There are several different types of competition in economics, which are largely defined by how many sellers there are in a market. For example, in a monopoly, there is just one business controlling the market with no competition at all. This one business is able to set higher prices and earn better profits. However, the more businesses that enter a market, the more competition there is. Competition lowers prices as businesses compete for customers and market share. It’s important for business owners and consumers to understand competition in economics and how it affects different markets.
Competition in economics happens when a market has a sufficient number of buyers and sellers so that prices remain low. When there are a large number of sellers, consumers have many options, which means companies have to compete to offer the best prices, value and service. Otherwise, consumers will go to the competition. When consumers enjoy many choices, businesses must remain on their toes and continue to offer the best prices. In this way, competition self-regulates the supply and demand of markets, keeping goods affordable for consumers. This is called the invisible hand theory.
Under a truly competitive market, no one company is able to exploit prices because consumers always have a choice to go somewhere else. There must be a healthy amount of competition in a market for this to work. Certain markets may not have as much competition, thus driving up prices.
Perfect competition happens when there are many sellers of nearly identical products. Because of so many companies selling similar products, there are many substitutes available for consumers. Prices are controlled by supply and demand, and are generally low for consumers. One example of this is apple farming. If there are several apple farms in a geographic region, they will have to price their products competitively. When one farm prices their apples too high, consumers will go to another farm. There are abundant options, meaning substitutes are easy to come by. The lower priced apple farm will sell the most product, and other farms must keep up by lowering their prices, too. This may require farms to lower operating costs or be run out of business.
Of course, it’s important to note that things don’t usually work this way in the real world. Perfect competition is purely theoretical. Through marketing, brands are able to differentiate their products, thus convincing consumers to pay higher prices. For example, one farm might choose to place a premium on a special type of apple. Perhaps they have the best product in the region or they create an exceptional and unique hybrid apple. Some consumers will be drawn to what they perceive as a higher quality product and pay extra for it. This is especially true with gourmet or artisanal food products.
Monopolistic competition is a market where there are many competitors, but each company sells a slightly different product. A few examples of businesses involved in monopolistic competition are restaurants, retail shops, salons and consumer electronics. Each of these groups of businesses are in competition with one another. For example, say there are two restaurants across the street from one another. One is Greek and the other is Mexican. They are each competing for customers, but their businesses aren’t exactly perfect substitutes for one another. They offer two totally different types of cuisine, and perhaps even two different price points and dining experiences.
In monopolistic competition, there is a relatively low barrier of entry for businesses. This means there will be many companies entering the competition. They must each use marketing to differentiate their products and convince consumers of why their company’s product should be chosen over all the others. For example, in a city like New York, where there are over 20,000 restaurants, competition is stiff. This is why restaurants must use marketing to differentiate themselves and compete. Because of the abundance of competition, demand is elastic. If a company significantly raises their prices, many consumers will likely go elsewhere. If your neighborhood pizza place raises its prices by 33 percent, you'll probably find someplace else to get pizza, unless you’re extremely attached to that particular pie.
An oligopoly is a market where there are more than two competitors, but no more than a handful. Usually, oligopoly markets have a high barrier to entry. One historic example of this is railroads. Only a few companies were given the proper licenses and permits to build railroads, and only a few companies had the money. In oligopolies, all companies are at risk of entering a price war, which can ultimately be harmful to a business’ bottom line. Profit margins tend to be higher in oligopolies because there is little competition.
Usually, governments set laws that prohibit oligopolies from engaging in price fixing or collusion. Unfortunately, the practice is not unprecedented. OPEC has famously found ways around laws to continue fixing prices on oil. Further, companies competing in an oligopoly tend to follow price leaders – when one price leader business raises prices, the others follow suit, raising prices overall for consumers.
A monopoly exists when there is only one company covering an entire market. This company is the sole market for the product and can set prices without any competition. This lack of consumer choice usually results in high prices. Sometimes a business is a monopoly because the barrier to entry is too great for other companies to enter the market and compete. Other times, a monopoly is artificially created, such as when a government is the sole controller of a product, like electricity, mail delivery or gas. Another reason monopolies exist is that one company has a patent on a product, and that patent protects the company from others entering the market and creating price competition.
Sometimes, a particularly large and profitable company will buy up all the competition, effectively taking over a market. This company is then a monopoly, able to effectively set prices however they want. Antitrust laws are meant to prevent monopolies and protect consumers from their effects. Markets must continue to be open to new competitors if prices are to stay low and goods are to remain affordable.
Perfect competition: An example of perfect competition is the plant market. Many greenhouses and home stores sell similar plants. If one shop prices their plants too high, consumers will go to the competition. Unless the type of plant is rare and difficult to find, there is no reason for a consumer to pay $10 for a small lavender plant when they could pay $3 at the greenhouse next door. Again, perfect competition is not a reality in most markets, because marketing and differentiation often comes into play. If the lavender plant is a rare type, or organic and food grade, consumers might be willing to pay a little more.
Monopolistic competition: A good example of monopolistic competition can be seen in clothing stores. Each store sells clothing, which creates competition. But there are many differences in styles and offerings from store to store. Since there are abundant clothing retail options, each store must be mindful of competition when setting prices. Most consumers will not be willing to pay $200 for a plain black T-shirt, especially if the shop across the street is selling them for $20. Of course, in the retail clothing market, marketing and product differentiation is key. Some luxury brands do, in fact, convince consumers to spend $200 on a black T-shirt, thanks to stellar marketing. However, most lower and midpriced brands will have to compete for consumers who have many choices.
Oligopoly: The commercial airline market often shows signs of oligopoly. Airlines use dynamic pricing, meaning their prices change constantly. Sometimes, airline prices will change multiple times per day. It is well-known that airlines often put flights on sale on Tuesday mornings. They do this to move seats for flights that are selling slowly. Usually, these seats are attractively priced, perhaps even at a loss for the company. As a result of the sale, an all-day price war ensues, with competing airlines slashing prices to keep up with the competition. By late Tuesday afternoon, the airlines have sold all of the cheap seats they intend to move and raise prices once again. All of the other airlines follow the price leader and raise their prices, too.
Monopoly: One example of a monopoly is when there is only one electric company in your geographic area. This company can set prices however it wants and you are unable to go to the competition. Another example of a monopoly is the drug Viagra. Originally, Pfizer had the sole drug patent and so no one else could enter the marketplace. Pfizer could charge whatever it wanted for Viagra, since there was no true substitute for the drug. Today, Viagra is available in generic form, eliminating Pfizer's monopoly.
Competition affects several aspects of a business. It tends to determine the barrier to entry for a business. For more competitive industries, the barrier to entry is relatively low. Many competitors can enter the marketplace and afford to do business. In less competitive markets, it is difficult to enter the market and compete with the existing entities. This could be due to cost or legal difficulties. For example, if you want to build a railroad, you are going to be in for a difficult undertaking. Building new railroad tracks requires government approval, which is not easily given. Further, the amount of money needed for such a project is not available to most.
Another way competition affects a business is in price-setting. In competitive industries, a business must always be conscious of its pricing when placed next to comparable companies. For example, if you are opening a bar, you must be conscious of what other bars in the area are charging for drinks. You may be able to convince your customers to pay $8 for a Bud Light when the bar next door charges $4 if you offer entertainment or some other worthwhile attraction. But ultimately, you will always be somewhat bound to the prices your competition charges. That is, unless you are able to differentiate yourself substantially from what others are offering.
Finally, competition affects a business’ profits. Say you are in the dry cleaning business. You have relatively few competitors, and because of that, you are making high profit margins. A few other entrepreneurs hear that your dry cleaning business is making money hand over fist. This compels three new dry cleaners to enter your market. The new businesses may force you to lower prices or offer higher value to your customers. As a result, the competition will eat into your profits. Usually, competition is quick to enter high profit industries, driving down profits for everyone.