Competitive Markets
and Efficiency
1
Firms in high competitive markets face a very nasty competitive environment.
As we will see, this competitive environment forces firms to act in ways that
benefit consumers in the short run by achieving productive efficiency. It is not
clear, however, that many firms in highly competitive markets are able to
achieve dynamic efficiency.
THE MARKUP IN HIGHLY COMPETITIVE INDUSTRIES
As discussed above, the markup is the amount of money a firm adds to the
average production cost in order to determine the goods price.
P
=
Markup + Average Cost.
If it costs $8 on average to produce a pair of sunglasses, and the sunglasses
producer wants to make $4 profit on average, then the price the producer will
set will be $8 plus a markup of $4, giving a price to consumers of $12 for a
pair of sunglasses.
Suppose that for all firms in the sunglasses industry, the average cost to
produce a pair of sunglasses is $8. Suppose, however, that some firms in the
industry want to earn a higher markup than the other firms in the industry. The
firms that want a $5 markup are identified as firms 1 to 20. The firms that are
satisfied with a $4 markup are identified as firms 21 to 200.
Table 1-1 shows the prices for the two groups of firms and an indication of
the average sales the typical firm makes in each of the two groups.
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Competitive Markets and Efficiency
Table 1-1
Firms 1 - 20
Firms 21 – 200
Average Cost to produce good
$8
$8
Markup
$5
$4
Price
$13
$12
Sales for each firm in group
300
700
Firms 1 to 20 have a higher markup and, so, have a higher price ($13 versus
$12 for other sunglasses). As a consequence, firms 1 to 20 have lower sales and
most consumers seek out sunglasses with a lower price then $13.
Eventually, the lower sales and lower profits of firms 1 to 20 will put them
at a competitive disadvantage. They will, therefore, be forced to lower the
markup they use if they want to stay in business.
In a highly competitive industry all firms find that competition puts
downward pressure on their markups.
Say, however, that someone outside the industry would be willing to make
sunglasses and earn a markup equal to only $3. Because this highly competitive
industry is easy to enter (and I’m assuming this new firm can also produce
sunglasses at an average cost of $8), this new firm will have a price of $11,
which would undercut the price charged by the other firms in the industry.
This new business firm will take away sales at the expense of other firms in
the industry with its $11 price for sunglasses. The other firms, if they want to
stay in business, will have to be satisfied will a $3 markup.
In highly competitive industries, entry is relatively easy and, so, markups
tend to be driven down to a level equal to that earned by the low markup firm
in the industry and, indeed, to the level anyone outside the industry might be
willing to accept.
Not surprisingly, the owner of firms in highly competitive constantly
complain about the low markups and low profit that they earn and the
constant struggle for survival.
PRODUCTION COSTS IN HIGHLY COMPETITIVE INDUSTRIES
I assumed above that all firms in this sunglasses industry just happened to have
the same average costs of production. But this is a pretty extreme assumption.
A more realistic assumption is that firms have different average costs of
production. Some firms might use different methods to produce their
sunglasses, some of which might be more expensive than the others.
Competitive Markets and Efficiency
229
Table 1-2 shows the production costs and markups for three firms within
the sunglasses industry. I assume that the markup for each firm is initially $4. I
will assume that firm 107 is the low cost producer in the industry.
Table 1-2
Firm 43
Firm 107
Firm 152
Average Cost to produce good
$8
$6
$10
Markup
$4
$4
$4
Price
$12
$10
$14
Sales for each firm in group
500
800
200
Firm 107 has the lowest average production cost of $6. Because all firms
initially have the same markup of $4, firm 107 also has the lowest price and,
so, the highest sales. Firm 152 is particularly disadvantaged: they have a
production cost of $10 and, so, a price that far exceeds that of firm 107. Not
surprisingly, firm 152 have low sales. Firm 43 is better off than firm 152, but
will its sales suffer in comparison with firm 107.
Firm 152 is making low profits because of its low sales. To improve matters,
or at least to improve sales, they must lower their price. If it matches the price
of firm 107 ($10) firm 152 will earn no markup – and, so no profit – at all! If
they instead have a price of $12 (equal to that of firm 43), firm 152 will have a
markup of $2. In this situation – earning lower profits than firm 43 and firm
107, firm 152 will likely continually lose competitive position and might go
bankrupt.
But a way out exists. Firm 152 can try to reduce their production costs to
the same low level as others in the industry. If they successfully lower their
production costs to $6 (the level of firm 107’s production cost), then firm 152
will be able to improve its position (and profits!) greatly.
Firm 43, if it wants to boost its profits and maintain its competitive
position, must also find a way to lower its production costs.
No guarantee exists that firms 43 and 152 will be able to successfully lower
their production costs to $6. If they fail to do so, they might be forced to exist
the industry.
But, even if firms 43 and 152 do successfully lower their production costs to
$6, they cannot necessarily rest easy. Firm 107, or perhaps yet another firm,
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Competitive Markets and Efficiency
might find a way to produce the good at a still lower cost, say $5. This will set
off a new round of firms seeking ways to lower their production costs.
In short, in highly competitive industries firms are forced to match the low
production costs of the low cost producer. Not all will be able to and they will
likely slowly fade away from the industry.
LOW PRICES
Competition in highly competitive industries forces firms to produce the good
at the lowest possible cost. Competition in highly competitive industries also
forces firms to accept the lowest markup acceptable to anyone inside (or
outside) the industry.
If the production cost is the lowest possible and if the markup is the lowest
any business would accept, then the price for this good or service will be the
lowest it could possibly be within a capitalist economy. In these periphery
industries,
P = Lowest Acceptable Markup + Lowest Average Cost .
Firms sell this good/service at the lowest possible price not because they like
low prices and not necessarily because they want to help consumers, but
because competition forces them to sell the good at this lowest possible price.
SUMMARY
Firms in highly competitive industries face relentless competition. The low
barriers to entry for industries filled with periphery industries or to market
segments filled with peripheral firms in industries dominated by giant firms
means that even after some competitors are forced to leave after they lose the
competitive battle, new firms will enter the competitive fray competition will
continue unchecked.
This competition drives down the prices offered by these firms. If the
competition face by these firms is extreme enough, the goods these firms
produced are made at the lowest cost possible and the markup is the lowest any
firm will accept.
Further, these firms generally have an incentive to find a way to further
lower their costs. If they success they might achieve a (temporary) competitive
advantage. But once other rivals match these low costs, consumers will the ones
that benefit.
Competitive Markets and Efficiency
231
A highly competitive industry is a very nasty environment for businesses.
Consumers, however, seemingly benefit greatly from this high competition.
Consumers are able to buy the good which is produced at the lowest unit
production cost and which has the lowest markup possible. And, consumers
benefit from firms attempts to find a lower cost method of production.
Yet, one qualification is necessary. Because firms in highly competitive
industries face such relentless competition few of them make any noteworthy
profit. As a result, most of these firms find it hard to finance the seeking out of
new ways to produce their good or the seeking out of improvements in the
good or service they sell. They are all just trying to survive.
As a result, it is possible that while peripheral firms produce the good using
the cheapest known way of producing the good, improvements in knowledge of
how to produce the good grows only slowly in such industries.
Firms in highly competitive industries, then, almost always achieve
production efficient. Yet few are able to achieve dynamic efficiency.
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Competitive Markets and Efficiency