How Should We Measure Competition?

By: Brian Albrecht (Truth On The Market)

Unfortunately, there is no universal measure of competition. The way we quantify competition is highly dependent on the economic model we use.

For instance, in a Cournot model (named for the 19th-century French mathematician Antoine Augustin Cournot), the number of sellers in the market is considered the primary indicator of competition. When we ask, “What happens when competition increases?” we typically mean, “What happens if more sellers enter the market?” This makes sense within the model, as more sellers drive down prices, markups (price over cost), and profits. Observing low prices and low profits in a market can suggest a high level of competition.

If you, like me, find the idea of firms magically appearing unrealistic, you might prefer to imagine firms incurring a fixed cost to enter the market, and then competing as in the Cournot model. If entry costs decrease, more firms will enter, reducing profits and markups. Measuring entry costs can help us gauge competition; when they drop, it indicates increased competition. Often, we must infer entry costs from observable data about existing firms in the market. Otherwise, market concentration may serve as our best proxy for entry costs.

However, this neat connection between entry costs, concentration, and competition doesn’t always hold. I’ve discussed the problems with using concentration to measure competition extensively, so I won’t dwell on it. In short, in many models, increased competition can actually lead to higher concentration.

Consider firms deciding whether to enter local markets, each requiring a separate investment. When trade costs are reduced, the least-cost producer can dominate a larger share of the overall market, leading to higher concentration but also lower prices, markups, and profits.

Competition as Lack of Markups

Another way to define competition is as the absence of market power. Market power is the ability of a firm to influence the price at which it sells its products. A firm with market power will have a markup where the price exceeds the marginal cost. Measuring the elasticity of demand or the markup can provide insight into competition.

This method isn’t perfect either. We shouldn’t assume rising markups indicate weakening competition, as this is akin to reasoning from a price change, since the markup is a residual price received by the seller. Prices can rise due to demand or supply reasons, and simply observing price changes doesn’t clarify the cause.

Similarly, markups can rise due to demand, supply, or reduced competition. For example, a large monetary stimulus can increase demand, leading to higher prices and markups. While one might say this stimulus reduces competition, as there’s less relative competition for each dollar, it’s more accurate to attribute the increased markups to higher demand…

CONTINUE READING…