers different prices).
  • ·      economies of scale (larger size leads to lower unit cost) of mass production, distribution, marketing, retailing, financing or online businesses. 
  • ·      proprietary or “firm-specific” knowledge, including patents.  
  • ·      innovation or the creation of proprietary knowledge.
  • ·      all forms of market friction and transaction costs (costs to the company of doing business with other companies or customers). 
  • ·      positive and negative externalities (negative externalities are costs of doing business that the company does not pay, such as pollution).

Imperfect competition includes any or all of the above. All are business competitive strategies and possible sources of competitive advantage. They can change a market structure. If they are eliminated, what is left is perfect competition.

Perfect competition assumes its market structure. The model then explores the dynamics inside the structure that define equilibrium. Possible strategies are limited so as not to change the structure.

Perfect Competition Model

Perfect competition is the economist’s favorite type of competition.  It is also the ideal type.  Economists believe that an economy consisting of nothing but perfectly competitive (PC) industries is the best of all possible (economic) worlds.

Perfect competition is defined by four conditions that describe the industry. These conditions are:

1.    Homogeneous product. In English, this means that all the products offered by all the competitors are exactly alike.  Another word for homogeneous product is “commodity.” Farm products, raw materials and minerals are often used as examples. This implies that all types of marketing, such as advertising or fancy packaging or brand names, are a waste of effort and money.  Buyers know that all competing products are alike. Purchasers are only influenced by price, not at all by marketing.

2.    Lots of buyers, lots of sellers.  This implies that no one buyer or seller is big enough to have “market power,” the power to influence the market price of the product.  It is usually assumed that economies of scale are nonexistent.  This means that small firms, small relative to the size of the industry, can produce at minimum average cost.

3.    “Perfect information.” This means that everyone in the market knows everything.  No trade secrets, no patents, no proprietary information.  All information is public and readily available.  No buyer or seller has a market advantage because of private knowledge or inside information.

4.    Easy entry, easy exit. Easy entry is related to number 3. This says that a new entrant can learn whatever is needed to know to compete equally with existing producers. “Incumbent” firms have no cost or technological advantage over potential entrants. There are no barriers to entry. Easy exit implies that a firm that wants to leave the industry can recover its original capital costs, its original investment.  Thus, the fear of losing all or part of the initial investment is not a deterrent to entry.



Every company’s demand curve is horizontal, which illustrates that the company can sell as much as it can produce at the market price. But all companies use the same technology, which limits each one of them to a very small percentage of total output. 

Thus, PC companies are price-takers and quantity adjusters.  The only short-run decision a manager or owner makes is how much to produce.  The rule is to expand output as long as marginal cost (the increase in unit variable cost) is less than price, thus increasing profit.  The only long-run decision is to stay in the industry or exit.

Perfect Competition as the Ideal Industry Structure

The conditions that define a perfectly competitive industry are strict. That is why it is the ideal type of industry structure. 

For examples of PC industries, economists usually point to agricultural products like wheat and milk. One problem is that farming in all industrialized countries is subsidized and protected by governments, interfering with the setting of equilibrium price.  Some raw material and metals markets were good approximations, although now most of the world’s production is performed by huge mining corporations or government-owned companies. A recent counter example has been the introduction of fracking technology, which has led to the entry of hundreds of relatively small American companies into the activity of crude oil extraction.   

Companies in a PC Industry Do Not Compete on Price

Because all companies produce exactly the same product, customers are only concerned with the market price. They do not care, and usually do not know, which company produced the product they buy. Producers of grains like wheat, for example, usually deposit their output in huge grain silos (storage tanks) where it is mixed with the grain from many other producers.

Market price is determined by the interaction of total market supply with total demand. No one company has any control over the price it charges or receives. So companies do not even compete on the basis of charging different prices or using different price strategies such as price discrimination. 

Many Small, Local Companies Do Not Equal Perfect Competition

According to the 2015 Census of Businesses, there are about 28 million businesses in the United States. About 10 million are home-based. Some of them may not be active. 

Of the 28 million businesses, over 22 million are small businesses that are individually or family owned and operated. About six million have at least one paid employee, of which about 3.6 million have four or fewer employees.

Many of these companies are not only small but also serve a small or local market. 

There is tremendous diversity among small and local businesses. This diversity is a major source of the economy’s flexibility. Many small companies are small stores, local services like hair and nail salons, specialized services connected with maintaining homes and commercial real estate, professional services (lawyers, accountants, doctors), or restaurants. Small businesses can often compete with large corporations (restaurant chains, large hardware stores like Home Depot). But this does not mean there are a large number of similar companies in the local market. Also, local customers do not pick companies solely on the basis of price. Companies like restaurants attempt to differentiate their business from competitors and establish steady customers who like their food and atmosphere. Reputation is important, especially with customer evaluations posted on the Internet.

Equilibrium and Disequilibrium in a PC Industry

For given hypothetical industry supply and demand curves, economic theory has a simple explanation of how the industry reaches equilibrium (intended supply equals intended demand). But there is no explanation of why the industry was in disequilibrium (supply not equal to demand) or how long it takes to reach equilibrium.

If the industry is in equilibrium, and a supply curve or a demand curve shifts, the industry is in disequilibrium. The reasons for the shifts occur outside the industry. On the demand side, the industry demand curve might shift because of changes in consumer “preferences,” possibly because of new or improved competing products or services developed outside the industry. Also, demand for a primary commodity like wheat is “derived” from demand for products made with wheat such as wheat bread, Wheaties or Wheat Thins. They compete with commodities that are inputs into competing consumer products such as oats in Cheerios or Quaker Oats oatmeal. These branded, advertised products are not sold in a perfectly competitive market or market segment.

Farmers do not sell their wheat directly to consumers. They sell to large food processors. Many of the final markets or market niches (product categories) are oligopolistic and companies use many or all of the competitive strategies listed at the beginning of this essay.

On the supply side, shifts in the industry supply curve may be due to changes in the cost or productivity of inputs bought from capital goods or other input industries. Inputs are often produced by large companies in oligopolistic industries. 

=====================================================================

The Agricultural Revolution II:  A Function of the Industrial Revolution

Because of the Industrial Revolution, agriculture has been radically transformed. Like other industries, agriculture has gone through waves of absorbing innovation and new technology developed by input suppliers.

An agricultural, raw material or mining industry can be transformed by innovation or economies of scale in input supplier companies. Agriculture, especially grain production, has been transformed by 
  • steel plows and implements. 
  • animal-drawn harvesters and combines. 
  • tractors and other mechanized equipment.
  • chemical fertilizers.
  • pesticides.
  • herbicides.
  • irrigation systems.
  • hybrid and genetically-modified seeds.
  • production planning information systems.

Many suppliers became large corporations, including Ford (tractors), John Deere, International Harvester, Caterpillar, and Monsanto. Modern equipment manufacturers are currently incorporating sensors, robotics, GPS-based production systems, and artificial intelligence into their products and software. Driverless tractors and automated computer-controlled planting, growing, and harvesting systems are being developed.

Farmers have combined many of these inputs to realize economies of scale. The result of all this innovation, plus better-educated farmers, has been dramatic increases in productivity – output per acre and output per farmer – and reduction in real unit costs.

 Organic farmers use fewer inputs (no chemical fertilizers, no herbicides, no pesticides) so should have lower costs. But yields (output per acre) are so much lower that the unit cost is higher.

A consequence of the “industrialization” of agriculture has been that farming has changed from subsistence farming (raising food to feed the farming family) to commercial farming (growing crops to sell in markets). Owners of larger farms also tend to specialize. 

Even if some agriculture continues to retain some aspects of perfect competition, they rely on suppliers of inputs to provide them with waves of innovation to reduce unit costs and increase productivity. They sell to large food production companies that rely on new product development, branding, marketing, price discrimination, and economies of scale to increase sales and profits.

Agriculture, the dominant economic activity before the Industrial Revolution, has been radically transformed by the technological innovations of the Industrial Revolution. Before the Industrial Revolution, about 90% of producers were farmers or farm workers. Today, about 2% of the workforce is in farming. About 6 million farmers and agricultural workers produce enough food to feed 325 million Americans and over $140 billion of exports.

  














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