May 3, 2013

Competition in Context: Firms

In last week's post I outlined five points about competition that tend to go overlooked in economic discourse:
  • The amount of things we are competing for changes over time.
  • The future amounts of things we are competing for are uncertain.
  • The things we are competing for may be created by the competitors themselves.
  • The amount of things we are competing for may be artificially constrained (this is basically a roundabout way of describing the way we often create markets using public or non-rivalrous goods).
  • The current allocation of things we are competing for may have important effects on the ability of competitors to compete for more of them (this is basically a roundabout way of describing things like economies of scale, network effects, path dependency, and first-mover advantage).
I want to take these ideas and look at what they can mean for competition situated in various contexts. What does it mean for a country to be competitive as compared with a competitive business or a competitive worker? I don't want to give a full account of how competition in these areas works, rather to think about why the points I've made above are important.

In all three of these competitive arenas, competitiveness comes from offering more value than competitors are offering. Typically 'offering value' means selling similar (aka substitutable) products or services more cheaply than a rival worker, firm, or country. Although these three realms of competition are similar in the abstract, they compete to provide that value in different ways. Today's post is about competition between businesses.


Firms are more straightforwardly in competition for value than nations are. Unlike nations, there is no exchange rate for firms, so firms don't simply get poorer, they "lose"--broken apart in the messy death of bankruptcy. While nations could be said to compete for value only as a means to an end (such as citizen welfare), firms are competing solely for revenue. And by competing in more or less distinct markets for products and services, the competitive dynamics between firms are easier to see.

Those distinct markets are more volatile than the macro-level "markets" that national economies compete for, so firms face a greater degree of change in size in the markets they are competing in. A population of fish may collapse due to overfishing, or the demand for bottled water may increase exponentially--such changes are rarely so dramatic on a national scale. This uncertainty increases competitiveness between firms because it means that incumbent firms have to adapt to continue to "win".

More specifically, however, the dynamic nature of certain markets can create an interesting variety of competitive dynamics. Competition in growing markets is very different from "mature" or from shrinking markets, because firms can grow even if they might be a worse option than a competitor--witness all of the bad investments that were initially successful in the dotcom bubble. In a shrinking market, on the other hand, even competitive firms can get squeezed down to nothing. (e.g. Kodak in the consumer camera market as it lost ground to camera phones)

While firms compete in ways different from national economies, they are similar in that they are creators of the value (good and services) that they want to exchange for other value (revenue they then reinvest or pay to shareholders). As individual firms attempt to "build up" value by attracting it away from their competitors, this can increase the size of the overall pie that they are competing for. But it does not have to, as we will see below.

Firms build up value by organizing production and utilizing technology in ways that reduce costs; the firms that do this best are rewarded with more money from customers. They are rewarded with less money from each customer--because that is why the customers chose this particular firm's products--but more customers are paying so they have the potential to receive more value overall. By trying to provide the most value for the least in return, we see firms experiencing the same competitive dynamics as when national economies "race to the bottom".

In our previous posts about efficiency and costs, we discussed how some cost reductions are things we would think of as "effiency increases" while others simply shifting costs from one party to another.

This idea helps us see the two possibilities when firms reduce costs: if they truly increase their output per worker they increase the size of the pie that everyone is competing for; but if their cost reductions are based on redirecting value away from the "costs" of workers, purchasers of the product gain exactly the expense of the workers. Alternatively, businesses can inflate the "value" of their products if they are not facing adequate competition. I don't want to get into the issues associated with this pattern of loss/gain here; the point is that because of the fungibility of money, competition can incentivize increasing the size of the pie or it can also incentivize redirecting the value within the pie. And the latter can be problematic.

The final two misconceptions about competition are right on target here. Network effects and artificial scarcity are two important ways that firms can redirect flows of value toward themselves in defiance of what we might think of as an "ideal" market. Any attempt to use market forces for the public good needs to recognize these pitfalls.

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