There’s an old, near-funny joke about economists that goes something like this:
A physicist, a chemist and an economist are stranded on a desert island, with no food to eat. A can of soup washes ashore, but it’s sealed. So each professional ponders how to get it open…
“I’ve got it. Let’s smash the can open with a rock,” exclaims the physicist.
“No, no. The soup will splatter that way,” says the chemist. “Let’s build a fire and heat the can first.”
“You’re both wrong,” retorts the economist. “Let’s assume we have a can opener….”
The joke is corny at best. It may have even gone over your head. My apologies.
But the stereotypes in the joke are spot on, especially for the economist. One of the biggest gripes that people have with economists (and economics as a whole) is that the models that they build to represent the world often require unrealistic or even impossible assumptions in order to get results. What’s the point of building models that do not accurately represent reality?
One of the most cited examples of wishful thinking in economics is the model of perfect competition. Those of you that took Econ 101 in undergrad are (or at some point were) probably familiar with this idealist representation of how economic markets distribute goods and services. In short, perfect competition is a market condition in which no market participants (buyers, sellers, etc.) are powerful enough to set the price of a homogenous good or service.
Economists expect markets to be perfectly competitive when the following conditions hold:
- Products are identical: sellers offer the exact same product and buyers are equally willing to buy from any seller.
- Many small price-taking participants: there are numerous buyers and sellers, none of which has the ability to influence the market price substantially, and no single firm or consumer accounts for a large portion of production or purchases.
- Perfect information: Buyers and sellers are fully informed about the quality of products and prices available in the market.
- Identical sellers: suppliers have full access to the same inputs and production technologies as one another.
- Free entry and exit: many new firms can enter the market on the very same terms as existing ones if the market is profitable and, similarly, firms can exit the industry without incurring extra costs.
Can you think of a market that satisfies these conditions? I certainly can’t… I myself used to be baffled at how strict its assumptions were. Models are supposed to be an accurate representation of reality, and this one certainly is not.
Conditions 1-3 above generate the equilibrium of a theoretical market. Firms will earn a profit at the market equilibrium if the market-clearing price is greater than the firms’ average total cost. But the presence of profits will entice more firms to enter, driving up production and pushing down prices until such competition and entry completely destroy profits. Products, prices, firms and consumers are all the same, so no one company can do anything about it. Perfect competition prevails leaving no profit.
Conditions 4-5 eliminate many of the market frictions experienced by real-world companies trying to enter or exit an industry. With all firms equally efficient and free to come and go as they please, competition is as intense as one can imagine. Since firms can leave, so no businesses make losses but none make money either. They simply break even. In this environment, one starts to question what’s so “perfect” about this form of competition. From a manager’s point of view, it’s hard to think of anything so far from ideal…
But when you look at it that way, I hope a lightbulb goes off for you. True, perfect competition is not a very useful model with which to classify modern industries today. But it’s a darn good one for a strategist to measure his or her firm against to see why and how their profit-making enterprises differ. To be clear, perfect competition is significant not because it is common (there are few to none of such markets in real life). Its real importance lies in the observation that departures from perfect competition are what underlie high profits and firms’ competitive advantages.
And for each departure from one of the model’s condition, firms have a chance to exploit attractive profit opportunities:
- Differentiated Products: in actuality, not all products are exactly the same, and thus some firms have the power to charge premiums for better quality or target different customer segments. A firm’s ability to create value for a customer through a differentiated product or service yields profits for the firm by being able to charge a higher price.
- Few, Price-Making Participants: actual markets are often dominated by a handful of powerful buyers or sellers that have substantial market power to move prices (the most extreme case being a monopoly who is the sole seller to a large number of buyers).
- Imperfect Information: in the real world, market information is far from readily available and buyers must spend time searching out reliable information. Buyers are often short on time and make decisions using cognitive shortcuts, not taking all information into account. So firms that can create customer loyalty will benefit greatly.
- Unique Sellers: some firms will ultimately have unequal access to production technologies and different input costs, making their overall costs structures very different. Firms with superior access to technology and cheap supplies can generate high profits even when the marginal firm earns no profits.
- Barriers to Entry and Exit: in reality, incumbent firms have certain advantages, such as prior experience, lower production costs, and others, that entrants cannot easily mimic, which discourages free entry into the industry. Similarly, exit costs may be substantially high, forcing loss-making firms to stay in the industry.
The sources of advantage above are by no means the only ones available to a firm, but encapsulate useful forces to think about when planning your firm’s strategy. Use them wisely and your firm will profit.
As I’ve argued before, economics is far from perfect and at times a bit idealistic. Models, like the theory of perfect competition, do not depict the state of affairs particularly well. Nonetheless, it’s sometimes the holes in economists’ models that provide the food for thought that can lead to a lasting business strategy or new innovation that changes an industry.
