Chapter 6 - Firm Competition

Learning Outcomes:
At the end of this lecture, you are expected to:
✓ Learn and explain why perfect competition usually does not happen.
✓ Discuss the different ways firms compete.
✓ Discuss how competition works in different market structures.

Introduction and Core Values Integration

Competition in the marketplace is good for consumers and good for business. Competition from many different companies and individuals. When firms
compete with each other, consumers get the best possible prices, quantity, and quality of goods and services. Antitrust laws encourage companies to compete
so that both consumers and businesses benefit.

One important benefit of competition is a boost to innovation. Competition among companies can spur the invention of new or better products, or more
efficient processes. Firms may race to be the first to market a new or different technology. Innovation also benefits consumers with new and better products,
helps drive economic growth and increases standards of living.

Being competent doesn’t necessarily mean you are better than anyone else. Rather, it is an indicator that you want yourself to be better than you already are.

Why Perfect Competition Usually Does Not Happen

The perfect competition model (and its variants like monopolistic competition and contestable markets) represents an ideal operation of a market. As we
noted in Chapter 5 "Market Equilibrium and the Perfect Competition Model", not only do the conditions of these models encourage aggressive competition
that keeps prices as low as possible for buyers, but the resulting dynamics create the greatest value for all participants in the market in terms of surplus for
consumers and producers.

Neo-classicalists argue that the market will naturally come to an equilibrium known as perfect competition. In this ideal utopia everything will be perfect.
Consumers get the lowest price, workers get a fair wage and businesses earn only ‘normal’ profits. No one is ripped off or exploited because no such nasty
things occur. There is no poverty, unemployment, inflation or recessions. There is no need for government to intervene or even exist. While it does describe
agriculture, it is completely irrelevant to the rest of the economy. It is a conservative’s dream, more like Narnia than the real world. Despite being taught in all
textbooks and described as the economy without government interference, it is instead a deeply flawed theory.

It is said to be based on unrealistic assumptions as we discussed in the previous chapter. The most crucial assumption of perfect competition and also the
easiest one to disprove is that all buyers and sellers are price takers. In order for perfect competition to work there must be an enormous number of
companies, perhaps numbering in the hundreds. Think for a moment, what industry is actually like this? What industry is comprised of hundreds of sellers
equally small and insignificant? The only case where this applies is in agriculture.

However, in recent decades circumstances have changed, even for farming, in a way that deviates from the assumptions of perfect competition. Now farmers
are unlikely to sell directly to consumers. Instead, they sell to food processing companies, large distributors, or grocery store chains that are not small and
often not price takers. Many farming operations have changed from small, family-run businesses to large corporate enterprises. Even in markets where
farming operations are still relatively small, the farmers form cooperatives that have market power. Additionally, the government takes an active role in the
agriculture market with price supports and subsidies that alter farm production decisions.

How firms compete?

1. Price. Some goods are price sensitive. For example, a good like petrol consumers will desire to buy the cheapest. Firms will struggle to differentiate the

Managerial Economics Page 1

 1. Price. Some goods are price sensitive. For example, a good like petrol consumers will desire to buy the cheapest. Firms will struggle to differentiate the
good as all petrol seems the same. Offering cut-price petrol will attract customers.
2. Brand loyalty. Consumers can develop a loyalty to their favorite brand and good. The consumer knows what to expect when they go to Starbucks
Coffee. Trying to increase brand loyalty is a reason why firms spend money on advertising to gain.
3. Convenience. For many goods and services, convenience and being in the right location is the most important factor. It is no point selling cheap petrol if
motorists have to drive many miles to purchase.
4. Service. For some products, the quality of the service is important. With restaurants, the price of the meal may be considered secondary to the quality
of the food and the environment of the restaurant.
5. Offering new products. Rather than reacting to consumer preferences, successful firms have developed new products that create new markets. For
example Apple with innovative iPod and iPad.

Competition in perfect competition

Perfect competition is a theoretical market structure, in which there is perfect information and the good is homogenous. Therefore, the price is the
determining factor and the model suggests that all firms will converge on selling at the market price.

Competition in Oligopoly and Monopolistic Competition

We can see more non-price competition as firms seek customers based on factors such as

• Loyalty card – encouraging repeat customers through discounts to loyal customers

• Direct mailing – a key method of retaining customers is through gaining access to their email address and then sending targeted promotions and news
about new features/products.

• Ethical/charity concerns. Some firms may promote an ethical line of marketing, for example, ‘fair-trade’ coffee appeals to customers who wish to buy
goods with a social conscience.

• Unique selling points. In recent years, firms have concentrated on offering differentiated products and products that can be customized to consumer
preferences. For example, when Henry Ford launched the Model T, he said, customers can have any product so long as it is black. But, the modern
customer seeks greater specialization. Innovative clothing companies allow customers to send in their own personal measurements to get clothes which
fit, rather than generic sizes of S, M, L.

• Advertising/brand loyalty. Firms spend billions on advertising because repeated exposure to famous brands can make consumers more likely to buy
‘trusted’ brands. High brand loyalty can also create barriers to entry. For example, many firms have tried to enter the market for cola, but have been
unsuccessful, due to the success of Coca-Cola and Pepsi in creating strong brand loyalty.

• After-sales service. For some goods, like TVs and car, offering free after-sales service can be a factor in encouraging customer trust.

• Cultivation of good reviews. In an online world, good reviews are increasingly important – especially for industries like tourism. Therefore, firms have an
incentive to encourage happy customers to leave reviews.

• Foreseeing trends in markets. Many successful retailers have gone out of business because they were stuck with old business models. Successful firms
need tremendous adaptability and innovation to move into new markets and trends. For example, retailers who successfully moved into an online
presence have been more adaptable to trends in consumer behavior.

• Pay for best workers. In some industries, success may all depend on the quality of staff. For example, restaurants may want to employ the top chef.
Football clubs the best footballers and managers. In other industries, firms may work hard to keep the workforce motivated by share employee
schemes – giving workers a share in the firm’s fortunes.

Different forms of price competition

Firms can also use different types of price competition to attract customers.

• Premium pricing. This occurs when a firm makes a good more expensive to try and give the impression that it is better quality, e.g. ‘premium unleaded
fuel’, fashion labels.
• Loss Leaders. This involves setting a low price on some products to entice customers into the shop where hopefully they will also buy other goods as
well. However, it is illegal to sell goods below cost, so firms could be investigated by OFT. The term loss leader is used in the sense that the product is
sold at “loss” so that it leads the sales of other products which, when combined together result in bigger sales and much larger profit.
• Price Discrimination. This involves charging a different price to different groups of consumers to take advantage of different elasticities of demand.
There are different types of price discrimination from first degree to third degree.
• Reference Pricing. This involves setting an artificially high price to be able to later offer discounts on previously advertised price.

References:
https://www.consumer.ftc.gov/sites/default/files/games/off-site/youarehere/pages/pdf/FTC-Competition_How-
Comp-Works.pdf
https://saylordotorg.github.io/text_principles-of-managerial-economics/s07-firm-competition-and-market-st.html
https://whistlinginthewind.org/2012/08/23/there-is-almost-no-such-thing-as-perfect-competition/
https://www.economicshelp.org/blog/143936/economics/how-firms-compete/

Managerial Economics Page 2