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Models of Competition

When Adam Smith developed the theory of the invisible hand he envisioned a model of competition far different from the model that exists today. His essential belief was that all businesses would compete selling identical products. In his theory these were small businesses and consumers would be free to select product on the basis of prices and not other factors. As we can now recognize Smith's theory runs contrary to basic human nature. Instead of small businesses competing based on price alone we see mergers, large corporations and a dizzying array of products all designed to gain market share and increase profits. If Adam Smith were with Dorothy he would turn to her and say, "we're not in Kansas anymore!"

Pure Competition

Pure competition is a market scenario that includes a large number of autonomous and knowledgeable buyers and sellers of an identical product. Yet none of which are capable of influencing the price. There are five major conditions, which characterize purely competitive markets.

  • The first condition is that there are a large number of buyers and sellers. No single buyer or seller is large enough or powerful enough to affect the price of the product.
  • The second condition is that buyers and sellers deal with identical products. Therefore buyers do not prefer one seller's merchandise over another's because there is no disparity in quality, no brand names, and no need to advertise.
  • The third condition is that each buyer and seller acts autonomously, there must be no collusion. If such a situation occurs, sellers would compete against one another for the consumer's dollar. Buyers also compete against each other and against the seller to obtain the best price.
  • The fourth condition is that the buyers and sellers are knowledgeable about the items for sale. Because all products are exactly the same, customers would have little reason to remain loyal to one seller. If sellers were reasonably familiar with other sellers' prices, they would have to keep their own prices low to attract customers.
  • The fifth and final condition is that buyers and sellers are free to get into, conduct, and get out of business; thus making it difficult for a single producer to keep the market just to itself. It is up to the producer to keep prices competitive or new firms will enter the industry and take away some business.

Monopolistic Competition

Since we live in a society were the five elements of pure competition are not available to us, then we are clearly operating in a state other than pure competition. Instead we operate under a different model of competition known as monopolistic competition. Any time the elements of pure competition are not met the existing model is monopolistic competition.

The fundamental difference between a pure competitor and a monopolistic competitor is that the latter refrains from selling identical products. By employing product differentiation, the monopolistic competitor is trying to establish a comparison between its product and another competitors product. Product differentiation is when manufacturers make design changes to basically identical products. An example might be the Big Mac and the Whopper. Each is a large fattening hamburger yet McDonalds and Burger King market them as totally different products in an attempt to make their product appear different and better. Instead of competing based upon price, we are competing based upon features. This is known as non price competition. This non price competition is rampant throughout our economy. How many different brands of blue jeans, sneakers, cars, etc are there that all claim to be different and somehow better? The reality is they are just trying to get a leg up on the competition.

Models of Monopolistic Competition

Oligopoly - a few large sellers dominate and have the ability to affect prices in the industry. Because of the fact that in an oligopoly there are very few firms, when ever one firm does something, the others follow suit. Since all the firms have considerable power and influence, firms tend to act together. There are times when the interdependent behavior of the firms results in a formal agreement to set prices; this is termed a "collusion". Price-fixing, a type of collusion, is the action taken by an oligopoly to charge the same or similar prices for a product. The firms must also agree to divide the market so that each is guaranteed to sell a certain amount. Yet collusion is against the law because it restrains trade. Price wars are also common in oligopolies. When one firm lowers prices, it leads to a series of price cuts by all producers that may lead to unusually low prices in the industry. Raising prices is also risky unless the firm knows that rivals will follow suit. Otherwise, the higher priced firm will lose out on sales. An example might be Coca Cola and Pepsi which dominate the soft drink market.

Pure Monopoly is a situation in which there is only one seller of a specific product that has no substitutes. Yet in the United States there is no situation like the aforementioned. Therefore, when economists discuss monopolies, they are referring to near monopolies. There are four types of. near monopolies.

  • Natural Monopoly. This is where society would be best served by the existence of the monopoly. Also called a franchise, it is a market situation where costs are minimized by having a single firm produce the product. Oftentimes, the government gives a company the exclusive right to do business in a certain area without competition. By accepting such a privilege, the companies also are subject to a certain amount of government regulation. Natural monopolies also bring about lower costs. If a firm grew larger and larger, its growth would result in the lowering of its costs. This trend is called economy of scale. Often these natural monopolies are accepted because it would be too great an inconvenience to have competition. Imagine ripping up the streets for new natural gas and lines.
  • Geographic Monopoly - In this case, there are times when a business has a monopoly because of its location. When there is low demand for a certain type of firm, it often reflects in the amount of stores or business located in an area. Yet a geographic monopoly is not free from competition. If a business begins to make a great deal of money, competitors may come along in order to "share in the wealth". Also too, if a business keeps its prices too high, another business of the same type may come along with lower prices in order to elicit competition.
  • Technological monopoly - These monopolies are really special rights given to those who invent a new product or create some type of work. By provision of the Constitution, the United States government is allowed to grant patents to inventors guaranteeing them the right to manufacture, use, or sell any new improvement they have made. Inventions are covered for 17 years and designs can be patented for shorter periods. Art and literary works are protected in much the same way through a copyright. Microsoft's control of the Windows operating system is such an example.
  • Government Monopoly - a business the government owns and operates. Government monopolies are found at all levels and in most cases, involve products people need that private industry may not adequately provide like the post office.


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