The simplest meaning of the term is rivalry between alternative buyers and sellers, each seeking to pursue their own ends. It is central to economics because it provides the mechanism through which the actions of agents can be co-ordinated. It is the basis for Adam Smith’s claim that every individual ‘is led by an invisible hand to promote an end which was no part of his intention’ (Smith 1979 [1776]: 456). It requires both a plurality of potential buyers and sellers and a competitive attitude. Thus its opposite may be either monopoly (the usage in most modern economics) or custom and co-operation (as was the case for J.S. Mill).
When Adam Smith and the classical economists used the term competition, they referred to the process whereby prices were forced down to costs of production, and wages and profits to their ‘ordinary’ levels. The requirement for this was what Smith termed ‘perfect liberty’ in which there are no barriers to mobility and ‘every man, as long as he does not violate the laws of justice, is left perfectly free to pursue his own interests in his own way, and to bring both his industry and his capital into competition with those of any other man’ (Smith 1979 [1776]:687). This is what has since been termed the long period aspect of competition, the process whereby capital and labour are moved from one activity to another taking considerable time. In contrast, the short period aspect of competition concerns the way markets operate. For the classical economists, the short period aspect of competition was summarized by the law of one price: the proposition that there cannot be two prices in the same market. It embodies a static notion of competition, for the process whereby price differences are eliminated is ignored.
Between the 1870s and the 1930s a number of economists (notably W.S.Jevons, L.Walras, F.Y. Edgeworth, V.Pareto, A.Marshall and K.Wicksell, J.Robinson and E.H.Chamberlin) developed the concept of perfect competition. Like the law of one price, and in contrast to what the classical economists understood by competition, perfect competition is a static concept. It is not a process but a type of market in which each agent is so small as to be unable to influence the price at which goods are bought and sold. Agents are price-takers. It is contrasted with imperfect competition, a state in which individual agents are sufficiently large to be able to have some control over the price of what they are buying or selling. Imperfect competition covers a variety of market structures ranging from monopoly (one seller) and monopsony (one buyer) to oligopoly (a small number of sellers) and bilateral monopoly (one buyer and one seller).
Perfect competition is a situation where most of the phenomena commonly associated with competition (brands and product differentiation, advertising, price wars—phenomena that were extensively discussed in the late nineteenth-century US literature) are absent, yet it has provided the dominant theory of competition in economic theory since the 1940s. Economists have explored, with great rigour, the conditions under which perfect competition will occur. Perfect competition has been shown to be efficient in the sense that in a perfectly competitive equilibrium it is impossible to make any individual better off without simultaneously making someone else worse off (Pareto efficiency). Perfect competition was, at least until the 1980s, the almost universally used assumption about market structure in diverse areas of economics such as international trade, inflation and unemployment.
The main reason why economists rely so heavily on models of perfect competition is that imperfect competition, in particular oligopoly, is much more difficult to analyse, one of the main problems being that in order to work out what is the best action to take, agents (usually firms) have to take into account how their competitors are likely to respond. Nowadays the most widely accepted solution to this problem is to use game theory. Using game theory economists have managed to construct theoretical models of aspects of competition such as entry deterrence, strategic investment, product variety and R&D expenditure.
While the focus of most economic theory has been on perfect competition, dynamic aspects of competition such as concerned Smith and the classical economists have not been neglected. The Austrian School, based on the work of C.Menger, sees competition as a dynamic process of discovery, dominated by the figure of the entrepreneur. It is entrepreneurs who see the possibilities for making profits by producing new goods, or by producing existing goods in new ways. The competitive process involves the continual creation and subsequent elimination of opportunities for profit. The contrast between orthodox and Austrian conceptions of competition is shown by the debate, in the 1920s and 1930s, over whether rational (i.e. efficient) economic calculation was possible under socialism. Market socialists such as O.Lange focused on the static concept of perfect competition, arguing that it was possible to design a set of rules for a socialist economy (in which there was no private ownership of capital) that would produce the same allocation of resources as would occur in a competitive, capitalist economy. Against them, Austrians such as L.von Mises and F.A.von Hayek argued that competition in the sense of rivalry was necessary if new products and new technologies were to be discovered: that those aspects of competition that K.Marx saw as wasteful (e.g. the building of two factories, one of which was subsequently eliminated by competition) were a vital feature of capitalism that could not be emulated under socialism.
Perhaps the best-known economist working in the Austrian tradition was J.A.Schumpeter. His vision was of competition as a process of ‘creative destruction’. Entrepreneurs discover new technologies, earning large profits as a result. Over time their discoveries are imitated by others, with the result that competition forces profits down. This theory fits into a longer tradition of evolutionary theories of competition, whose history goes back to the social Darwinism of the late nineteenth century in which competition was seen as eliminating the unfit. Among the most prominent modern exponents of evolutionary theories of competition are R.R.Nelson and S.G.Winter, who combined the Austrian idea that entrepreneurs explore alternative ways of responding to novel situations with the Darwinian idea that those who make good choices survive, with competition eliminating those who make bad ones.
The Austrian emphasis on innovation also results in a different attitude towards the role of numbers in competition. The standard view is that the smaller the number of firms, the less is the degree of competition. Attempts have therefore been made to measure competition by measuring variables such as concentration ratios—the share of output produced by, say, the largest five firms. Austrians, however, emphasize potential competition, which may be unrelated to the number of firms in the industry. A similar line has been pursued by W.J.Baumol who has developed the notion of a ‘contestable’ market. A perfectly contestable market is one in which entry and exit are absolutely costless, the result being that potential competition will keep prices low even if there are few firms in the industry.
Roger E.Backhouse
University of Birmingham
Reference
Smith, A. (1979 [1776]) An Inquiry into the Mature and Causes of the Wealth of Nations, ed. R.H.Campbell and A.S.Skinner, Oxford.
Further reading
Backhouse, R.E. (1990) ‘Competition’, in J.Greedy (ed.) Foundations of Economic Thought, Oxford.
Lavoie, D. (1985) Rivalry and Central Planning: The Socialist Calculation Debate Reconsidered, Cambridge, UK.
McNulty, P.J. (1987) ‘Competition: Austrian conceptions’, in J.Eatwell, M.Milgate and P.Newman (eds) The New Palgrave Dictionary of Economics, London.
Morgan, M. (1993) ‘Competing notions of “competition” in late-nineteenth-century American economies’, History of Political Economy 25(4).
Schumpeter, J.A. (1976) Capitalism, Socialism and Democracy, 5th edn, London.
Stigler, G.J. (1957) ‘Perfect competition, historically contemplated’, Journal of Political Economy 65(1). Reprinted in G.J. Stigler (1965) Essays on the History of Economics, Chicago.
—(1987) ‘Competition’, in J.Eatwell, M.Milgate and
P.Newman (eds) The New Palgrave Dictionary of Economics, London.
