2024-07-28 20:13:04
This article is part of The Conversation’s Business Foundations series, where we invite experts to discuss key concepts in business, economics and finance.
It’s hard to remember a time before the cost of living crisis dominated the headlines. Most of us would surely like it to be over soon.
But the central question—the one we must address—seems simple. What determines the price we pay?
The cost of producing goods and services is, of course, an important factor in determining how much we pay for them. So is how much we are willing to spend.
But when we talk about lowering prices, we’re also usually talking about increasing competition—that is, the number of companies competing to sell us a particular product.
Effective pricing is so important that the government agency responsible for ensuring that markets are fair is called the Australian Competition and Consumer Commission, or “ACCC” for short.
But why would more people trying to sell us products drive down prices? Can companies find a way to fix this?
The more sellers, the lower the price
In a free market system, there are several different types of competition.
In the best case scenario, Perfect Competition In order to become a market, companies must use resources efficiently to produce products that consumers want at the lowest possible cost.
exist Perfect Competition:
- The products and services traded are the same (or very similar)
- There are many buyers and sellers
- Perfect information
- Businesses can enter and exit freely.
A company that charges prices far above its minimum cost will be unable to sell any goods or services and will be forced out of the market. Why? Because its competitors can steal customers by selling the exact same product at a slightly lower price.
kps1664/Shutterstock
Only the lower-cost firms will stay and drive prices down until they can cover the minimum cost of supplying the good or service, plus an average or normal “return on capital employed.”
At a high level, this return can be viewed as an acceptable monetary reward for a business to invest its capital and take the risks required to operate.
If an industry earns above-average returns for its level of risk, new firms will enter and charge lower fees until it earns only normal returns.
Conversely, lower-than-normal profits will cause firms to exit, thereby reducing supply and raising prices.
Do perfectly competitive markets exist? There are some examples that come pretty close, such as temporary labor services, some agricultural products such as grains, livestock, and fruit, and financial and monetary markets.
But there are more examples of insufficient market competition.
Winner Takes All
At the other extreme, monopoly A market in which there is only one seller of a good or service. Typically, there are barriers that prevent new companies from entering the market and drive down prices.
Without government regulation, monopolies would reduce supply, raise prices, and earn higher-than-normal profits.
Dan Simbrechts/AAP
Sometimes, however, monopolies emerge naturally because it is much more efficient to have a single coordinated provider of a particular service—letter delivery, railroad tracks, or internet infrastructure, for example.
To achieve a balance, governments often regulate or have a monopoly.
Acquaintance and difference
More common than monopoly is the so-called Monopolistic CompetitionThis is the market structure for many of our technology, entertainment, and food and beverage goods and services.
In monopolistic competition, firms attempt to provide different By investing in R&D and advertising so that they don’t have to compete solely on price.
Think of Apple’s iPhone versus Samsung’s Galaxy. Technically, they are the same product, but each has created its own unique market.
Differentiation enables firms to price above minimum cost and earn above-normal rates of return, at least until new firms enter and imitate them, causing supply to increase and prices and profits to fall back to normal levels.
A few large companies hold market power
In Australia, many important goods and services are produced in Oligopoly market.
Oligopolies occur when a few large companies dominate a particular industry, such as supermarkets, domestic airlines, banks, mobile telecommunications and petrol retailing.
Some oligopolistic markets are so competitive that prices fall to cost plus a normal return on capital. But in other more concentrated markets, there are only a few strong companies, which may have significant Market forces and be able to keep prices above competitive levels.
Joel Caret/AAP
Having market power is not illegal, but it is illegal under Australia’s Competition and Consumer Act 2010 to use it “with the purpose, effect or likely effect of substantially lessening competition”.
For example, it is illegal for businesses to explicitly cooperate in setting prices. This is called collusion. They also cannot force suppliers to deal only with them or set prices below cost when new businesses try to enter the market.
But that doesn’t mean some companies haven’t learned clever and legal ways to reduce competition.
For example, loyalty programs and charging special loss-making prices may seem beneficial to consumers at first glance, but they can also raise the cost to consumers of switching to the lowest-price company.
Are we getting a good deal?
However, you may have noticed that different companies in the economy charge very similarly for many goods and services.
Have these prices been driven down by competition to costs plus a normal return on capital, or have firms abused their market power to reduce competition in the market?
What should we do if companies use legal means to reduce competition?
These are just some of the challenges that governments and industry are currently grappling with.
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