Election Economic Misconceptions (6) Competition

Modern political parties seem to have an obsession with “competition” as a solution to economic problems. They are all announcing policies that they claim will increase “competition” in different sectors of the economy, as if that would solve the cost of living problem. However, they give no evidence that these policies would be effective.

University lecturers who teach Economics like “perfect competition” because it can be demonstrated that this produces economic efficiency. Unfortunately, their proofs only work under particularly restrictive assumptions about the structure of the economy. The problem is that these assumptions are usually missing in the real world. There are almost no markets that experience perfect competition.

When the restrictive assumptions required for perfect “competition” are removed, the models become unstable, and the outcomes produced are uncertain.

The reality is that “more competition” is rarely a solution to rising prices or high prices.

Businesses are not stupid. They realise that getting into a “price war” with their competitors is a lose-lose option. If one business cuts its price to increase market share, its competitors will have to match the lower price. But if that happens, the business that initiated the price-cutting will lose any benefit it gained, and every business will lose some of its margin. They are all worse off, and their market shares will remain the same.

Most businesses will assume that serious price competition would make them worse off, so they refuse to take the risk. They tend to watch the prices of their competitors, and they change their prices to match them. This is the safe option. Very few businesses will rock the boat by getting into serious price-cutting.

Businesses find it more productive to compete on issues other than price. There are numerous ways to increase sales that are less risky than a price war.

• Provide better quality products
• Provide a better range of products
• Provide better support services.
• Operate from a more convenient site.
• Adopt better advertising techniques.
• Offer short-term sales and price specials.
• Operate loyalty schemes
• Target specific customer segments.

All these are common and effective ways for businesses to compete with each other.

If competition does push prices down, it tends to be a one-off effect. Once the competition is in place and market shares have stabilised, future increases in price will need to be passed on by all competitors. The business with the lowest price might try to minimise the size of the increase, but the difference will be marginal.

Various examples show that competition does not lead to a significant reduction in prices. The best example is the banking sector. (I will explain in my next post.)