What is Competition? – Econlib

Economists extol the importance of competition in markets for driving prices down and quality up. But what is “competition” and how does it actually work? 

To non-economists, the word conjures the idea of something like a sporting contest, where there can be one winner while everyone else loses. But this comparison fails on at least two dimensions.

First, for there to be a single “winner” in a market exchange would require there to be a single, identical good that each competitor is trying to provide, vying for scarce consumer dollars. This is a fine thought-experiment for the classroom, textbooks, and academic papers. But that is not how market exchanges really work, even for any particular good. While it is true that important lessons can be learned from these abstractions and thought experiments, go ahead and tell someone with discerning taste that Coke, Pepsi, and RC Cola are “basically the same” and let me know their reaction.

Second, a single winner, many losers scenario would also imply that if the number of competitors were increased, competition itself would increase. After all, winning a world title is far more impressive than winning “just” a national title. But that misses something about how competition works. In a small town with just two hardware stores, “competition” between those two stores can be much more fierce than in a larger city with twenty stores.

So what actually is competition, then?

Recently, my mom and her husband’s furnace went out while they were out of town. In Michigan. In the winter. Since they live just two miles down the road from me, I was the designated emergency contact. The next morning, a technician was on site, diagnosing the problem. (Being a firm believer in specialization, I have no idea what was wrong, only that some part needed replacing.)

Both of us knew that he had me stuck between a rock and a hard place. No other company in town could get this done faster and I wasn’t about to let my mom’s pipes freeze. Despite this, when the bill came, everything was normal. There was a standard fee for parts and labor that was perfectly reasonable and no trace of a markup for an “emergency service” or anything of the sort that, given the circumstances, I would have agreed to.

Why not?

This year marks the 250th anniversary of Adam Smith’s Wealth of Nations, and the furnace repair job illustrates what Smith understood about competition. It’s not about the textbook definition of identical firms producing identical products, battling over price until (economic) profit is driven to zero. Indeed, Smith wouldn’t have recognized this formal model of perfect competition. But Smith understood, and helped clarify, the fuller insight about how commercial activity shapes behavior over time.

Smith recognized that markets don’t just allocate scarce resources. They cultivate habits of honest dealing. A firm that cheats will likely profit in the short run, but certainly not in the long run. The firm that treats and charges customers honestly builds a reputation, attracts repeat business, and ultimately outlasts the swindler.

Smith referred to this as the “discipline of continuous dealings,” which game theorists have taken to calling “repeated play.” When a firm expects future dealings, either with the same customer or with people that customer talks to, cooperation (not defection) becomes the dominant strategy. This isn’t because people become angels, but because cheaters ultimately get punished when their market counterparts do business with someone else instead.

The furnace technician operates in a world of Yelp, Google Reviews, and social media. The company has been in business for decades at this point and (presumably) plans to be in business for many more to come. Every service call that the technician makes is part of his “continued dealing,” and he plays accordingly.

This completely transforms how we should think about things like “market power.” The standard story says that when a seller faces a buyer with no realistic alternatives, exploitation follows. Sometimes it does. But more often than not, we find honest dealings instead. Competitive markets create pressures that persist even in temporarily non-competitive moments. The company that gouges today will face competition tomorrow, and its reputation will follow.

“Competition,” then, isn’t really about the number of rivals at any one moment. It’s about the ongoing possibility of rivalry, and the understanding that customers can leave, that alternatives exist or could emerge, and that word of good or bad behavior spreads. These possibilities discipline market transactions so consistently that fair dealing becomes virtually automatic.

Two hundred and fifty years after Smith wrote, his insight remains underappreciated. Markets are not just mechanisms for setting prices. They also shape behavior by rewarding fairness and cooperation. By doing so, they can make ordinary self-interest look remarkably similar to virtue.

My mom’s pipes didn’t freeze. The repair company earned a loyal customer. If told this story, Adam Smith would probably take a sip of his claret and nod.