Competition is the set of deliberate actions that sellers take against each other as they each try to increase their own profits. In actual competition sellers alter the prices and quality of their products as they try to win larger shares of a market from each other. In contrast to this, cooperation between sellers is the set of deliberate actions that sellers take together as they seek greater overall profits. Sellers sometimes conspire against buyers to set prices above competitive levels, but at other times cooperate in the development of new products and technologies.

Our understanding of competition has changed over time. Most early economists agreed that competition was a rivalrous and open- ended process. Modern economists disagree over the exact nature of competition.

Adam Smith argued that competition in free markets causes self-interested individuals to promote the welfare of others. The reason for this is that individuals who wish to gain something for themselves by trading with others can only do so by agreeing to terms that also benefit their trading partners. Smith saw competition among buyers and sellers as a means of reconciling the interests between buyers and sellers. Smith also recognized a potential for sellers to conspire together with the government to raise prices above competitive levels.

In the 19^th century, Antoine Cournot argued that sellers could divide market share between each other and then act collectively to increase prices above competitive levels. Joseph Bertrand argued that since sellers could dramatically increase market share by cheating on Cournot type agreements, efforts between sellers to cooperate in setting prices above competitive levels always end in failure. This argument is consistent with Smith’s view that monopolies were nothing more than government granted privileges.

During the early 20^th century, economists developed the concept of perfect competition. Perfect competition exists under the following conditions. First, there are a large number of buyers and sellers trading a uniform product. Second, there is free entry and exit to this market. Third, all market participants are fully informed regarding all opportunities for trade. Fourth, bargaining and price changes cost nothing. Fifth, enforcing the terms of a transaction is costless. Under these conditions, individuals will engage in trades that bring about perfection in the allocation of existing resources. This is a static view of competition that treats it as an end- state or goal rather than as an ongoing process.

Some economists used the theoretical results of perfect competition as a standard in judging the performance of real world markets and found the market system lacking. In this view, private businesses wield "market power" to set prices above perfectly competitive levels. These economists argued that governments could improve upon actual competition with policies that bring about perfectly competitive results.

Harold Demsetz counters these conclusions by arguing that perfect competition is too high a standard for either real-world markets or the government to meet. The reason why this is true is because there is a positive cost to operating any economic system. Since both competitive market systems and planned economies cost something to operate, neither will allocate resources perfectly. These operating costs create imperfections in both private markets and the public sector. Demsetz argues that economists who condemn the free market on these grounds fail to account for the possibility that government intervention aimed towards correcting market imperfections is itself imperfect. Thus, when the government intervenes to correct the market, it might make matters worse. Demsetz also demonstrated that abnormally high profit rates tend to disappear over time.

In addition to this, Friedrich Hayek argued that the concept of perfect competition misconstrues the true nature of competition. According to Hayek, perfect competition actually represents a situation where actual competition has ended. To Hayek, competition is a procedure in which competitors search for opportunities for profit. Competitors begin this procedure with relatively little knowledge of the situations that they face in the markets in which they sell. Competition between sellers then amounts to a discovery procedure as sellers learn how to increase their profits, and buyers discover new opportunities for consumption. This directly contradicts the assumption of perfect information in the theory of perfect competition. Hayek stressed that competition is important precisely because it drives individuals to improve upon the limited knowledge that they posses. Consequently, attempts to condemn the market system because sellers lack perfect information make no sense.

Since competition involves the discovery of new opportunities for trade the assumption of perfect information means that "perfect competition" is a situation where all competition is over. Israel Kirzner extended these arguments of Hayek’s by emphasizing the importance of alertness on the part of entrepreneurs in discovering new opportunities for profit.

Hayek and Kirzner emphasized that competition is an open- ended process because they doubted the realism of perfectly competitive models. Under perfect competition, competition is an end state where all individuals know who their best potential trading partners are. By focusing on continuous discovery, Hayek and Kirzner demonstrated the importance of competition as a means of collecting the information that the perfect competition concept takes for granted.

George Stigler and Lester Telser emphasized the importance of advertising to competition as a means of reducing the costs of gathering information. To Stigler and Telser, advertising fosters competition by informing individuals about the opportunities that await them in markets.

Some economists stress that in some markets natural barriers to entry and exit limit competition and may even result in the formation of private monopolies. While this is a legitimate concern there are two important points to keep in mind. First, economist William Baumol argues that potential competition can work just as well as actual competition. In some cases, monopolies may form even though it is possible for other sellers to enter the market. In such instances, monopolists will price their products as if they had actual competitors. In other words, monopolists that fear potential competition will charge low prices in order to prevent entry by competitors. Since the primary complaint about monopolies is that they charge prices above competitive levels, it makes little sense for anyone to worry about monopolies that use low prices as a barrier to entry.

Second, even if a monopolist secures another type of barrier to entry and sets prices above competitive levels this does not imply that there is no competition. Instead, these situations generally imply that competition has moved to a different level. Barriers to market entry are seldom free and generally require maintenance. Demsetz points out that if some companies have higher profits than others do it may be because they have some un-capitalized asset, such as trademark or goodwill. Some entrepreneurs create a barrier to entry through innovation. If an entrepreneur creates a new product or develops new technology that reduces costs then that entrepreneur could charge prices above competitive levels. Patent laws facilitate this process by enabling entrepreneurs to earn extra profits by patenting new products and technologies. While it is true that these entrepreneurs can charge monopolistic prices, it is also true that they also invest money in research and development. The money that entrepreneurs invest in R+D represents the cost of gaining monopoly status and the extra profits that they earn represent a return on the money that they invested in creating their monopoly. Since patents run out, these monopolists must re-invest in research and development in order to maintain their monopoly status over time. This results in long term technological progress and product innovation that Joseph Schumpeter described as "creative destruction".

Edwin Chadwick distinguished between competition within a field and competition for a field. Chadwick’s drew a clear line between competition between sellers for customers, and competition between sellers for the means to exclude each other. Gordon Tullock revived this issue by arguing that entrepreneurs lobby governments to construct artificial barriers to entry as a means of gaining monopoly control over prices. Labor unions and professional associations like the AMA are examples of resource market monopolies that derive from artificial governmental barriers. These monopolists pay for their privileges, though in this case the resources that the monopolist invests in constructing and maintaining their barriers do nothing to enhance long-term progress and prosperity.

In competitive markets, entrepreneurs compete with each other for customers. In monopolistic markets, entrepreneurs compete with each other to either win or maintain monopoly status. In the absence of government granted privileges, competition enables individuals to benefit from gains from trade and innovation. However, competition does become onerous when individuals compete for special privileges from the government that enable them charge monopolistic prices without improving the quality of their products or services.

Doug MacKenzie

Kean University

Sources on Competition

Baumol, William "Contestable Markets, an Uprising in Economic Theory" The American Economic Review (1981)

Bertrand, Joseph "Theorie Mathematique de la Richesse Sociale"

Chadwick, Edwin "Results of Different Principles of Legislation and Administration in Europe; of Competition within the Field of Service" Royal Statistics Society Journal, (1859)

Cournot, Atoine "Recherches sur les principles mathematiques de la theorie des Richess" (1838)

Dilorenzo, Thomas, and High, Jack "Antitrust and Competition, Historically Considered" Economic Inquiry (1998)

Demsetz, Harold "Information and Efficiency, another Viewpoint" The Journal of Law and Economics (1969)

_____________ "Two systems of Belief About Monopoly" In "Industrial Concentration, The New Learning" (1974).

_____________ "Barriers to Entry" American Economic Review (1982)

Ekelund, Robert jr., and Hebert R.F. "Uncertainty, Contract Costs, and Franchise Bidding" Southern Journal of Economics (1980)

Hayek, Friedrich "The Use of Knowledge in Society" The American Economic Review (1945).

_____________ "Competition as a Discovery Procedure" in "New Studies in Philosophy, Politics, Economics, and the History of Ideas" (1978)

Kirzner, Israel "Competition and Entrepreneurship" U. Chicago Press (1973)

Smith, Adam "The Wealth of Nations" Liberty Press (1976 (1776))

Stigler, George "The Economics of Information" The Journal of Political Economy (1960)

Telser, Lester "The Economics of Advertising" The Journal of Political Economy (1969)