Potential Competition

Background

Potential competition refers to the notion that the presence of possible future competitors can influence the behavior of existing firms in a market. This effect is especially pronounced in markets characterized by constant returns to scale and freedom of entry. The concept underscores the idea that even monopolistic firms may act competitively if they believe that new entrants could challenge their market position.

Historical Context

The idea of potential competition became particularly prominent in the late 20th century as economists sought to understand market behaviors that were not entirely explained by existing models of competition and monopoly. The theory was further developed with the concept of contestable markets, which formalizes the conditions under which potential competition serves as a deterrent to monopolistic practices.

Definitions and Concepts

• Potential Competition: The competitive pressure exerted by the threat of new entrants to a market, influencing the behavior and pricing strategies of existing firms.
• Constant Returns to Scale: A situation in which increasing the quantity of inputs results in an equivalent increase in quantity of outputs.
• Freedom of Entry: The condition where there are no significant barriers preventing new firms from entering a market.
• Contestable Markets: Markets where there are no sunk costs of entry and exit, allowing new competitors to easily challenge incumbents.

Major Analytical Frameworks

Classical Economics

Classical economists did not explicitly consider the concept of potential competition, focusing instead on the immediate presence of firms and market structures. However, the fundamentals of market entry barriers have roots in classical theories.

Neoclassical Economics

Within neoclassical frameworks, potential competition gains importance as it implies that market outcomes may still be efficient even in highly concentrated industries, depending on the ease of market entry.

Keynesian Economic

Keynesian perspectives focus more on macroeconomic factors and aggregate demand, often sidelining the microeconomic intricacies of market structure, including potential competition.

Marxian Economics

Marxian economics usually emphasizes the capitalistic drive towards monopolies and overlooks the potential regulatory impact of newer market entrants.

Institutional Economics

Institutional economists might analyze how legal frameworks and organizational behaviors create or dismantle barriers to entry, thereby affecting potential competition.

Behavioral Economics

Behavioral economists may explore how perceptions of potential competition influence managerial decisions and strategies beyond traditional rational models.

Post-Keynesian Economics

Post-Keynesians often analyze the collective and dynamic processes within economies, sometimes considering the role of potential competition within broader market dynamics.

Austrian Economics

Austrian economists value the role of entrepreneurship and market entry dynamics as crucial for market health, aligning closely with the idea of potential competition.

Development Economics

Development economics might consider how opening up markets to new competition influences economic growth and development in emerging economies.

Monetarism

Monetarism pays more attention to macroeconomic indicators like money supply, generally giving less emphasis to the microeconomic concept of potential competition.

Comparative Analysis

Potential competition is a nuanced form of market pressure that differs from actual competition. In highly contestable markets, even the threat of new entrants can lead incumbent firms to lower prices, innovate, or improve quality, thereby approximating the outcomes observed in more competitive markets. This dynamic is starkly different from monopolistic markets with significant entry barriers where existing firms may exploit their position fully.

Case Studies

1. Airline Industry: The deregulation of the U.S. airline industry in the 1970s increased the contestability of the market, markedly changing the competitive landscape.
2. Telecommunications: Advances and liberalization of telecommunications markets around the world have shown fluctuations based on the extent of potential competition.

Suggested Books for Further Studies

1. “The Theory of Contestable Markets” by William Baumol, John Panzar, and Robert Willig
2. “Industrial Organization: Theory and Applications” by Oz Shy
3. “Markets and Hierarchies: Analysis and Antitrust Implications” by Oliver E. Williamson

Related Terms with Definitions

• Contestable Market: A market where entry and exit can occur at negligible cost, allowing even the threat of competition to discipline incumbents.
• Barriers to Entry: Obstacles that make it difficult for new firms to enter a market.
• Monopoly: A market structure characterized by a single seller, with high barriers to entry preventing competitors from entering the market.
• Constant Returns to Scale: An economic condition where an increase in the quantity of inputs results in a proportionate increase in the quantity of outputs.