A2 Micro: Competition and Efficiency

Are highly competitive markets most likely to lead to outcomes that achieve economic efficiency? The common characteristics of markets that are considered to be “competitive” are:

• Lower prices because of many competing firms. The cross-price elasticity of demand for one product will be high suggesting that consumers are prepared to switch their demand to the most competitively priced products in the marketplace.
• Low barriers to entry – the entry of new firms provides competition and ensures prices are kept low in the long run.
• Lower total profits and profit margins than in markets which dominated by a few firms.
• Greater entrepreneurial activity – the Austrian school of economics argues that competition is a process. For competition to be improved and sustained there needs to be a genuine desire on behalf of entrepreneurs to innovate and to invent to drive markets forward and create what Joseph
Schumpeter called the “gales of creative destruction”.
• Economic efficiency – competition will ensure that firms move towards productive efficiency. The threat of competition should lead to a faster rate of technological diffusion, as firms have to be responsive to the changing needs of consumers. This is known as dynamic efficiency.

The importance of non-price competition

In competitive markets, non-price competition can be crucial in winning sales and protecting or enhancing market share.

Perfect competition and efficiency

Perfect competition can be used as a yardstick to compare with other market structures because it displays high levels of economic efficiency.

1. Allocative efficiency: In both the short and long run we find that price is equal to marginal cost (P=MC) and thus allocative efficiency is achieved. At the ruling price, consumer and producer surplus are maximised. No one can be made better off without making some other agent at least as worse off – i.e. we achieve a Pareto optimum allocation of resources.

2. Productive efficiency: Productive efficiency occurs when the equilibrium output is supplied at minimum average cost. This is attained in the long run for a competitive market. Firms with high unit costs may not be able to justify remaining in the industry as the market price is driven down by the forces of competition.

3. Dynamic efficiency: We assume that a perfectly competitive market produces homogeneous products – in other words, there is little scope for innovation designed purely to make products differentiated from each other and allow a supplier to develop and then exploit a competitive advantage in the market to establish some monopoly power.

Some economists claim that perfect competition is not a good market structure for high levels of research and development spending and the resulting product and process innovations. Indeed it may be the case that monopolistic or oligopolistic markets are more effective long term in creating the environment for research and innovation to flourish. A cost-reducing innovation from one producer will, under the assumption of perfect information, be immediately and without cost transferred to all of the other suppliers.

That said a contestable market provides the discipline on firms to keep their costs under control, to seek to minimise wastage of scarce resources and to refrain from exploiting the consumer by setting high prices and enjoying high profit margins. In this sense, competition can stimulate improvements in both static and dynamic efficiency over time.

The long run of perfect competition, therefore, exhibits optimal levels of economic efficiency. But for this to be achieved all of the conditions of perfect competition must hold – including in related markets. When the assumptions are dropped, we move into a world of imperfect competition with all of the potential that exists for various forms of market failure.