Element 2.2: Competitive Markets

“Competition is conducive to the continuous improvements of industrial efficiency. It leads producers to eliminate wastes and cut costs so that they may undersell others. It weeds out those whose costs remain high and thus operates to concentrate production in the hands of those whose costs are low.”⁽³¹⁾

Competition is the lifeblood of a market economy. Competition is present when the market is open and alternative sellers are free to enter. Rival firms may operate in local, regional, national, or even global markets. The competitive process places pressure on each to operate efficiently and cater to consumer preferences. Competition weeds out inefficient producers. Firms failing to provide consumers with quality goods at attractive prices will experience losses and eventually be driven out of business.

Successful competitors outperform rival firms. They may do so through a variety of methods, including quality of product, style, service, convenience of location, advertising, and price, but they must consistently offer consumers at least as much value relative to the cost of producing that value as is available from rivals.

What keeps McDonald’s, Carrefour, Amazon, General Motors, or any other business firm from raising prices, selling shoddy products, and providing lousy services? Competition is the answer. If McDonald’s fails to provide a tasty sandwich at an attractive price delivered with a smile, people will turn to KFC, Burger King, Wendy’s, Subway, Taco Bell, and/or other rivals. Even the largest firms will lose business to small upstarts that find ways to offer better products at lower prices. Automobile manufacturing is dominated by large firms, but competition is still intense. Firms as large as Toyota, (Japan) and General Motors (US) will lose customers to Changan (China) or Maruti (India) and other automobile manufacturers, some we haven’t even heard of yet if they fall even a step behind in providing the types of vehicles people want at competitive prices.

Competition gives firms a strong incentive to develop better products and discover lower-cost methods of production. No one knows precisely what products consumers will want next or which production techniques will minimize costs per unit. The discovery process of markets provides the answer. Is the online marketplace the greatest retail idea since the shopping mall? Or is it merely another idea that will soon be replaced by something even better? Profits and losses in open, competitive markets will constantly reveal the answer, which will change through time with changing consumer preferences, new technology, and discovery of better ways of doing things.

In a market economy, entrepreneurs are free to innovate. They need only the support of investors (often including themselves) willing to put up the necessary funds. The approval of central planners, a legislative majority, or business rivals is not required. Nonetheless, competition holds entrepreneurs and the investors who support them accountable because their ideas must face a “reality check” imposed by consumers. If consumers value an innovative new product enough to cover its costs, the new business will profit and prosper. But if consumers find that the new product is worth less than its per-unit costs, the business will suffer losses and fail. Consumers become the ultimate judges and jury of business innovation and performance.

When new products are introduced, they generally follow a predictable price-quality pattern. Typically, new products are initially very expensive and purchased by relatively few consumers, mostly those with high incomes. These consumers will pay dearly for the early availability, because during this initial phase, product quality tends to be lower as firms work out unexpected start-up issues but the price high due to limited levels of production. These initial purchasers play a vital role: They provide the revenue to cover the product’s start-up costs and allow the firms to acquire experience, improve quality, and reduce per-unit cost in the future. With time, entrepreneurs will figure out how to make the product more affordable and expand its availability to more and more consumers.

Numerous goods, including automobiles, televisions, air conditioners, dishwashers, microwave ovens, and personal computers have gone through this same pattern.⁽³²⁾ All were highly expensive when initially introduced, but entrepreneurs figured out how to produce them more economically and improve their quality, making them more affordable to the overwhelming bulk of consumers. As we reflect on the role of both entrepreneurs and the competitive process, it is important to recognize this pattern of price and quality through time.

Smartphones illustrate this price-quality pattern. When cell phones were initially introduced in the 1980s, they sold for around $4,000 (adjusted for inflation, nearly $10,000 today), were about the size of a brick, and could not do much more than make calls. With time, their size shrank, their information processing power and functions exploded, and their prices fell. Today, they are available at a fraction of the initial price, and they are viewed as a necessity by many consumers in all income brackets in every country where the government allows, enabling friends, families and business associates to communicate instantly for pennies. In 1920, for example, a 10 minute telephone call from New York to Los Angeles costs over $400 in 2024 proces. In 2024, however that callcan be made for free using services such as Zoom or Whatsap.

Producers who wish to survive in a competitive environment cannot be complacent. Today’s successful product may not pass tomorrow’s competitive test. In order to succeed in a competitive market, entrepreneurs must be good at anticipating, identifying, and quickly adopting improved ideas.

Competition reveals the business structure and size of firm that can best keep the per-unit cost of a product low. Unlike other economic systems, a market economy does not mandate the types of firms that are permitted to compete. Any form of business organization is permissible. An owner-operated firm, partnership, corporation, employee-owned firm, consumer cooperative, commune, or any other form of business is free to enter the market. To succeed it must pass only one test: cost-effectiveness. It must produce quality products at attractive prices if it is to profit and succeed. But if its structure results in higher costs than those of other forms of business organization, competition will drive it from the market. Of course, competition also ensures that products of different quality can coexist so long as some consumers opt for the differing quality/price trade-offs. A Mercedes can sell (at a high price) alongside a lower-priced Volkswagen. On the other hand, the East German car brand Wartburg and the Russian make Zhiguli were unable to survive without some form of interference with market forces —as was common among communist countries that banned or imposed high tariffs on imports from market economies.

The competitive process will also determine the size of firms in various sectors of the economy. In some sectors—airplane and automobile manufacturing, for example—firms will need to be quite large to take full advantage of economies of scale. A firm producing a few dozen automobiles would have an extremely high per-unit cost; in contrast, when the fixed costs are spread over many thousands of units, the costs of producing each car can plummet. Naturally, consumers will tend to buy from the firms that can produce goods economically and sell them at lower prices. In such industries, small firms will be unable to compete effectively and only large firms will survive. Another example is the telecommunications market. With substantial infrastructure costs, the telecommunications market is dominated by large firms in Europe, including Vodafone, Deutsche Telekom, Telefonica, and Orange.

In other sectors, however, small firms, often organized as individual proprietorships or partnerships, will be more cost-effective. When consumers place a high value on personalized service and individualized products, small firms tend to dominate while large firms struggle. This is generally the case in the markets for legal and medical services, gourmet restaurants, personal services, and specialized printing. Thus, these markets are usually dominated by small firms. The craft beer and microbrewery sector in Europe has seen a significant rise, with small breweries playing a major role in diversifying the beer market. Countries like Belgium, the UK, Germany, and the Czech Republic have vibrant scenes where small firms innovate in beer production, offering a wide range of styles and flavors not typically available from larger producers.

Paradoxical as it may seem, self-interest directed by competition is a powerful force for economic progress. Dynamic competition among products, technologies, organizational methods, and business firms will weed out the inefficient and consistently lead to the discovery and introduction of preferred products and superior technologies. When the new methods improve quality and/or reduce costs, they will grow rapidly, often replacing the old ways of doing things.

History abounds with examples. The automobile replaced the horse and buggy. The supermarket replaced the mom-and-pop grocery store. Fast-food chains like McDonald’s and Wendy’s largely replaced the local diner. Carrefour and Metro Cash & Carry grew rapidly while other retailers shrank or even went out of business. Personal computers replaced typewriters, smartphones took the place of rotary-dial phones fixed in a partular sportless mobile computer devices. LED lighting is effectively phasing out incandescent bulbs and computers (or even phones themselves) replaced abacuses, slide rules or even fingers in doing math due to improvements in convenience, cost-effectiveness, and quality combined with reductions in price. Companies that were slow to adapt to the digital revolution, such as Kodak, faced significant business challenges. In contrast, those that embraced digital technology, like Canon and Nikon, continued to thrive and lead the market. One could go on and on with similar examples. The great economist Joseph Schumpeter referred to this dynamic competition as “creative destruction” and argued that it formed the very core of economic progress.

Competition harnesses personal self-interest and puts it to work elevating our society’s standard of living. As Adam Smith noted in The Wealth of Nations:

“It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.”⁽³³⁾

Taken together, private ownership and competitive markets provide the foundation for cooperative behavior and efficient use of resources. When private property rights are clearly defined and enforced, producers face the opportunity cost of their resource use. That is, as we discussed in part 1, they must provide more value from the resources used or else more cost-effective producers will overwhelm them. The prices in open and competitive markets provide them with a strong incentive to keep costs low, cater to the desires of consumers, and discover superior products and better ways of doing things.

Competition is “pro-consumer” - consumers are the big winners. Competitive markets are not “pro-business.” In fact, businesses do not like to face competition, and, instead, they commonly lobby for government policies to protect themselves from it. They will often seek to erect barriers limiting the market entry of potential rivals. As we move on to the analysis of regulation in the next element and the political process in part 3, examples of businesses’ efforts to reduce the competitiveness of markets will arise again and again. The European Union, through the European Commission, has a comprehensive set of competition policies aimed at preventing anti-competitive practices. This includes the power to investigate companies, impose fines, and require divestments or changes in business practices to maintain market competitiveness. The goal is to ensure that consumers benefit from a wide choice of services and products at competitive prices. On the other hand, it is important to be on the lookout for regulatory capture whereby a large firm already in an industry tries to get regulators to make rules that are so expensive to meet that small, start-up firms that might have a better product find it impossible to enter the industry. As an example the EU’s “General Data Protection Requirements” (GDPR) involve so much record keeping and administrative costs that potential new on-line business sites may find it to expensive to try out their possibly innovative idea.