Firm Level Price Determination: A Comparison of Theories (Perfect Competition, Imperfect Competition, and the Theory of Real Competition)

By Ezra Pugh

“The best of all monopoly profits is a peaceful life,” (John Hicks, 1935).

“The division of labor within society brings into contact independent producers of commodities, who acknowledge no authority other than that of competition…the ‘war of all against all,’”      (Karl Marx, 1867)

George Stigler defines the term competition as “the absence of monopoly power in a market,” (Stigler 1957, 14). This could seem a curiously narrow definition to the businessperson or the worker. But this notion has been ubiquitous in the teaching of economics for decades. It originates, of course, from the Neo-Classical theory of perfect competition. Abstraction is necessary to any theoretical investigation. Assumptions must be made for the purpose of conducting analysis. But in flattening the meaning of a term like competition in such a way, is there a risk that some essential insights may be lost?

Perfect Competition

Perfect competition is the foundational parable of orthodox economics. A perfectly competitive market is an abstract ideal with a number of specific attributes:

•          There is a very large number of firms, such that no single firm can affect the overall market for its product.

•          There is a very large number of buyers for the industry’s product.

•          Each firm produces exactly the same undifferentiated product.

•          Firms, and their consumers, have perfect knowledge of all relevant economic information related to their industry and its product.

•          Firms have unrestricted power of entry and exit in their industry.

•          Firms are entitled to a ‘normal rate’ of profit, which is included in its operations costs.

• ·         Marginal costs drop at first then eventually increase with each unit sold. As a result, average cost is also upward sloping.

From its perspective, a firm in perfect competition is just a speck, dwarfed by the size of the market it competes in. The market can absorb whatever the firm can produce, provided it is sold at market price. The firm’s perceived demand curve is horizontal, or perfectly elastic. As a result, the demand curve is identical to its supply curve. The overall demand curve of the market, however, is downward sloping.

The firm must accept the prevailing market selling price for its good. If it sets its price above the prevailing price, even by an iota, the firm will lose all of its sales to the myriad other sellers. If it sets its price below, it will not be able to make enough profit to survive. A firm in a perfectly competitive market is therefore known as a price-taker, as it is powerless in the face of market pressures. Consequently, “a perfectly competitive firm has only one major decision to make—namely, what quantity to produce,” (Greenlaw 2018, 189).

Being rational, the firm’s motivating goal is to generate profit. Its profit (r), is defined as total revenue (TR) minus total cost (TC). Total revenue is made up on the products price (P) multiplied by the quantity produced (Q) minus the average cost per unit (AC) multiplied by the quantity produced. This can be written as:

To maximize its profit, the firm must continue producing more output up until the point its marginal revenue equals its marginal cost – the point where an additional unit of output contributes no more profit. Marginal revenue (MR) and marginal cost (MC) are defined thus:

Because the market price the firm experiences does not change based on its output, the firm’s marginal revenue is a constant. Each additional unit sold adds the same value, which is equal to the price of the product. If marginal revenue is equal to price, and profit maximization occurs when marginal revenue equals marginal cost, the firm should produce up until the point where its marginal costs equals the price of its product.

The firm’s average cost is its total cost divided by quantity produced, and is assumed to initially fall then eventually be upward sloping. Because innumerable sellers all sell the same good, in the long run (which generally does not have a specific definition), all ‘economic’ profits—those which are above the assumed ‘normal’ profits—are eventually eroded completely away. If positive economic profits existed, more firms would enter the market, increasing supply and lowering price. If economic profits are negative, firms would leave the market, causing the opposite effect. As a result, in the long run perfect competition causes sellers to produce their goods at the lowest point on their average cost curve.

“When profit-maximizing firms in perfectly competitive markets combine with utility-maximizing consumers, something remarkable happens,” we are told, “the resulting quantities of outputs of goods and services demonstrate both productive and allocative efficiency,” (Greenlaw 2018, 206). Productive efficiency is attained because in the long run, firms produce at their absolute lowest cost. Allocative efficiency is achieved because the resulting goods’ price is equal to its marginal cost—precisely the value of the ‘social cost’ of producing it.

Imperfect Competition and Monopoly

But of course, this state of affairs does not resemble the world in which we live. This utopian optimality, we are told, is distorted and mutated by the anti-competitive behavior of firms and government. Due to that meddling, we live in a world of imperfect competition—monopoly, monopolistic competition, and oligopoly. Paradise lost. In monopoly, a firm is the lone provider of a good, in monopolistic competition many firms produce differentiated products, and in oligopoly a small cabal of firms control the marketplace and exert price pressure.

The culprit which creates each of these distorted market types is barriers to entry. Whether natural or legal, barriers to entry prevent firms who would otherwise enter a market from entering. The few firms which are active in the market have control of too large a slice. As a result, they can affect the market price based on how many units they produce. Instead of a horizontal perceived demand curve, the firms in imperfect competition face a downward sloping demand curve.

To maximize its profit, the imperfectly competitive firm still produces at the level where MR = MC. But because of its outsized effect on the market, P no longer equals MR. With each unit produced, the increased supply exerts downward pressure on the price, which effects the price of all other units produced by the same amount. If such a firm produces too much, it can hurt its own bottom line. Because it supplies as much as it wants and not what consumers want, a true monopoly will have perpetual positive economic profits at a level which depends on the elasticity of the product’s demand schedule. Monopolistic competition, however, will in the long run result in a total erosion of economic profit as firms enter the market, all producing at a point on the AC curve, albeit not at its minimum point. As a result, none of these markets is productively or allocatively efficient. The amount of goods produced is below what consumers would have wanted under perfectly competitive conditions, they are more expensive than they are socially worth, and firms inefficiently do not produce at their minimum average cost. Customers are robbed of potential utility. Such markets are sadly the norm, because, we are told, “firms have proved to be highly creative in inventing business practices that discourage competition,” (Greenlaw 2018, 220). This is a great state of affairs for the firms, however, because “once barriers are erected, once a barrier to entry is in place, a monopoly that does not need to fear competition can just produce the same old products in the same old way,” (Greenlaw 2018, 229). Managers can kick back and watch the profits roll in.

Historical Overview

Sketched out above is the dominant parable in economic thought and teaching. Interestingly, almost none of this resembles the real world. How did we get here? An outline is sketched below.

Adam Smith is generally credited with establishing economic thought, or Political Economy, as a distinct field of study. His work An Inquiry into the Nature and Causes of the Wealth of Nations (1776) is regarded as the first modern work of economics. A key figure in the Scottish Enlightenment, Smith was interested in observing economic phenomena, describing them, and discovering the hidden patterns within. David Ricardo furthered and built on Smith’s ideas, advancing theories on rent, trade, and value. Over the course of the three volumes of Capital (1867), Karl Marx extended this theoretical framework even further with sharpened historical and class analysis, building a signature value theory in the process. Along with others, these thinkers are referred to as the Classical economists.

But in the 1870’s there occurred what is known as the Marginalist Revolution. The Long Depression (1873-96) caused a crisis of confidence in the capitalist world. Interestingly, it was during this period that the most utopian theoretical depictions of capitalism were popularized. W.S. Jevons (1871), Carl Menger (1871), and Leon Walras (1874) independently and almost simultaneously developed this new theoretical paradigm. They perceived fundamental flaws in the theoretical framework and methodologies of the Classical economists and sought to “pick up the fragments of a shattered science and to start anew,” (Jevons 1879/1965, Preface lii). The Classicals believed that the ultimate source of an item’s value was the amount of labor embodied in it and that market prices were connected to costs—prices of production. The Marginalists vehemently disagreed. “Value,” wrote Jevons, “depends entirely upon utility” (Jevons 1871/1965, 1). Echoing this sentiment, Menger wrote “there is no necessary and direct connection between the value of a good and whether, or in what quantities, labour and other goods of higher order were applied to its production” (Menger 1871/2007, 146). Value then stemmed from a buyers utility gained from a good; that utility being an index of the good’s scarcity.

Jevons and Walras both used advanced mathematics to express their ideas. Adopting algebra and calculus, they could express complex ideas with greater accuracy than was possible previously. "Why should we persist in using everyday language to explain things in the cumbersome and incorrect way, as Ricardo has often done,” wrote Walras, “when these things can be stated far more succinctly, precisely, and clearly in the language of mathematics?" (Heilbroner 1997, 226). Walras pioneered what is known as general equilibrium theory—the notion that a complex balance of supply and demand can exist in and between markets.

It is during this period that supply and demand curves and the modern theory of perfect competition are introduced. In order to make their highly abstract models functional and defined, economists had to make assumptions that did not necessarily fit with, and often outright contradicted economic reality. "The pure theory of economics, it must precede applied economics,” wrote Walras, “and this pure theory of economics is a science which resembles the physic-mathematical sciences in every respect," (Heilbroner, 224). Actual people and actual societies faded from the picture in favor of platonic ideals. This fundamental methodological shift opened up many new avenues of exploration for economists, but the descriptive and predictive usefulness of the new models was not necessarily clear. Perfect competition became the theoretical jumping off point for all ‘rigorous’ analysis, and Marshall (1890) systematized the theoretical structure into what would recognize as modern Neo-classical economics. Dobb notes, "at the purely formal level, there can be little doubt that the new context and methods, with their mathematical analogy if not mathematical form, resulted in enhanced precision and rigor of analysis…the cutting knives of economic discussion became sharper -- whether they were used to cut so deeply is another matter" (Dobb 1973, 176).

In the 1920s, unease with the dominance of perfect competition was growing. Sraffa (1925) aimed a potentially devastating critique at the then-dominant Marshallian partial equilibrium theory, demonstrating that the theoretical structure was not capable of dealing with non-constant returns (increasing or decreasing costs) adequately (Mongiovi 1996). The next year, Sraffa (1926) suggested a solution might be found using the lesser utilized monopoly theory as a starting point. Even in competitive markets, monopolistic tendencies could easily be observed because 1.) firms can exert some control over their own prices, and 2.) they frequently experience increasing returns (decreasing costs). Sraffa argued that these circumstances are not the exception, “rather they are normal and persistent features of the economic landscape, with 'permanent and even cumulative' consequences for market equilibria. When these influences are operative, each firm is to be viewed as having its own distinct market; prices are set so as to maximise profits on the supposition that the relevant demand curve is not perfectly elastic,” (Mongiovi 1996, 214). Building on these ideas, Robinson (1933) and Chamberlain (1933) independently, but simultaneously, developed the theory of imperfect competition that is taught today. Eventually abandoning Marshallian theory altogether, Sraffa’s publication of Production of Commodities by Means of Commodities (1960) is credited with establishing a distinctive Sraffian or Neo-Ricardian school.

Real Competition

In Capitalism: Competition, Conflict, Crises (2016), Anwar Shaikh erects a theoretical framework independent of perfect and imperfect competition. Formalizing insights developed by the Classical economists, a theory is built which is both analytically sound and corresponds to observed economic phenomena. The theory of real competition, as it is called, “is as different from so-called perfect competition as war is from ballet,” (Shaikh 2016, Ch. 7.I.). The classical economists stressed themes that were either diminished or omitted completely by Neo-classical economists, including conflict, class, and temporality. In Capital, Volume 1, Karl Marx writes that the economic realm is bellum omnium contra omnes, ‘war of all against all,’ (Marx 1867/1990, 477). All evidence of this is lost in the parables of perfect and imperfect competition. But in Capitalism, the theory of real competition “pits seller against seller, seller against buyer, and buyer against buyer. It pits capital against capital, capital against labor, and labor against labor,” (Shaikh 2016, Ch. 7.I.). Abstracting away from the essentiality of conflict to capitalist production and distribution makes Neo-Classical analysis not only unrealistic, but totally misleading.

But even on pure theoretical grounds there are issues with the theory of perfect competition. For one, there is a fundamental contradiction within the assumptions. Firms are assumed to have perfect knowledge of the market in which they are competing, yet their perceived demand curve is assumed to be flat. These two assumptions cannot hold at the same time. “If firms are assumed to be sensible in their expectations, then the theory of perfect competition collapses. More generally, even mildly informed firms would have to recognize that they face downward sloping demand curves under competitive conditions,” (Shaikh 2016, Ch. 8.I). If a firm in a perfectly competitive market has perfect knowledge, it would quite easily deduce that the market signals it is receiving are being received by every other firm, and those firms will react in a predictable manner. As a result, the firm would know that it does not face a flat, perfectly elastic demand curve, and would act in exactly the same manner as a monopolistic firm, with just the same results.

Another problematic assumption within the orthodox framework is that firms are entitled to a normal rate of profit, which is included within its cost structure. The action of competition completely erodes excess profits away but leaves normal profits intact. This, of course, is wildly unrealistic because “no capital is assured of any profit at all, let alone the “normal” rate of profit. Indeed, all capitals face losses at some point, and a certain number drown in red ink in every given interval. It is therefore completely illegitimate to count “normal profit” as part of operating costs,” (Shaikh 2016, Ch. 7.I.). The prospect of making a loss is the dark cloud that hangs over every business manager, driving them unceasingly into conflict with agents both inside and outside the firm. Abstracting away from this motive force fundamentally misdiagnoses the motivations of economic agents.

In the theory of perfect competition, a firm’s only decision is how much to produce. Likewise, in imperfect competition, pricing and quantity decisions are mechanically connected. But in the works of the Classicals and in the theory of real competition, firms are active price setting, cost cutting entities. Neo-Classical theory stresses that firms will flock to higher profit rates at a given price. But once firms have the power to set their own price, the picture becomes more complicated. In their endless search for higher rates of return, firms cut prices to attract more buyers and increase market-share. In the process, “the advantage in this perpetual jousting for market share goes to the firms with the lowest cost,” (Shaikh 2016, 7.II.). If firms have the power to cut their own prices, they have the power to starve out other firms—even ones that are potentially more profitable at initial prices. Neo-Classical theory stresses that firms will adopt whatever method yields the highest profit at a given price, but “when costs differ, there is always a set of prices at which the lower cost firm has the higher profit rate. This does not mean that [it] has to drive the price down to that level. It has only to get the message across to its competitor that the future has arrived,” (Shaikh 2016, 7.VII.). This is demonstrated in Table 1 below. Pricing wars, which are extremely common occurrences in the real economy, highlight the conflictual nature of economic relations—"these are the operative principles of warfare: attackers try to impose greater losses on the other side. We will see that such behavior is the norm in the business world. It follows that the highest profit that is sustainable in the face of price-cutting behavior is generally different from the price-passive profit assumed in theories of perfect and imperfect competition,” (Shaikh 2016, 7.II.). Only the theory of real competition deals with this common behavior adequately.

Conclusion

Contrary to Hicks’ assertion, a peaceful life is not included in a firm’s profit—no matter their degree of monopoly. There is perpetual conflict generated both inside and outside of the firm that must always be contended with. For real firms, “price is their weapon, advertising their propaganda, the local Chamber of Commerce their house of worship, and profit their supreme deity,” (Shaikh 2016, 7.II.). Abstraction is a necessary tool for analysis. But the specific method of abstraction used in the theories of perfect and imperfect competition does not serve to elucidate truths that would be otherwise unattainable. Neo-Classical economics was formulated during a crisis of capitalism to create a utopian vision in order to justify capitalist social relations. Capitalist relations have been shown to be the most powerful and productive in history, but that does not justify obscuring their fundamentally destructive and chaotic elements. Competition is not merely the absence of monopoly power—it is the struggle of all against all.

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