Britannica Money

Table of Contents

Perfect competition

Market conduct and performance in atomistic industries provide standards against which to measure behaviour in other types of industry. The atomistic category includes both perfect competition (also known as pure competition) and monopolistic competition. In perfect competition, a large number of small sellers supply a homogeneous product to a common buying market. In this situation no individual seller can perceptibly influence the market price at which he sells but must accept a market price that is impersonally determined by the total supply of the product offered by all sellers and the total demand for the product of all buyers. The large number of sellers precludes the possibility of a common agreement among them, and each must therefore act independently. At any going market price, each seller tends to adjust his output to match the quantity that will yield him the largest aggregate profit, assuming that the market price will not change as a result. But the collective effect of such adjustments by all sellers will cause the total supply in the market to change significantly, so that the market price falls or rises. Theoretically, the process will go on until a market price is reached at which the total output that sellers wish to produce is equal to the total output that all buyers wish to purchase. This way of reaching a provisional equilibrium price is what the Scottish economist and philosopher Adam Smith (1723–90) described when he wrote of prices being determined by “the invisible hand” of the market.

Adam Smith, drawing by John Kay, 1790.

If the provisional equilibrium price is high enough to allow the established sellers profits in excess of a normal interest return on investment, then added sellers will be drawn to enter the industry, and supply will increase until a final equilibrium price is reached that is equal to the minimal average cost of production (including an interest return) of all sellers. Conversely, if the provisional equilibrium price is so low that established sellers incur losses, some will withdraw from the industry, causing supply to decline until the same sort of long-run equilibrium price is reached.

The long-run performance of a purely competitive industry therefore embodies these features: (1) industry output is at a feasible maximum and industry selling price at a feasible minimum; (2) all production is undertaken at minimum attainable average costs, since competition forces them down; and (3) income distribution is not influenced by the receipt of any excess profits by sellers.

This performance has often been applauded as ideal from the standpoint of general economic welfare. But the applause, for several reasons, should not be unqualified. Perfect competition is truly ideal only if all or most industries in the economy are purely competitive and if in addition there is free and easy mobility of productive factors among industries. Otherwise, the relative outputs of different industries will not be such as to maximize consumer satisfaction. There is also some question whether producers in purely competitive industries will generally earn enough to plow back some of their earnings into improved equipment and thus maintain a satisfactory rate of technological progress. Innovation would effectively be discouraged. Finally, some purely competitive industries have been afflicted with what has been called destructive competition. Examples have been seen in the coal and steel industries, some agricultural industries, and the automotive industry. For some historical reason, such an industry accumulates excess capacity to the point where sellers suffer chronic losses, and the situation is not corrected by the exit of people and resources from the industry. The invisible hand of the market works too slowly for society to accept. In some cases, notably in agriculture, government has intervened to restrict supply or raise prices. Leaving these qualifications aside, however, the market performance of perfect competition furnishes some sort of a standard to which the performance of industries of different structure may be compared.

Monopolistic competition

In the more complex situation of monopolistic competition (atomistic structure with product differentiation), market conduct and performance may be said to follow roughly the tendencies attributed to perfect competition. The principal differences are the following. First, individual sellers, because of the differentiation of their products, are able to raise or lower their individual selling prices slightly; they cannot do so by very much, however, because they remain strongly subject to the impersonal forces of the market operating through the general level of prices. Second, rivalry among sellers is likely to involve sales-promotion costs as well as the expense of altering products to appeal to buyers. This is a competitive game that all will play but that nobody, on average, will win, and the long-run equilibrium price will reflect the added costs involved. In return, however, buyers will get more variety. Third, since sellers are unlikely to be equally successful in their sales-promotion and product policies, some will receive profits in excess of a basic interest return on their investment; such profits will come from their success in winning buyers. Monopolistic competition may, like perfect competition, include industries that are afflicted with destructive competition. This may result not only from a failure to get rid of excess capacity but also from the entry of too many new firms despite the danger of losses.

Monopoly

While single-firm monopolies are rare, except for those subject to public regulation, it is useful to examine the monopolist’s market conduct and performance to establish a standard at the pole opposite that of perfect competition. As the sole supplier of a distinctive product, the monopolistic company can set any selling price, provided it accepts the sales that correspond to that price. Market demand is generally inversely related to price, and the monopolist presumably will set a price that produces the greatest profits, given the relationship of production costs to output. By restricting output, the firm can raise its selling price significantly—an option not open to sellers in atomistic industries.

The monopolist will generally charge prices well in excess of production costs and reap profits well above a normal interest return on investment. His output will be substantially smaller, and his price higher, than if he had to meet established market prices as in perfect competition. The monopolist may or may not produce at minimal average cost, depending on his cost-output relationship; if he does not, there are no market pressures to force him to do so.

If the monopolist is subject to no threat of entry by a competitor, he will presumably set a selling price that maximizes profits for the industry he monopolizes. If he faces only impeded entry, he may elect to charge a price sufficiently low to discourage entry but above a competitive price—if this will maximize his long-run profits.