Economists praise the importance of competition in markets to lower prices and improve quality. But what is “competition” and how does it actually work?
For those who are not economists, this term brings to mind something like a sports contest where one person wins while everyone else loses. But this comparison fails in at least two ways.
First, for there to be a single “winner” in a market exchange, there must be a single, identical product that each competitor is seeking and offering for scarce consumer funds. This is a great thought experiment for classrooms, textbooks, and academic papers. But that’s not how real market trading works, even for a specific product. While it’s true that there are important lessons to be learned from these abstractions and thought experiments, try telling someone discerning that Coke, Pepsi, and RC Cola are “basically the same” and hearing their reaction.
Second, the one-winner, many-losers scenario means that competition itself increases as the number of competitors increases. After all, winning a world title is much more impressive than winning “only” a national title. But that’s missing something about how competition works. In a small town with only two hardware stores, the “competition” between the two stores can be much more intense than in a large city with 20 stores.
So what actually is competition?
Recently, the furnace went out while my mother and husband were out of town. In Michigan. In winter. Since they lived only two miles away from me, I was designated as their emergency contact. The next morning, a technician came to the scene and diagnosed the problem. (I’m a big believer in specialization, so I have no idea what went wrong, just that some parts need to be replaced.)
We both knew he had me between a rock and a hard place. No other company in the city could get this done faster, and I wasn’t going to let my mom’s pipes freeze. Nevertheless, when the bill arrived, everything was fine. The standard rates for parts and labor were completely reasonable, and there was no sign of any markups such as “emergency services” which I would have agreed to given the circumstances.
Why not?
This year marks the 250th anniversary of Adam Smith’s Wealth of Nations, and the furnace repair job shows that Smith understood competition. It is not about the textbook definition of identical companies producing identical products and competing over price until their (economic) profits are zero. In fact, Smith would not have recognized this formal model of perfect competition. But Smith helped understand and articulate a more complete insight into how commercial activity shapes behavior over time.
Smith recognized that markets do more than just allocate scarce resources. They develop the habit of dealing honestly. Companies that commit fraud may benefit in the short term, but definitely not in the long term. Companies that treat and charge customers honestly will build a reputation, attract repeat business, and ultimately outlive scammers.
Smith called this the “discipline of continuous trading,” but game theorists call it “repetitive play.” If a company anticipates doing business with the same customers or people who talk to them in the future, cooperation (rather than defection) becomes the key strategy. This is not because people become angels, but because fraudsters are ultimately punished when their market counterparties trade with someone else on their behalf.
Furnace technicians are active in the world of Yelp, Google reviews, and social media. The company has been in business for several decades now, and (presumably) plans to continue doing so for many more years to come. All service calls made by our technicians are part of our “continuous response” and will be responded to accordingly.
This completely changes the way we think about things like “market power.” The standard story says that exploitation occurs when a seller is faced with a buyer for whom he has no real options. Sometimes it happens. But more often than not, an honest deal is made instead. Competitive markets create pressures that persist even when competition temporarily disappears. Companies that skimp today will face competition tomorrow and their reputations will follow.
So “competition” isn’t really the number of competitors at any given moment. It’s about understanding that competition may continue, that customers may leave, that alternatives exist or may emerge, and that word will spread whether your actions are good or bad. These possibilities consistently discipline market transactions so that fair trade is virtually automatic.
It’s been 250 years since Smith wrote, but his insights remain underappreciated. Markets are more than just a mechanism for setting prices. It also shapes behavior by rewarding fairness and cooperation. In doing so, ordinary selfishness can be made to look strikingly similar to virtue.
My mother’s water supply never froze. The repair company has gained a loyal customer base. If told this story, Adam Smith would probably take a sip of claret and nod.
