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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