COMPETITION IN THEORY AND PRACTICE

We are still concerned mainly with the free enterprise or capitalist system where price movements are a major factor in determining the actions of producers and consumers. It is now time to turn to a study of the various market conditions under which these prices are determined. The capitalist sys­tem is said to be based upon the principle of competition and we must, therefore, examine the nature and extent of competitions in the markets for goods and services.

In order to assess the degrees of competition in differ­ent markets it is necessary to have some kind of 'measuring rod', or 'standard of comparison'. We begin, therefore, by looking at the conditions necessary for a state of perfect competition — an extreme situation in which competition reaches its highest possible degree.

Perfect competition

The economist's model of perfect competition is highly theoretical, but it does provide a useful tool of economic analysis and helps us to make some sense of real world condi­tions. The real world is much too complicated to understand all at once; it is necessary to examine one feature at a time. Economists are able to use their model of a perfect market as a means of assessing the degree of competition in real world markets. They set out the conditions necessary for a perfect market and then contrast these with the situations found in the markets for goods and services. The degree of competition in these real markets is based upon the extent to which they approximate to the model of perfect competition. It is neces­sary to point out that the competition referred to here is price competition. Firms are assumed to be engaged in a rivalry for sales which takes the form of underselling competitors.

In a market operation under the conditions of perfect competition, there will be one, and only one, market price,

and this price will be beyond the influence of any one buyer or any one seller. These conditions can only be satisfied in a market which contains certain characteristics. They are:

1. All units of the commodity are homogeneous (i.e.
one unit is exactly like another). If this condition exists,
buyers will have no preference for the goods of any particu­
lar seller.

2. There must be many buyers and many sellers so that the
behaviour of any one buyer, or any one seller, has no influence
on the market price. Each individual buyer comprises such a
small part of total demand and each seller is responsible for
such a small part of total supply that any change in their plans
will have no influence on the market price.

3. Buyers are assumed to have perfect knowledge of mar­
ket conditions; they know what prices are being asked for the
commodity in every part of the market. Equally sellers are
fully aware of the activities of buyers and other sellers.

4. There must be no barriers to the movement of buyers
from one seller to another. Since all units of the commodity
are identical, buyers will always approach the seller quoting
the lowest price.

5. Finally, it is assumed that there are no restrictions on
the entry of firms into the market or on their exit from it.

We can now see why, in a perfect market, there will be one and only one market price which is beyond the control of any one buyer or any one seller. Firms cannot charge dif­ferent prices because they are selling identical products, each of them is responsible for a tiny part of the total supply, and buyers are fully aware of what is happening in the market.

Monopoly

Monopoly power

Monopoly in the market place indicates the existence of a sole supplier. It may take the form of a unified business organisation, or it may be an association of separately con-

trolled firms which combine, or act together, for the purpose of marketing their products (e.g. they may charge common prices). This latter example indicates that monopoly power is concerned with supply — it does not necessarily mean that there is one producer. The main point is that buyers are fac­ing a single seller.

A monopolist has the power to determine either, (a) The price at which he will sell his product, (b) The quantity he wishes to sell.

He cannot determine both price and quantity, because he cannot control demand, If he decides on the price at which he is prepared to sell, the demand curve will deter­mine the quantity he can dispose of at the chosen price. If he wishes to market a given quantity per month, then the demand curve will determine the price at which this quanti­ty may be disposed of. The monopolist's power to influence price depends upon two factors.

(i) The availability of close substitutes.

(ii) The power to restrict the entry of new firms.

These two features are closely related because (ii) has some influence on (i).

If there are a number of substitutes available, the prices of which compare favourably with the price of the monopo­list's product, his market power will be very limited,

Monopoly power has been defined as the ability to earn long-run abnormal profits. We know from our analysis of perfect competition that this will only be possible if there are some effective barriers to the entry of new firms. The more effective the restrictions on the emergence of new firms, the greater will be the power of the monopolist to exploit the consumer by charging prices well above his average cost.

Monopolistic practices

Although the word 'monopoly' conjures up a picture of a single large firm, this is by no means the general form taken by monopoly organisation. Much more pervasive in

the structure of industry, prior to the UK legislation on monopolies, was the situation where groups of indepen­dently controlled firms actively collaborated in operating agreements to restrict competition within an industry, if an industry is made up of say 10 or 20 firms but they agree to restrict competition between themselves, say by means of a price agreement, then we have a monopoly situation. Effectively the buyers are facing a single seller.

A report by the UK. Monopolies Commission in 1955 indicated that such restrictive trade practices were a common feature of the business world. As already noted, many of these practices have now been abandoned or declared ille­gal, but it might be interesting to look at some those which were widely practised.

Exclusive dealing and collective boycott Producers agree to supply only recognised dealers, nor­mally only one dealer in each area, on condition that the dealer does not stock the products of any producer outside the group (or trade association).

Should the deafer break the agreement, all members of the group agree to withhold supplies from the offender. This practice has proved a very effective restriction on competi­tion for it means that any new firms would find it extremely difficult to secure market outlets for their products. Price and output agreements

The firms in an industry (or the majority of them) may agree not to compete on price and, where the product is fairly standardised, they may agree to charge common prices. The agreed price is normally well above the average costs of the more efficient firms since, in order to persuade enough firms to join the scheme to make it operational, the price must be high enough to provide profits for the less effi­cient. In order to make the price effective, a price agreement is usually supported by a complementary agreement to limit output (e.g. firms agree to accept output quotas).

Cartels

In its most developed form a cartel comprises a selling syndicate, formed by a group of firms, through which the outputs of the member firms are marketed. The syndicate or selling agency pays the producers a fixed price for their out­puts and markets the product as a single seller. Profits are distributed to member firms in proportion to outputs. Marketing boards such as the British Milk Marketing Board are, in fact, a type of cartel.

Collusive tendering

There are many goods which are not produced 'in anticipation of demand', but are made 'to order'. The buy­ers announce their requirements by publishing a specifica­tion and producers are invited to tender for the contract to supply. This is the normal procedure in the building indus­try, the civil engineering industry, snip-building, and heavy engineering. The preparation of a tender for the building of a bridge or the erection of large industrial plant can be an expensive operation and, since only one firm can succeed in getting the contract, the unsuccessful bidders incur heavy nonrecoverable expenses. In some industries producers have combined to eliminate competition by means of schemes which ensure that the available contracts are shared out between the cooperating firms. This may be done by the var­ious firms agreeing not to submit lower tenders than the firm which is entitled to the next contract.

The pooling of patents

In some industries, especially the technically advanced industries, competition may be seriously restricted when the existing firms combine for the purpose of pooling the patents held by individual firms. Technical cooperation of this type means that the firms which are party to the agree­ment have access to a substantial amount of technical expertise and specialised equipment which is denied to any potential competitors.

 

Resale price maintenance

This is the practice whereby the manufacturer fixes the price of his product at each stage of distribution. Although the goods are being distributed by independent wholesalers and retailers they are obliged to charge prices which are laid down by the manufacturers. It means, of course, that the profit margins at these subsequent stages are being fixed by the manufacturers. Resale price maintenance can be enforced by manufacturers either collectively or individual­ly by the threat of withholding supplies if the distributor breaks the price agreement. At one time in the UK manu­facturers were given the right to enforce RPM through the courts. RPM is a practice which prevents price competition taking place at the retail stage. Shops cannot pass on any improvements in efficiency in the form of lower prices. It almost certainly maintains prices at higher levels than would be the case if RPM were not in force. Manufacturers anx­ious to maintain the maximum number of retail outlets tend to fix retail prices at levels which give satisfactory profits to the less efficient retailers. Legislation in 1964 effectively ended the practice of RPM in the UK.

Discriminating monopoly

One of the criticisms of monopoly is based on the fact that a monopolist is often able to discriminate in his pricing policy. He can charge different prices in different markets for the same commodity. Three basic conditions are neces­sary for such a policy to be effective and profitable.

1. In order to charge different prices the seller must be
able to control the supply otherwise competitors would
undersell him in the dearer market. Only a monopolist has
the power to determine the price (or prices) at which he sells
his commodity.

2. The markets must be clearly separated so that those
paying lower prices cannot resell to those paying higher
prices.

3. The demand conditions in the separate markets must be different so that total profits may be increased by charg­ing different prices, ft is really a matter of separating a group of consumers willing to pay higher prices from those that are only able or willing to pay lower prices.

We have plenty of evidence from our everyday experience to show that these conditions can be met. Markets may be sep­arated by a time barrier. Most passenger transport undertak­ings charge cheaper rates for off-peak journeys. Electricity and telephone charges are varied according to the time at which they are consumed. These are examples of services which can­not be transferred from the cheaper to the dearer market.

Markets may be separated by transport costs and tariffs. Firms often sell their goods more cheaply in export markets than in the home market. The price differential, of course, cannot exceed the cost of transporting the good back to the home market plus any tariff on imports.

A third type of price discrimination is found where it is possible to separate buyers into clearly defined groups. Before the National Health Service was established doctors commonly charged lower fees to poorer patients than to their wealthier clients. Milk is sold more cheaply to indus­trial users than to householders. Electricity charges also vary according to the type of consumer.

Price discrimination means that some groups are charged higher prices than others and although this may be regarded as an 'unfair' practice it is possible for price dis­crimination to be beneficial. Where it leads to a great expan­sion of sales and output and a significant fall in average costs of production, even those in the higher priced market may be obtaining goods at lower prices than they would be charged in a single market. For example, a large export market (gained by selling at prices lower than the home price) may lead to economies of scale which benefit home consumers even though the home price is higher than the export price.

Monopoly and competition — some comparisons

Prices and outputs

Economic theory indicates that, under monopoly, out­put will be lower and price will be higher than would be the case under perfect competition. We have seen that firms in a perfect market produce where price equals marginal cost, and competition between these firms forces price down­wards until it is equal to minimum average cost.

A monopolist, however, has the power to restrict market supply and he will adjust his output until marginal revenue equals marginal cost. At this output, price is greater than marginal cost, and greater than average cost.

Under perfect competition, PRICE = MC = AC

Under monopoly, PRICE > MC and PRICE > AC

This is probably the major argument against monopoly. Critics point to the power to exploit consumers by charging prices well above average cost and they assume that the desire for profits will lead to the abuse of this market power. Allied to this argument is the charge that monopolists can indulge in price discrimination and oblige one group of consumers to subsidise another group. The argument here is not against the principle of subsidisation, but against the system which allows the monopo­list to decide which group should benefit and which group lose.

Economies of scale

The argument that monopoly will lead to higher prices and lower outputs is based upon the assumption that, if a competitive industry were monopolised, the costs of pro­duction would be unaffected. This is not very realistic. If a number of small competing firms are combined into one large integrated enterprise then many of the economies become attainable. These economies of scale, if achieved, would mean that the cost curves of the monopolist would be lower than those of a competitive industry.

In industries where there are many competing firms each producing its own particular design or model (e.g.

parts and components in electrical and mechanical engi­neering), monopolisation would make possible a much greater degree of standardisation. This would be an impor­tant factor in making larger scale production possible.

It may be that in some industries the total market (e.g. for some small standardised part for motor cars) could be supplied by one firm of optimum size. In this case a single supplier would operate at much lower cost than several smaller competing firms.

The economies of scale argument in favour of monopoly/ is very strong in the case of the public utilities supplying water, gas, electricity, and telephone services. In all these industries fixed costs form a very high proportion of total costs and com­petition would mean a wasteful duplication of fixed capital. A number of competing firms would have fixed costs similar to those of a single supplier (e.g. competing electricity supply companies would all have to lay main services), but they would each have only a fraction of the total market over which to spread their fixed costs. Average cost would be much high­er in a competitive industry than in a monopoly.

Economies of scale are attainable where the monopoly takes the form of a unified enterprise which takes advantage of the possibilities arising from rationalisation and standard­isation. It does not follow that these gains will always be achieved by a monopoly organisation, neither does it neces­sarily follow that any economies so achieved will be passed on to consumers in the form of lower prices.

Efficiency and innovation

Those who believe in the virtues of competition argue that the absence of such competition will lead to less effi­cient production. The monopolist is not 'kept on his toes' by the pressures from competing producers. He does not have the same incentive to improve his product and his methods as does a firm in a competitive framework. On the other hand it is pointed out that, when there is a single supplier,

much of the 'waste' of competitive advertising is eliminated. Competition may lead to an excessive variety of product which prevents the industry achieving economies from large-scale production.

The monopolist, of course, does have an incentive to improve his performance since any reduction in costs means larger profits. The fact that a monopolist is earning profits cannot, in itself, be taken as an indication that the firm is efficient since a monopolist can use his market power to raise prices in order to cover costs.

The tack of competition is often used to support the view that monopoly leads to a slowing down of the rate of technical progress. The monopolist, it is argued, has little incentive to innovate, that is, to develop new products and new techniques of production. If he does not innovate, his control of the market means that he can still make profits. The competitive firm, however, may fear that if it does not innovate it will lose its market to its competitors who will take advantage of new developments. Monopoly is also accused of retarding technical progress by restricting the entry of new firms. It is important that entrepreneurs with progressive ideas should be free to put them to the test in the open market. When an industry is monopolised, this source of new ideas may be lost to the community.

On the other hand there is much support for the view that monopoly organisation encourages technical progress. A unified monopoly is more likely to have the resources required for research and development than a small firm in a competitive market. In addition the monopolist has more incentive to innovate since his secure market ensures that he obtains all the gains from any successful new technique or product. He can, moreover, retain these gains over the long run. Under competition any innovation will soon be copied and the gains to the innovator will be short-lived (although the patent laws provide some protection).

Stability

One argument in favour of monopoly is that it provides greater stability of output and prices. In a competitive market producers respond to market signals (i.e. price changes) in the expected manner. If an increase in demand leads to higher prices, producers will react by revising their production plans upwards. But the aggregate effect of a very large number of individual decisions to raise output is likely to be excess sup­ply in the next marketing period. This will lead to a sharp fall in prices and producers will revise their output plans down­wards. Again, the total effect is likely to be an over-adjust­ment and a severe shortage in the next marketing period with a corresponding rise in prices. A highly competitive market, especially where there is a substantial time lag between the decision to produce and the availability of supplies, is likely to be characterised by fairly extensive price swings.

A monopolist, on the other hand, is likely to react to demand changes in a more effective manner. He supplies the total market and should be capable of estimating the true extent of market trends much more accurately than a small firm supplying a tiny part of the market.

His adjustments of output, therefore, are likely to bring about an equilibrium situation fairly quickly. This particular argument provides the basis for many cartels (often govern­ment inspired) in the markets for agricultural products such as coffee, cocoa, and milk.

Monopolistic competition (Imperfect competition)

Perfect competition is not to be found in the real world and absolute or pure monopoly is also virtually impossible to achieve since it implies operating in the absence of competi­tion (i.e. no substitutes). While it is not difficult for a firm to become a sole supplier (by the use of brand names and trade marks) it is extremely difficult to achieve a situation where there are no substitutes for the product. A more realistic def­inition of monopoly would be 'a sole supplier of a commod-

ity for which there are no very good substitutes'. In fact the degree of monopoly in the real world tends to be judged on the basis of the share of the total market accounted for by any particular supplier. If a single enterprise accounted for, say, 50 per cent of the total market, it would be deemed to have a significant degree of monopoly power (i.e. the power to influence the prices of the products in this market).

Product differentiation

Modern capitalism is characterised by a large number of 'limited' monopolies. They are sole suppliers of branded goods, but other firms compete with them by selling similar goods with different brand names. This is the market situa­tion describes as monopolistic or imperfect competition. Thus the commodities produced by any one industry are not homogeneous; the goods are differentiated by branding and the use of trade marks. The individual firm has a monopoly position (e.g. only 1CI can supply Dulux), but it faces keen competition from firms supplying very similar goods. It has, therefore, only a limited degree of monopoly power — how much depends upon the extent to which firms are free to enter the industry. Product differentiation is emphasised (some would say, created) by the practice of competitive advertising which is, perhaps, the most striking feature of monopolistic competition.

Advertising is employed to heighten in the consumer's mind the differences between Brand X and Brand Y. It is important to realise that we are concerned with the differ­entiation of goods in the economic sense and not in the technical sense. Two branded products may be almost iden­tical in their technical features or chemical composition, but if advertising and other selling practices have created different images in the consumer's mind, then these prod­ucts are different from our point of view because the con­sumer will be prepared to pay different prices for them.

Oligopoly

In many industries, especially the science-based, and technologically advanced industries, we find a market situa­tion known as oligopoly. As the name implies, this is where the market is dominated 'by the few'. In other words, a small number of very large firms account for practically the whole output of the industry. Good examples of oligopoly are to be found in the industries producing oil, detergents, tyres, motor cars, synthetic fibres, and cigarettes.

Where there are important technical economies of scale to be gained, the processes of merger and amalgamation have drastically reduced the number of firms in an industry and brought into being some very large business units. In several industries in the UK more than 90 per cent of the market is supplied by no more than three or four firms.

Competition among the few, especially where each one of the few is a giant firm supplying a significant share of the market, presents very difficult problems in economic analy­sis. Oligopoly does not really fit into the framework we have used for monopoly and perfect competition for the simple reason that we cannot use the assumption that 'other things remain equal'. Remember that the demand curves used in the preceding analysis are drawn on the assumption that if a firm changes its price other things will not change. We can­not make this assumption for oligopoly because each firm has such a powerful influence on the total market that any change in its marketing policies is almost certain to provoke some reaction from its rivals. But what that reaction will be is uncertain. If a firm cuts its price it may finish up with increased sales, or it may find itself selling less. It all depends on how its rivals react. If they counter-attack by making even larger price cuts, the firm which started the process may well lose some of its market. If its competitors react with relatively smaller price cuts, the firm may be able to increase its share of the market. The uncertainty about what

happens when an oligopolist changes his price means that we cannot use the normal demand curve in analysing the determination of output.

Non-price competition

This unpleasant prospect encourages oligopolists to favour some sort of tacit agreement on prices. They may decide to accept price leadership from the largest firm — moving their prices in line with that firm's prices, or arrange in some other way for their prices to stay in line (although in most countries restrictive price agreements are illegal).

The level at which prices are fixed depends upon the effectiveness of the barriers to entry. Where these are not very restrictive, prices may be very little higher than the competitive price, but, if the existing firms are very large, the barriers are likely to be formidable and prices could be fixed much higher than the competitive price.

The reluctance to indulge in price competition has given rise to many types of non-price competition. We are all familiar with the free gift schemes, the use of trading stamps, and 'special offers'. Firms also compete on the bases of bet­ter or more attractive packaging, improved after-sales ser­vice, and more luxurious retail outlets. The most important form of non-price competition, of course, is advertising.

Do firms maximise profits?

In the real world of imperfect competition, firms have some degree of discretion in determining the prices of their products. In the previous discussions on this subject it has been assumed that firms will always adjust prices or outputs so as to maximise profits. There is much argument as to whether this is a realistic assumption about the behaviour of firms in modern industrialised societies. The validity of the assumption of profit maximisation has been questioned on several grounds.

1. It has been pointed out that many business people are
not aware of the concepts of marginal revenue and margin­
al cost and, of those who do have knowledge of these ideas,
many would find it extremely difficult to obtain any precise
measurements of MC and MR. It is sometimes said, there­
fore, that firms do not maximise profits because they lack
the knowledge necessary for them to do so.

But even if the foregoing assertions are true, they do not destroy the profit-maximisation theory. If business people try to increase profits by trial and error adjustments of their prices, they will be tending towards the output where MR = MC, even if they are unaware of these concepts.

2. If firms tried to maintain output at the point where
MR = MC, it is likely that prices would be very unstable
because firms would have to adjust price and output levels
following every change in cost and demand conditions.
Many firms are reluctant to carry out frequent changes in
price because such changes impose administrative costs and
they lead to a loss of goodwill on the part of their customers.
Instead of making frequent changes in price so as to equate
MR and MC and maximise profits in the short-run, firms
may be more concerned with the longer run effects of their
pricing policies, that is, they will take into account the effects
of today's prices on tomorrow's sales. It has been suggested
that this type of behaviour does not conflict with the idea that
firms try to maximise profits since they are attempting to
maximise long-run rather than short-run profits.

3. Some studies of business people's activities have led to
the view that, rather than trying to maximise profits, some
firms tend to opt for a 'quiet life'. They seem content with
some acceptable level of profit which might be less than they
could earn if they adopted more fiercely competitive poli­
cies. Managements may be reluctant to accept the increased
risks and pressures which go with more aggressive and ambi­
tious practices. While this option may be available to a firm

with some degree of monopoly power, firms in very compet­itive markets, where no firms has any significant market power, must attempt to maximise profits in order to survive.

4. The fact that larger firms are not directly controlled
by shareholders (the people most likely to be interested in
profit-maximisation), but by professional managers pro­
vides another basis for criticising the theory of profit-max­
imisation. The status, prestige, and remuneration of man­
agers is closely linked to the size of the firm and it is likely,
therefore, that such people will be more interested in max­
imising sales rather than maximising profits. They cannot be
indifferent to the profit and loss account of the firm, but,
having achieved a level of profit which they believe will sat­
isfy shareholders, managers are more inclined to make
sales-maximisation their major objective.

5. Several investigations into business practices have
revealed the fact that a large number of firms fix their prices
on what is described as a full-cost basis. Estimates are pre­
pared of the firm's average total cost. There is evidence that
this may be constant over a wide range of output. To this
average cost figure management adds some conventional
profit margin (described as the 'mark-up') and this deter­
mines the price at which the product is marketed. Sales are
determined by what the market will absorb at this price (i.e.
by demand). Under this system the critical decision is the
extent of the mark-up. It seems that the mark-up is period­
ically adjusted in the light of changes in demand conditions
and the extent of competition from other firms. If this is so,
full-cost pricing may be the industrialist's way of moving
towards the price/output combination which yields maxi­
mum profits.

We must recognise the fact that there is no theory of the behaviour of the firm which commands general acceptance. Firms clearly can have several goals, for example, profits, stability, maximum sales, protecting their share of the mar-

ket, management status, and so on. There is no theory which successfully embraces all these aspects of decision-making. The assumption of profit-maximisation is useful because it is simple to understand and enables us to con­struct a theory of business behaviour. It possibly describes the way in which firms behave at least as well as any other plausible assumption.