Glossary · Economic ideas
Competition
Competition is the rivalry between sellers for the same buyers. It pushes prices down toward cost and pushes firms to make things better.
Also called: market competition, perfect competition, competitive market, price war
In plain words
One lemonade stand on a hot street can charge $3 a cup. When a second stand opens across the road at $2.50, the first has to match it or lose customers. A third stand opens, then a fourth. Soon lemonade costs only a little more than the lemons, sugar and cups. That race is competition.
Rivals compete not only on price but on quality, speed, service and new ideas. Every firm would rather have no rivals, but each one’s effort to win customers is what keeps prices low and products improving.
Economists describe a ladder from monopoly (one seller) through oligopoly (a few) to perfect competition: so many sellers that none of them can move the price, like wheat farmers.
Example
A lemonade price war
Each cup costs $1.25 to make. Here is what happens as rivals arrive.
- One stand: it charges $3.00 and keeps $1.75 a cup.
- Two stands: one cuts to $2.50 to win customers, and the other follows. Each keeps $1.25 a cup.
- Three stands: $2.00. Four stands: $1.60, leaving 35 cents a cup.
- A fifth stand would earn so little that nobody bothers. The price stops near cost plus a fair pay for the work.
Buyers save $1.40 a cup, and no law was needed: competition did it.
One level deeper
In a perfectly competitive market, many firms sell the same product, buyers know all the prices, and anyone can enter or leave. The price then falls to the cost of making one more unit, and profits beyond a normal return disappear. Real markets are never perfect, but the closer they get, the lower the prices.
Competition is how the invisible hand works: the threat of losing customers is what makes self-interest serve buyers. It also drives creative destruction, as new firms with better ideas replace old ones.
Firms try to escape it, with brands, patents, loyalty programs or by buying rivals. That is why most countries have competition (antitrust) authorities that review big mergers.
Why it matters
It is the main force that keeps prices close to costs.
It rewards firms that make better or cheaper products, which over time lifts living standards.
When it weakens, prices tend to rise and quality to slip, so how much competition a market has is one of the first questions economists ask about it.
A common mistake
Myth: Competition is a race to the bottom: worse products for less money.
In fact: Rivals compete on quality as much as on price: phones, cars and TVs have become both better and cheaper in markets with many competitors. Where products did get worse, it is usually because buyers couldn’t tell the difference, not because of competition itself.
Questions people ask
What is perfect competition?
A textbook market with many small sellers of an identical product, full information and free entry. No one can set the price, and profits beyond a normal return vanish. Farm products come closest.
Why is competition good for consumers?
Because each seller has to offer a better deal than its rivals or lose customers: lower prices, better quality, more choice.
What are the four types of market structure?
Perfect competition, monopolistic competition (many sellers of slightly different products, like restaurants), oligopoly (a few big sellers) and monopoly (one seller).
Read more on BigCapital
About the numbers
- This page explains a term. It is not investment advice.