The Strange World Of Perfect Competition

Economists have a concept called perfect competition but as a business owner it won’t sound very perfect to you.

Perfect competition is a world where there is an equilibrium and all the firms operating in the market produce profits which exactly match their cost of capital.

Remember in Pillar 1 What Is Profit I introduced the idea of super-profit, the return you get over and above your opportunity costs.

Perfect competition is a world where there are many competitors who are free to move into the industry if companies start to make more than the cost of capital and to move out of if returns fall below the cost of capital.

Perfect competition is a world where there is no product differentiation. Everyone knows how to make the product or service to the same standard and in the same time periods.

In perfect competition there are many buyers and they are all of similar sizes and they all have perfect information of their buying options. Information is free and there aren’t any transactions costs which make it easier or cheaper to deal with one supplier than another.

But this is the important point – it is when these assumptions are broken that create the opportunity for sustained profit or loss within an industry:

  • When there are few buyers
  • When there are few suppliers
  • When products and services are different
  • When new competitors find it difficult to enter an industry
  • When existing competitors find it difficult to leave
  • When information isn’t freely available to customers about the best prices and deals
  • When information isn’t available to competitors about the best methods to market, sell and supply their products
  • When there are transactions costs which create a connection between particular buyers and sellers and a disincentive to trade with others.

If there are few buyers, then they acquire massive power to negotiate better deals and lower prices. Food manufacturers often have this problem with supermarkets. In The UK, the big 4 РTesco, Asda, Sainsbury and Morrison Рdominate with over 75% of the grocer trade in 2009 and the next tier down РCo-op /Somerfield,  Waitrose, Marks & Spencer Рare also strong negotiators.

Where there are few suppliers – and I’ve seen this in the steel industry when demand picks up after a recession – you are forced to accept terms and prices laid down with the take it or leave it approach.

If products and services are different, then price differences can exist since it is difficult to compare one similar product with another. While there is some competition, good marketing and customer service can build a strong brand preference which justifies a price premium.

Some industries are much more difficult to enter than others and when this happens, the businesses are protected until an innovator finds a way around the barrier. Sometimes even more serious is when there are barriers to stop a struggling firm getting out of the business. This creates at least one firm who is desperate to do whatever it can to stay in business and can destabilise everyone else through silly promotions.

Information also plays a big part since perfect competition assumes that all customers know and can make realistic assessments of the value for money of all the competing products. This forces down prices and the pressure can be seen as certain apps get popular on smart phones to show you the “best price in the city”. It’s then up to you whether you want the bargain or you value convenience.

Information doesn’t just affect customers. Suppliers have access to all the best practice information they need to create an efficient¬† and effective business while at the same time able to make the best purchasing decisions.

The final thing that creates perfect competition is zero transactions costs – in money, time, convenience or relationships – so the buyer doesn’t mind which supplier he buys from.

You’ll see how many of these factors are used to determine the opportunity for profits in one of the most famous business stratgy models – Michael Porter’s Five Forces.

Return to P3M3 Industry Attractiveness

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