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p. 6 of 62 BACK | NEXT Purpose and Structure of the Toolkit Overview of Practices Controlled by Competition Law Countries with Competition Law Systems Benefits of Competition Policy Summary of Typical Benefits of Competition Benefits of Competition Disadvantages of Monopoly Practices Controlled by Competition Law Key Concepts and Tools Competition, Privatization, and Regulation Emerging Economies Enforcement Mechanisms ADB Resources and Projects Other Resources Glossary and List of Abbreviations

Competition Law Toolkit : Benefits of Competition Policy

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Benefits of Competition

At its simplest, the benefits of competition are lower prices, better products, wider choice for consumers, and greater efficiency than what would occur under conditions of monopoly. According to neo-classical economic theory, social welfare is maximized in conditions of perfect competition. For this purpose, "social welfare" is not a vague generalized concept, but instead has a more specific meaning: that allocative and productive efficiency will be achieved. The combined effect of allocative and productive efficiency is that society's wealth overall is maximized. Consumer welfare, which is specifically concerned with gains to consumers as opposed to society at large, is also maximized in perfect competition. A related benefit of competition is that it will have the dynamic effect of stimulating innovation as competitors strive to produce new and better products for consumers. This is a particularly important feature of high technology markets.

Discussions of the benefits of competition often begin with a theoretical model of so-called "perfect competition", which will be described below. Before doing so, however, it would be appropriate to point out that this theory is not reflected in the real world, albeit that the more prosaic idea of "workable competition" is certainly plausible. Indeed, there are dangers associated with an undue adherence to the theoretical model of perfect competition, particularly in developing countries, where it is important that firms should be able to build towards an efficient scale that will enable them to compete effectively in a broader international environment. What follows is a somewhat stylized way of introducing the benefits of competition policy by reference to theoretical extremes, but policy makers will wish to bear in mind that real world problems may not always reflect these.

Under perfect competition [ PDF ], economic resources are allocated between different goods and services in such a way that it is not possible to make anyone better off without making someone else worse off; consumer surplus—the net gain to a consumer when buying a product—as well as total surplus—a combination of consumer and producer surplus—are at their largest. Goods and services are allocated between consumers according to the price they are prepared to pay, and price never rises above the marginal cost of production (cost for this purpose, including a sufficient profit margin to have encouraged the producer to invest his capital in the industry in the first place, but no more).

The achievement of allocative efficiency [ PDF ], as this phenomenon is known, can be shown analytically on the economist's model. Allocative efficiency is achieved under perfect competition because the producer, assuming that it is acting rationally and has a desire to maximize its profits, will expand its production for as long as it is privately profitable to do so. As long as it can earn more by producing one extra unit of whatever it produces than it costs to make it, it will presumably do so. Only when the cost of a further unit (the "marginal cost") exceeds the price it would obtain for it (the "marginal revenue") will it cease to expand production. Where competition is perfect, a reduction in a producer's own output cannot affect the market price and so there is no reason to limit it; the producer will therefore increase output to the point at which marginal cost and marginal revenue (the net addition to revenue of selling the last unit) coincide. This means that allocative efficiency is achieved, as consumers can obtain the amounts of goods or services they require at the price they are prepared to pay: resources are allocated precisely according to their wishes. In stark contrast, a monopolist can restrict output and increase its own marginal revenue as a consequence of doing so.

Apart from allocative efficiency, many economists consider that under perfect competition, goods and services will be produced at the lowest cost possible, which means that as little of society's wealth is expended in the production process as necessary. Monopolists, free from the constraints of competition, may be high cost producers. Thus, competition is said to be conducive to productive efficiency [ PDF ]. Productive efficiency is achieved because a producer is unable to sell above cost (if it did, its customers would immediately desert it for producers who are selling at cost), and it will not of course sell below it (because then it would make no profit). If a producer were to charge above cost, other competitors would move into the market in the hope of profitable activity. They would attempt to produce on a more efficient basis so that they could earn a greater profit. In the long run, the tendency will be to force producers to incur the lowest cost possible in order to be able to earn any profit at all. An equilibrium will eventually be reached where price and the average cost of producing goods necessarily coincide. This, in turn, means that price will never rise above cost. If, on the other hand, price were to fall below cost, there would be an exit of capital from the industry and, as output would therefore decrease, price would be restored to the competitive level.

A further benefit of competition, which cannot be proved scientifically, is that producers will constantly innovate and develop new products as part of the continual battle of striving for consumers' business. Thus, competition may have the desirable dynamic effect of stimulating important technological research and development. This assumption has been questioned. Some argue that only monopolists enjoy the wealth to innovate and carry out expensive research. Noted Austrian economist Joseph A. Schumpeter was a champion of the notion that the motivation to innovate was the prospect of monopoly profits and that, even if existing monopolists earned such profits in the short term, outsiders would, in due course, enter the market and displace them. A "perennial gale of creative destruction" would be sufficient to protect the public interest, so that short-term monopoly power need not cause concern. Empirical research tends to suggest that neither monopolists nor fierce competitors have a superior track record in this respect, but it would seem clear that the assertion that only monopolists can innovate is incorrect. In practice, in most economies innovative efficiency is likely to be more important than allocative and productive efficiency.

The theoretical model just outlined suggests that in perfect competition, no producer will be able to affect the market price. The producer is a price-taker, with no capacity to affect the price by its own unilateral action. The consumer is sovereign. The reason the producer cannot affect the price is that any change in its own individual output will have only a negligible effect on the aggregate output of the market as a whole, and it is aggregate output that determines price through the law of supply and demand.

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