Download Revision Guide Chapter 10

Chapter 10: The Competition Environment
Key Revision Points
Introduction to the competitive environment
Economists define markets in terms of the interaction between two groups:
 Those seeking to buy products
 Those seeking to sell them
Economists distinguish between those economic influences that operate at the level of
the individual firm and those that relate to the economy as a whole. The study of an
organisation and its customers/ suppliers in isolation from the rest of the economy is
generally referred to as microeconomic analysis. In this type of analysis, the national
economy is assumed to be stable.
Market structure
The term market structure is used to describe:
 The number of buyers and sellers operating in a market
 The extent to which the market is concentrated in the hands of a small number of
buyers and/or sellers
 The degree of collusion or competition between buyers and/or sellers
Market structures range from the theoretical extremes of perfect competition and pure
monopoly. In practice, examples of the extremes are rare.
Perfect Competition
This is the simplest type of market structure to understand. Although rarely found in
practice, a sound understanding of the way they work is essential for understanding
competitive market pressures in general.
Perfectly competitive markets are attributed with the following principal characteristics:
 There are a large number of producers.
 There are also a large number of buyers.
 Buyers and sellers are free to enter or leave the market.
 There is a ready supply of information.
Perfect competition implies that firms are price takers in that competitive market forces
alone determine the price at which they can sell their products.
The most important reason for studying perfect competition is that it focuses attention
on the basic building blocks of competition: demand, supply and price determination.
Demand
Demand is measured in terms of how many people are actually able and willing to buy a
product at a given price and given a set of assumptions about the product and the
environment in which it is being offered. Demand is also expressed in terms of a
specified time period, for example so many units per day.
A demand curve is based on a number of assumptions. For example, that the price
of substitutes for cheese will not change or that consumers will not suddenly take a
dislike to cheddar cheese.
Actually collecting information with which to plot a demand curve poses theoretical and
practical problems. The main problem relates to the cross-sectional nature of a demand
curve. However, this kind of information can often only be built up by a longitudinal
study of the relationship between prices and volume over time.
Supply
Supply is defined as the amount of a product that producers are willing and able to
make available to the market at a given price over a particular period of time.
It is important to distinguish movements along a supply curve from shifts to a new
supply curve.
Price determination
It is possible to redraw the demand and supply lines on a single graph.
In perfectly competitive markets, the process of achieving equilibrium between supply
and demand happens automatically without any external regulatory intervention.
It is important to remember that in a perfectly competitive market, individual firms are
price takers. The market alone determines the "going rate" for their product. Changes in
the equilibrium market price come about for two principal reasons:
 Assumptions about suppliers' ability or willingness to supply change, resulting in a
shift to a new supply curve
 Assumptions about buyers' ability or willingness to buy change, resulting in a shift to
a new demand curve
New equilibrium prices and trade volumes can be found at the intersection of the supply
and demand curves. In practice, both the supply and demand curves may be changing
at the same time.
Elasticity of demand
Elasticity of demand refers to the extent to which demand changes in relation to a
change in price or some other variable such as income.
Price elasticity of demand refers to the ratio of the percentage change in demand to the
percentage change in price. Where demand is relatively unresponsive to price changes,
demand is said to be inelastic with respect to price.
A number of factors influence the price elasticity of demand for a particular product.
The most important is the available of substitutes. The absolute value of a product
and its importance to a buyer can also influence its elasticity.
For any measure of elasticity, it is important to consider the time period over which is
being measured. In general, products are much more inelastic to changes in price
over the short term.
Elasticity of supply
The concept of elasticity can also be applied to supply, so as to measure the
responsiveness of supply to changes in price.
If suppliers are relatively unresponsive to an increase in the price of a product, the
product is described as being inelastic with respect to price. If producers increase
production substantially as prices rise, the product is said to be elastic.
As with price elasticity of demand, time is crucial in determining the elasticity of supply.
Limitations of the theory of perfect competition
These are some of the more important reasons why perfect competition is rarely
achieved in practice:
 Perfect competition only applies where production techniques are simple and
opportunities for economies of scale are few.
 Markets are often dominated by large buyers who are able to exercise influence
over the market.
 It can be naïve to assume that high prices and profits in a sector will attract new
entrants, while losses will cause the least efficient to leave.
 A presumption of perfectly competitive markets is that buyers and sellers have
complete information about market conditions. In fact, this is often far from the
truth.
Monopolistic markets
In its purest extreme, monopoly in a market occurs where there is only one supplier to
the market, perhaps because of regulatory, technical or economic barriers to entry.
However, this rarely occurs in practice. Sometimes, monopoly control over supply
comes about through a group of suppliers acting in collusion together in a ‘cartel’.
Government definition of a monopoly is less rigorous than pure economic definitions. In
the United Kingdom, two types of monopoly can occur:
 A scale monopoly occurs where one firm controls 25 per cent of the value of a
market.
 A complex monopoly occurs where a number of firms in a market together account
for over 25 cent of the value of the market and their actions have the effect of
limiting competition.
Effects on prices and output of monopoly
A monopolist can determine the market price for its product and can be described as a
"price maker" rather than a "price taker".
In a pure monopoly market, consumers would face prices that are higher than would
have occurred in a perfectly competitive market.
Implications of monopoly power for a firm's marketing activities
In a pure monopoly, a firm's output decisions would be influenced by the elasticity of
demand for its products. So long as demand remained elastic, it could continue raising
prices and thereby its total revenue.
Organisations that think strategically will be reluctant to fully exploit their monopoly
power. By charging high prices in the short-term, a monopolist could give signals to
companies in related product fields to develop substitutes that would eventually provide
effective competition.
Imperfect competition
Most firms would like to be in the position of a monopolist and able to control the price
level and output of their market. This is an unrealistic aim for most firms, but, in practice,
firms can create imperfections in markets that give them limited monopoly power over
their customers.
An entrepreneur can seek to avoid head-on competition with its competitors by trying to
sell something that is just a little bit different compared to its competitors. If a trader has
successfully differentiated its product, it is no longer strictly a price taker from the
market.
The role of brands
The process of branding is at the heart of organisations' efforts to remove themselves
from fierce competition between generic products.
Branding simplifies the decision-making process by providing buyers with a sense of
security and consistency which distinguishes a brand from a generic commodity.
The traditional role of branding has been to differentiate products, but brands have been
increasingly applied to organisational images too.
Imperfect competition and elasticity of demand
Firms face a downward sloping demand curve for each of their products, indicating that,
as prices fall, demand increases and vice versa.
In the market for breakfast cereals, the demand curve for cereals in general may be
fairly inelastic, on the basis that people will always want to buy breakfast cereals of
some description. Demand for one particular type of cereal, such as corn flakes, will be
slightly more elastic as people may be attracted to corn flakes from other cereals such
as porridge oats on the basis of their relative price. Price becomes more elastic still
when a particular brand of cereals is considered.
Total revenue is a function of total sales multiplied by the selling price per unit.
Oligopoly
Oligopoly lies somewhere between imperfect competition and pure monopoly. An
oligopoly market is dominated by a small number of sellers who provide a large share of
the total market output. All suppliers in the market are interdependent. One company
cannot take price or output decisions without considering the specific possible
responses of other companies.
Oligopoly is a particularly important market structure in industries with economies of
scale.
Competition policy
The vision of competitive markets that bring maximum benefit to consumers is often not
achieved. The imperfections described above can be summarised as resulting from:
 The presence of large firms that are able to exert undue influence over participants
in a market.
 Collusion between sellers (and sometimes buyers)
 Barriers to market entry and restraints on trade
 Rigidity in resource input markets
Because of the presumed superiority of competitive markets, the law of most developed
countries has been used to try and remove market imperfections where these are
deemed to be against the public interest. A growing body of legislation based on
statute law is now available to governments and organizations seeking to curb anticompetitive practices.
Common law approaches to improving market competitiveness
There is case law that holds that agreements between parties that have the effect of
restraining free trade are unlawful.
The "public interest" is important in deciding whether a restrictive agreement is
reasonable.
A claim of restraint of trade can also be made against a company buying a business
that restricts the future business activity of the person from whom they have bought the
business.
If a clause in an agreement is deemed by a court to be unreasonable, it may remove it
from the contract. It can however, be difficult to know what a court will consider to be
"reasonable" in the circumstances of a particular case.
Statutory intervention to create competitive markets
Common law has been supplemented by statutory legislation, that is laws passed by
government as an act of policy. One outcome of statutory intervention has been the
creation of a regulatory infrastructure, which in the United Kingdom includes the Office
of Fair Trading, the Competition Commission and regulatory bodies to control specific
industries.
Articles 85 and 86 of the Treaty of Rome
Article 85 of the Treaty of Rome prohibits agreements between organisations and
arrangements between organisations that affect trade between member states of the
European Union and in general prohibits anti-competitive practices.
Article 86 prohibits the abuse of a dominant market position within the European
Community insofar as it may affect trade between member states.
The EU often has difficulty in reconciling the need for firms to operate globally at a
large scale, and the resultant domination of the EU market by that firm.
UK Competition legislation
In the UK, the 1998 Competition Act reformed and strengthened competition law by
prohibiting anti-competitive behaviour.
A number of agencies have responsibility for preserving the competitiveness of markets
in the UK, the most important being:
 The Director General for Fair Trading
 The Competition Commission
 Public utility regulators
Evaluating claims of anti-competitive practices
A fine balance often exists between the co-operation among firms which leads to
lower prices / better products for consumers, and co-operation which leads to
collusion and a reduction in consumers' choice. There is diversity in interpretation of
the notion of the "public interest", which may be explained partly by cultural/ political
factors, and developments in our understanding of the consequences of market
imperfection.
Regulatory bodies are increasingly recognising that co-operative relationships
between companies can become anti-competitive.
Control on price representations
One of the assumptions of a perfectly competitive market is that participants in it have
complete information about competing goods and services. In reality, buyers may find it
very difficult to judge between competing suppliers because prices are disclosed in a
deceptive or non-comparable manner. Legislation, such as the Consumer Protection
Act 1987, makes it illegal for a company to give misleading statements about the price
of goods or services.
Regulation of public utilities
To protect the users of these services from exploitation, the government response has
been twofold:
 Government has sought to increase competition, in the hope that the invisible forces
of competition will bring about lower prices and greater consumer choice.
 Where competition alone has not been sufficient to protect the consumers' interest,
government has created a series of regulatory bodies which can determine the level
and structure of charges made by these utilities.
In utility markets where competition is absent, regulators have to balance what is
desirable from the public's point of view with the companies' need to make profits, which
will in turn provide new capital for investment in improvements.
Control of government monopolies
There are still many services that cannot be sensibly privatised or deregulated.
Therefore, where it is impractical to privatise publicly provided services, government has
taken a number of measures to try and protect consumers from exploitation. These are
some of the methods that have been used:
 Arms length organisations
 Market testing
 Customers’ charters