3.1.5.8–3.1.5.9 - Dynamic competition and contestability
Learn how competition changes prices, products and production over time. Section 3.1.5.8 explains rivalry and creative destruction; 3.1.5.9 explains why the threat of entry can affect an industry even when few firms currently operate in it.
Competition as a process
Competition is a continuing process of winning customers, rather than just a count of firms at one moment.
Price competition involves rivals cutting prices or improving value through discounts. In the short run this can reduce margins and transfer surplus toward consumers, particularly when customers can compare offers and switch. Firms may respond by cutting avoidable waste or negotiating lower input costs. A price cut does not automatically reduce production cost: a firm can accept lower profit instead.
Non-price competition involves quality, reliability, design, range, convenience or customer service. An illustrative delivery firm might compete through accurate arrival times and fewer damaged parcels, while another develops a booking system that saves customers time. These improvements can raise consumer welfare even if the money price is unchanged. Advertising can inform buyers of these advantages, but can also strengthen brand loyalty and make comparison harder.
In the long run, the prospect of losing customers encourages investment in better processes and products. A new sorting system may raise output per worker, reduce cost per parcel and allow lower prices. A genuinely improved product may meet a need that old products served poorly. These are dynamic gains: performance changes over time, rather than resources merely being rearranged with today's technology.
The incentives have limits. Intense rivalry can make innovation valuable, but margins may become too small to fund risky research. A price war may cause efficient firms to exit if they cannot survive short-term losses; fewer surviving rivals can later raise prices. Switching costs, misleading information and collusion can weaken rivalry. Competition is likely to create gains when buyers can act on useful information and effective current or potential rivals constrain firms.
Creative destruction
Creative destruction occurs when innovation creates new products or production methods while displacing existing businesses and markets.
Large monopoly profits attract entrepreneurs seeking part of that return. Entry may require more than copying the incumbent: innovators can overcome barriers by providing a substitute through a different technology or business model. In an original illustrative market, a town's only printing firm has expensive presses and established contracts. A new digital service cannot cheaply replicate every press, but may let customers design and order materials online and use distributed printers elsewhere. It changes the competitive constraint rather than simply adding a second identical local factory.
The chain is profits → an incentive to enter and innovate → new substitutes or cost advantages → customer switching → erosion of old market power. Successful innovators may gain temporary power themselves; later innovation can challenge them. This repeated process is a fundamental feature of competition in a market economy. It is a possibility with uncertain outcomes, not a promise that all barriers disappear quickly. Intellectual property, finance, network effects and access to customers can protect an incumbent for a long time.
New technology can increase productivity and consumer choice while imposing adjustment costs. Workers with skills specific to the old process may face unemployment; specialised assets may lose value. Resources must move toward expanding activities, and retraining or relocation takes time. An economy can therefore gain in the long run while particular workers, firms and regions lose in the transition. Profit incentives explain why innovation is attempted; they do not establish that every innovation has a positive net social effect.
To assess the process, compare the new service's cost and quality with the old one, identify which barrier was overcome, and examine the speed of adjustment. A new entrant using the same protected network under unchanged rules is different from an innovation that bypasses it altogether.
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