Forms of Competition
Many people think about competition in terms of the textbook model of Perfect Competition. But markets that are not perfectly competitive can still deliver significant benefits for buyers and sellers. A useful standard for analyzing real world markets is Effective Competition. The concept of Market Contestability is also useful for analyzing markets in which there are few players but market power is constrained by the potential for entry.
The textbook case of perfect competition rarely (if ever) occurs in practice. It is more an ideal than a market reality, and so is not useful as a standard for analysing the performance of real world markets. Perfect competition requires a number of conditions:
- The product concerned must be “homogeneous”. That is, the product must have identical attributes and quality regardless of who buys or sells it,
- There must be a large number of buyers and sellers for that product,
- Buyers must be homogeneous and perfectly informed,
- No single consumer or firm must buy or sell anything more than an insignificant proportion of the available market volume of that product,
- All buyers and sellers must enjoy the freedom to enter or exit the market at will and without incurring additional costs,
- There must be no economies of scale. Economies of scale arise where the average cost of production falls as the volume of production increases,
- There must be no economies of scope. Economies of scope arise when different products have significant shared fixed costs, so that a single firm can produce them using a common facility,
- There must be no externalities. An externality is an unintended side effect (either beneficial or adverse) of an ordinary economic activity that arises outside the market or price system so that its impact is not reflected in market prices and costs,
- There must be no regulation of the market or franchise obligations, and
- There must be no restrictions on capital.
Effective competition occurs in economic markets when four major market conditions are present:
- Buyers have access to alternative sellers for the products they desire (or for reasonable substitutes) at prices they are willing to pay,
- Sellers have access to buyers for their products without undue hindrance or restraint from other firms, interest groups, government agencies, or existing laws or regulations,
- The market price of a product is determined by the interaction of consumers and firms. No single consumer or firm (or group of consumers or firms) can determine, or unduly influence, the level of the price, and
- Differences in prices charged by different firms (and paid by different consumers) reflect only differences in cost or product quality/attributes.
In effectively competitive markets, consumers are protected to some degree from exploitative prices that firms, acting unilaterally or as a collusive bloc, could charge. Likewise, firms are protected from manipulation by large individual consumers (or groups of consumers) and from disruption or interference from other firms.
Competition occurs on the basis of both price and the quality or features of the product. Products are often differentiated, that is they are not identical across firms. One form of a product is usually a reasonable substitute for another form of that product. This is often referred to as “functional equivalence”. Sellers may also offer product combinations or bundles that appeal to specific consumers or consumer segments.
Effective competition can occur even in markets with relatively few firms that differ substantially in size, market share, and tenure. However, for such markets to be competitive, it is important that there are no barriers to entry and exit.
The CRTC adopted the approach that it should forbear from regulating when a market is “workably competitive”. In determining whether a market meets this test, the CRTC considers:
- The market share held by the largest firm,
- The sensitivity of customer demand to changes in prices, and
- The contestability of the market.
Clearly, effective or workable competitive markets cannot exist where any firm is dominant or, equivalently, has significant market power.
High firm concentrations in a given market may not lead to high market power. Even in markets where only one or a few firms can efficiently operate (for example due to economies of scale), it is possible for competition to work.
A market is said to be contestable when barriers to entry and exit are so low that the threat of potential entry prevents the incumbent from exercising market power.
In perfectly contestable markets there are no barriers to entry or exit. With free entry into and exit from the market, the threat of potential entry will constrain the behaviour of incumbent firms. Should an incumbent firm increase prices above the normal level of profits, then new firms will enter the market and force prices down again.
Contestability requires that there are no sunk costs for market entry. That is, should an entrant fail, it can recover its fixed costs (for example by selling assets or reusing them elsewhere).