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Personal Finance

Scott Wentlandwentlandsa@longwood.edu

434-395-2160Longwood University

201 High StreetFarmville, VA 23901

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Competition, Monopoly and Profit

Part 1 – The Role of Competition in Markets

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Competition and Profit

• For decades, people thought the Soviet Union’s economy was better than the U.S.– Why? – Wasteful competition

• Who needs 30 kinds of toothpaste? 50 kinds of laundry detergent? 100s of kinds of cars?

• Soviets: try to design the “best” or “most efficient” and just produce that

– Extra capacity for producing the other 29 toothpastes can go to produce other things!

– Profit motivation• US entrepreneurs are motivated by profit• Soviets motivated by altruism, to help The People

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Competition

• Is competition really wasteful?• Why make so many variations of cars?

• Competition is a market force that strives toward efficiency, not inefficiency– Ford’s competitors force them to constantly

increase quality and efficiency• If Ford doesn’t keep up, consumers choose Toyota, or

Honda, or VW…

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Consumer Sovereignty

• In a market economy, consumers really decide what is produced…– This is consumer sovereignty, or the idea that

consumers have the freedom to choose what they want to buy

– Businesses change to accommodate consumers, or else they parish…

• Ignoring customers is a sure way to go out of business– Why?

• Competition…if you don’t offer it, the other guy will.

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Consumer Sovereignty

• Doesn’t Big Business just make what is most profitable and try to sell it to us through advertising/marketing– Aren’t consumers just pawns that Corporate

America controls?

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Parable of “New Coke”

• In 1985, Coca-Cola reformulated its recipe– “New Coke”– One of the biggest marketing campaigns…EVER.

• Endless advertising• Huge roll out

• Problem: consumers didn’t like it– Pepsi gained market share– Coke gave up

• Solution: go back to Coca-Cola Classic– Gave consumers what they wanted, gained back

market share

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The Role of Competition

• The combination of consumer sovereignty and competition forces producers to make what consumers want– Consumers want higher quality– Consumers want lower prices

• Economics provides unseen insights– Markets set prices, not individual sellers– Consumers decide what producers produce, not the

individual producers

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The Role of Competition

• Without competition, these market forces are muted– Soviets (and other communist, non-market

countries) had terrible, low quality products relative to the US

– Other countries that shun competition (by making international trade difficult/costly, or burdensome regulations) tend to have:

• Low quality products• High prices

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Perfect Competition

• The more competitive the market: – The better it is for consumers– The worse it is for producers

• Perfect competition– Large number of buyers and sellers

• Firms are price takers– No entry or exit barriers– Perfect information– Buyers can easily switch from one seller to another– Products are very similar (if not identical)

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Perfect Competition

• In perfectly competitive markets:– Firms face intense competition such that economic

profits are at or near zero. • Why? Profit is like blood in the water draws more

firms (sharks), and bids down price– More on this later…

• Firms sell at marginal cost – Resources are used most efficiently

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The Role of Competition

• From a social standpoint, we want our resources to used efficiently– Competition is a benchmark

• Producers dislike competition, but should we care?– The purpose of the economy is to produce things that

people want. • Consumption is the ends production is a means• Competition helps a market economy achieve its ideal ends

(with some exceptions)

• Next part: what happens when there’s not a lot of competition? What role does profit play?

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Competition, Monopoly and Profit

Part 2 – Monopoly and Profit

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Monopoly

• Market economies sometimes have a monopoly in a particular sector– Monopoly: one single seller of a good/service (no

other competition)• Characteristics are generally the opposite of competition• Monopolies tend to have:

– High prices– High costs– Low quality products– Less responsive to consumers (poor customer service)

• Examples: local cable or telephone company

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Monopoly

• Sometimes businesses try to collude, to keep prices high, but collusion is difficult to maintain– Example: say, Coke and Pepsi decide to get together

and set prices of soft drinks to $5 per can• Side note: limits to how much they will charge based on

elasticity of demand (or how price sensitive consumers are)– Businesses that successfully collude have similar

effects as monopoly• Usually high prices, lower quality, etc.

– Governments in market economies generally try to prevent businesses from colluding

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The Role of Competition

• Problems with collusion– Competitive forces make it difficult for businesses

to collude– Why?

• If Pepsi and Coke collude, Coke may try to cheat and sell sodas for $4, instead of $5.

– It is always profitable to say you’re going to collude, but “cheat”• Pepsi responds, and the whole thing goes back to

competition– Other businesses may ENTER the soft drink business,

and take market share from Coke and Pepsi• Collusion falls apart if there is free entry

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The Role of Competition

• Businesses hate competition– Consumers love competition– Businesses will try to get government to enforce collusion– How?

• Through regulation. • Example: pre-1980s airline industry

– Government regulated prices and quality– Forbid airlines from charging lower prices and higher quality

– Not all regulation is anti-competition• Some have that effect, even if that is not the goal of the

policymakers unintended consequences• Regulations can be costly to comply with, and give bigger

businesses an edge and deter new entry into the market

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Secret to Business

• Entrepreneurs need to figure out what consumers want before their competitors do– Sometimes before even consumers know– What consumers knew they needed Facebook

before it came out? • Why do entrepreneurs go to all the trouble of

inventing new things, finding ways to make things better?– Spend countless hours, huge personal investment

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Profit

• Entrepreneurs and businesses seek profitProfit = Total Revenue – Total Cost

• Isn’t profit bad? – It is what you make ABOVE AND BEYOND your cost

• Why do you need that? • Isn’t that just gouging consumers? Charging them too much? • If consumers are charged too much, doesn’t that mean they

have less to buy for other things– Circular flow of economic activity isn’t less in consumers’

pockets bad for the economy?

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Profit

• Profit is more than just a formula– It is more than just maximizing revenue and

minimizing costs• Profit is:

– Motivation/incentive– Information– Temporary in a competitive market

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Profit Motive

• Profits motivate and incentivize people to– Take risks– Invent new things– Improve existing products/services– Make businesses and processes more efficient

• Lower costs and resource usage• Profit motive actually makes us more green

– Adam Smith explains this in The Wealth of Nations

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Profit Motive in the Real World

• Economies that reward entrepreneurs with profit are more innovative, efficient, etc.

• Soviet Union (and other economies that either don’t have the profit motive or don’t embrace it) are far worse off– Generally poorer– Less innovative– Less efficient

• Soviet economy really lost the Cold War

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Profit as Information

• Profit tells other companies what to imitate– Apple’s iPhone success leads others to make similar

products• Sometimes they are not only similar, but even improve upon

the original• Result: competition and product substitutes reduce demand

and ultimately reduce profits down to near 0. – Profits are like blood in the water

• Profits inform the market about what consumers want, and the sharks swoop in

• Attracts people to the market and try to grab their piece of profit

• Result: prices get bid down (trying to out-do the competition), reducing profit profits don’t last forever!

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Profits are Temporary

• Competition and free markets bid profits away– Pepsi will always try to outdo Coke

• Try to get the lowest price and highest quality• Result: razor thin economic profit

– If profits last, it is because competition is being hampered in some way

• Examples: – Monopoly power (maybe from patent rights, favorable regulation)– Entry barriers– Inability to imitate

» Sometimes a business is just “the best”

• Long term, sustained economic profit is rare in market economies ultimately good for consumers and society

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Conclusion

• So is competition and profit evil?

• US and other market-oriented economies are competitive and motivated by profit– This combination, plus consumer sovereignty, are

major reasons why market economies are the richest, most efficient in the world

– We owe our economic prosperity to competition, profit, and consumer sovereignty (among others)

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Conclusion

• Profit is powerful, yet temporary, as long as competition looms

• Who would have thought it would have been economics, not nukes, that won the Cold War?

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Thank You