Competition is a means by which limited resources can be allocated among rival bidders. The degree to which it is present in a market has a strong influence upon pricing in that market. Unrestricted or perfect competition is a hypothetical condition in which no-one is able to influence the market price of a product. At the other extreme, absolute monopoly, or the total absence of competition in the supply of a product, would give its holder the sole ability to influence the market price of that product. Perfect competition and total monopoly are conditions which can readily be analysed to give definite and straightforward answers, and for that reason they provide a valuable starting-point to the study of the microeconomics of market behaviour. Competition theory, is concerned with economic behaviour in markets whose characteristics lie between those hypothetical extremes. Its practical importance lies in the fact that competition or its absence can have a major influence upon the welfare of a community.
The hypothetical world with which the concept of perfect competition is concerned is one in which markets have the following characteristics:
- (a) All market shares are small. No supplier enjoys a share of the market which is large enough to enable him to influence the price of that category of product.
- (b) No collusion. Each supplier acts independently.
- (c) No barriers to entry. There is nothing to prevent any new supplier from entering the market for any category of product.
- (d) Homogeneity of product. All suppliers of each category of product are known to all buyers to supply identical products.
Suppliers are assumed to maximise their products and buyers are assumed to seek value for money. After a settling-down period, a market price emerges for each category of product. A supplier who attempts to sell a product above that price will find no buyers and a buyer who attempts to buy a product at below that price will find no sellers.
Those characteristics define the conditions for perfect competition among suppliers of products. They may similarly be defined in relation to suppliers of labour. And for pure competition to apply to the market as a whole, conditions analogous to (a) and (b) must also be satisfied by buyers: there must be no dominant buyers, and buyers must not collude.
According to the theorems of welfare economics a market which is in equilibrium in a state of perfect competition is "Pareto-efficient" , which is a condition from which no change could make anyone feel better-off without making someone else feel worse-off. The term optimal resource allocation is used to describe the theoretical outcome for the community as a whole. In non-technical language, this can be taken to mean the efficient allocation of resources as between different categories of product. Perfect competition ensures that the community's resources are used efficiently in the sense of making people feel well-off. If resources are allocated optimally, then people would not, for example, feel better off if they were able to afford more meat and less fish, nor vice versa. It cannot, however, be concluded that perfect competition maximises total economic efficiency. Competition theory,as outlined above, says nothing about productive efficiency, which is a component of economic efficiency. Nor is it strictly correct to say that perfect competition maximises economic welfare . That concept encompasses the way in which wealth is distributed as between different members of the community, and it cannot be claimed that perfect competition necessarily leads to an ideal distribution of wealth. The propositions which emerge from the concept of perfect competition are to do with the way in which resources are allocated between products, and not with how the product is manufactured, or to whom it is distributed.
The outcome will not necessarily be efficient if any supplier can impose costs on others. In economics terminology these are termed externalities. The conventional example is a supplier who pollutes the environment. The allocation of resources need not then be efficient because of the possibility that some people would feel better off with fewer goods in exchange for a cleaner atmosphere. Other examples include traffic congestion and mining subsidence. The theoretically ideal solution is for the polluter to compensate those affected.
If universal perfect competition were taken as the starting-point, there would be strong presumption that any departure from it will lead to a loss of economic efficiency. But, if the starting-point were one in which some markets are not perfectly competitive, it cannot be concluded that efficiency would be increased by restoring any one of them to perfect competition. This is a matter of some practical importance. For example it might be better from the consumer's standpoint to deal with a monopoly supplier of gas that is faced with a monopoly supplier of electricity, rather than an alternative in which the gas supplier would be free to exploit his monopoly power in face of a fragmented electricity supply industry. The theory of the second-best, as this is called, may seem seriously to undermine the application of competition theory, but in practice its implications are often less formidable. There is a clear need to take account of linkages between markets such as exist between the markets for gas and electricity. and there are many instances in which such linkages are so weak that the direct benefits of an increase in competition would clearly outweigh any adverse secondary effect. Cases are bound to arise, nonetheless, in which there is no analytical solution to the problem of the second-best.
Competition theory was augmented in the 1970s by analytical developments  in which the concept of perfect competition was replaced as a benchmark by the concept of perfect contestability. This has provided a new way of looking at competition. A perfectly contestable market was defined as one into which entry is absolutely free and exit is absolutely costless. If the initial outlays required for entry to a market were recoverable without loss, then any risk which might otherwise attach to entry could be eliminated. A new supplier who could see a profitable opportunity of entering a market in which prices had previously been raised by the exercise of market power would be aware that those prices would be likely to fall again as a result of his entry. But, given the opportunity of costless exit, that would not deter him from entering. There would be nothing to lose, provided that he remained in the market for only so long as it continued to be profitable to do so. Faced by such a threat, a monopoly supplier in a perfectly contestable market would thus be deterred from setting his prices at above the level which would rule under perfect competition by the knowledge that to do so would be to encourage entry. If successful entry actually occurred, he would eventually be forced to reduce his prices to the level which would rule under perfect competition in order to survive
Monopoly and oligopoly
The importance of the concept of perfect competition to the philosophy of competition policy is that it serves as a datum, or baseline, from which the departures which occur in the real world can be measured. It defines one of the polar extremes of possible real-world situations. The other polar extreme is perfect monopoly — that is to say, a product market in which the product has only one supplier and into which no other supplier can enter. Like perfect competition, this is a situation which can readily be analysed to produce unequivocal results. The diagrammatic analysis which appears in the standard economic textbooks demonstrates that under these circumstances the profit-maximising supplier would provide smaller quantities of the product, and at a higher price, than would be the case under perfect competition. The mechanism which leads to that unsurprising conclusion is of more interest than the conclusion itself. It rests on the fact that the monopolist always has the freedom to choose between supplying a greater quantity at a lower price and supplying a smaller quantity at a higher price.
The existence of such choices is said to confer market power upon the supplier in question. The possession of market power in that sense is not, however, confined to perfect monopolies. There are many markets in the real world in which there are several suppliers, each of which is large enough to enjoy a degree of market power in the sense of having some degree of choice concerning pricing policy. A great deal of theoretical work has been done on the subject but straightforward answers concerning the behaviour of a profit-maximising supplier in such an oligopolistic market are hard to find. The reason is that analysis of such markets is complicated by the need to postulate how each supplier reacts to the likely behaviour of his competitors, and by the need for a precise understanding of each supplier's cost structure.
Competition policy implications
Competition theory provides the intellectual foundation for antitrust and competition policy but it does not provide all that is needed to build a serviceable structure upon that foundation. It does not lead to unequivocal prescriptions except where competition is the only question at issue - and even then the questions of externalities and of ‘the second-best’ may introduce qualifications. Where the issue of gains in productive efficiency also arises, other branches of economic theory must be called in aid. The difficulties which then arise stem not so much from the limitations of the available theory, as from the fact that quantification is then needed in order to draw up a balance between losses of allocative efficiency and gains of productive efficiency. The information requirements for that purpose tend to be demanding, and commercial accounting systems are seldom capable of providing the necessary inputs. In practical terms, therefore, the economic rationale for competition policy is incomplete and, at best, its implementation depends partly upon judgement rather than entirely upon analysis.
Critics have argued that the entire rationale of mainstream competition theory is flawed by virtue of its methodology. That methodology, which is termed comparative statics, envisages a system which settles down to a stable equilibrium. The properties of that equilibrium are then analysed as though it were a static situation. In reality, of course, the postulated settling-down process may never end. New techniques and new products may emerge in a continuing stream; new firms may come into existence to turn the resulting opportunities into reality, and other firms may fail. Above all, there are uncertainties; and entrepreneurs are rewarded — if successful — for taking risks. None of those vital characteristics of the competitive process can be embodied in a comparative statics analysis. Consequently, it is argued, that form of analysis is inappropriate to the problem. The principal proponents of that line of argument are the Austrian School of economists, and their case is more extensively summarised in Littlechild (1986) and Reekie (1979)
- The term "Pareto-efficient" is defined in the articles on economic efficiency and welfare economics
- The concept of economic welfare is explained in the article on welfare economics
- Baumol Contestable Markets, in The American Economic Review, Vol. 72, No. 1, March 1982
- Littlechild The Fallacy of the Mixed Economy, Hobart Paper No. 80, Institute of Economic Affairs 1986
- Reekie Industry, Prices and Markets, Phillip Alan 1979.