Competition is one of the foundational concepts in economics. We’re taught in intro courses that competition lowers prices, because it allows markets to allocate resources efficiently. This is an example of Adam Smith’s “invisible hand” in action, a cornerstone of economic theory.

But does competition always lower prices? The answer is, yes, sort of — it just depends on the degree of competition.

Since that answer probably doesn’t satisfy anybody, let’s dig deeper.

Different types of competition affect prices differently

Not all competition is created equal. Perfect competition, which features prices that drop to the point where firms are barely covering their costs, is the ideal of economic efficiency. It’s easy to see this in action in certain industries — petrol stations and grocery stores come to mind.

Petrol (or gas) stations typically post their prices on large, easy-to-read signs. If you drive around town long enough, you’ll notice that the price of fuel at these stations tends to move in tandem. When one price falls, so do the others, and vice versa.

Gas is a commodity — a good with little differentiation — so consumers tend to seek the lowest price, and firms have little ability to price it above their costs. This means that inefficient firms (i.e.: with high costs) are forced out of business as the most efficient firms (i.e.: low costs) set their prices near their low costs. Customers flock to the efficient firms, the inefficient firms shut down, and prices stay low.

Budget-friendly grocers like the German chains Lidl and Aldi and the US chain Walmart are comparable. At these types of grocers, food prices tend to be quite low. And, it’s not uncommon to see promises of price matching among their aisles.

You can even witness competition lowering prices yourself in some grocery stores. In the UK, Sainsbury’s is a grocery chain with a price match guarantee for Aldi. If a customer finds a good at Aldi that’s cheaper than it is at Sainsbury’s, the grocer will lower the price to match Aldi’s. This is a clear example of how perfect competition works — rather than lose a customer, a firm will lower its prices to match its rival’s.

This perfect competition ideal is common, and it does genuinely lower prices, but it’s far from the only way that markets operate in the real world. Economists have identified several other types of competition where prices are set differently.

Imperfect competition

Many of the markets in today’s economy operate under “imperfect competition”, a state where goods are technically substitutes, but consumers do not view them as interchangeable. Tech is a great example of this. Both Dell and Apple manufacture computers, but hardly anybody would be perfectly indifferent between a Dell PC and an Apple Mac. Likewise for iPhones and Androids, Playstations and Xboxes, and all kinds of other gadgets.

Imperfect competition still pressures prices downwards, just not as much as perfect competition would. This is because consumers will still respond to price changes, just not as intensely (in other words, their price elasticity of demand is less elastic). An iPhone lover is probably willing to pay a premium (say, $200) to purchase a new iPhone over a new Android smartphone.

But there are limits to how high this price difference can go before most people would reconsider. If a new iPhone cost $1000 and a new Android cost $800, many iPhone users would happily buy the iPhone over the Android. But what if that price comparison was $1400 to $800? Or $2000 to $800? Many people would begin to buy Androids instead.

This demonstrates something about imperfect competition: firms are able to charge higher prices than they could under perfect competition, due to their brand strength, their unique product offerings, etc., but they still can’t charge whatever price they want. Imperfect competition thus lowers prices, but less than perfect competition does.

In other words, imperfectly competitive firms have some market power, which brings us to a very important discussion…

High prices (can) come from market power

The most classic example of a high-market-power firm is the monopolist. A monopoly is the only firm producing a good in the market, which means they can freely set prices and consumers must either pay those high prices or live without the product. This is precisely why monopolies are typically considered bad for consumers: usually, monopoly prices are inefficiently high and monopoly production is inefficiently low.

We can use market power as a sort of measure of how effectively competition is working. Or, we could consider market power to be the opposite of competition: market power raises prices while competition lowers them.

In perfect competition, firms have essentially zero market power, which is why we often call them “price-takers”. They simply accept the market price and work out how to make a (marginal) profit with that limitation. In imperfect competition, meanwhile, firms have some market power, and can set prices higher. Monopoly (or a very well-coordinated oligopoly) has the most market power, wherein a firm maximizes its own profit at the expense of consumers.

Still, not all monopolies are bad. For example, it’s often best for public utilities to become regulated monopolies, because of start-up costs. It takes a ton of investment to set up water pipes and plumbing, for instance, and it would be inefficient to have a half-dozen utility companies tearing up roads and sidewalks to install their own proprietary water pipes. Instead, the government typically awards a company a monopoly and sets price controls while subsidizing the market with tax dollars. This achieves a balance of high quantity delivered, low prices for consumers, and a guaranteed competition-free profit for the utility company.

And, of course, there are many other reasons prices can be high. Negative supply shocks, increases in demand, changing laws, etc. – all can influence prices. Still, in a vacuum, how low competition will push prices depends on how much market power the firms have.

How do firms achieve market power?

Firms are incentivized to make as much profit as possible, which means they aim to compete as little as possible with other firms… or, in other words, they aim to gain as much market power as they can. A surprisingly large amount of corporate strategy boils down to this.

Consider marketing. The author of this piece has been receiving a torrent of ads for laundry detergent and dish soap while watching Netflix lately. These goods are both good examples of commodities – is one dish soap brand really better than another? Generally, no… but the marketing departments of dish soap companies work very hard to convince you that this is indeed the case.

That’s because, if consumers believe one firm’s product is superior, they’ve just given that firm market power! Even with dish soap, if consumers (en masse) became loyal to one brand, that brand would be able to price at a premium. This would cause the dish soap market to look like the Apple vs. Android smartphone market: the products are seen as differentiated, and people develop strong brand loyalty.

Marketing isn’t the only way firms try to wrangle market power out of otherwise competitive markets. Loyalty programs, for example, are common in coffee shops and cafes, as well as grocery stores, movie theaters, and more. These programs typically offer free handouts to consumers who make enough trips to the store in question. This makes it slightly harder for consumers to justify going to a different place; if you can earn a free latte at Starbucks (say, every seventh time you order a coffee there), why bother going to a different coffee shop?

Firms can also achieve a measure of market power by being the first to innovate or enter a new market. This is called a “first-mover advantage” in economics (and can be represented by Stackelberg competition). Microsoft’s Windows became the default operating system because it was able to partner with IBM and Intel at crucial moments in the early PC industry, and allowed other manufacturers to use Windows on their computers (while Apple’s macOS is only usable on their computers). This made it very accessible for myriad companies during the PC boom, and subsequently made it hard for companies to justify trying to use a different operating system.

And of course, the fewer firms in a market, the more market power they’ll have. Monopolies have the most market power; duopolies or cartels that can coordinate have a high degree of market power (and may operate under a form of Cournot competition); perfectly competitive (or firms locked in Bertrand competition) have a low degree of market power.

What does research say?

These theories are well-represented in the real world. A high degree of competition tends to lower prices for consumers, and vice versa. Even so, economists are a curious bunch, and some have set out to analyze this issue even further.

Certain papers have found niche scenarios where increased competition can increase prices. Although these are theoretical papers, they add nuance to the mechanisms by which competition affects prices. These papers include Satterthwaite (1979), Chen and Riordan (2007), and Mangin (2024).

In general, these papers use mathematical models to study cases where prices can rise due to competition if certain conditions are met. For example, Mangin (2024) finds, in their model, that the expected price markup of a good is increasing as the number of firms increases. This result holds locally, not globally, and requires a specific condition to be met: that the elasticity of marginal utility is less than the elasticity of demand. This means that marginal utility would change less than demand when prices changed.

Even though it seems clear that competition lowers prices, it’s still important for economists to push the limits of commonly accepted and widely-proven theories. Much the same as any other science, the exceptions often cause us to learn more than the general case!

Curious readers ought to look into the research themselves, and can use any of these reference papers as places to start. Still, for the rest of us, the answer is clear: when it comes to low prices, competition is certainly our friend.

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References:

Satterthwaite (1979): Consumer Information, Equilibrium Industry Price, and the Number of Sellers. https://doi.org/10.2307/3003348

Chen and Riordan (2007): Price and Variety in the Spokes Model*. https://doi.org/10.1111/j.1468-0297.2007.02063.x

Mangin (2024): When is competition price-increasing? The impact of expected competition on prices https://doi.org/10.1111/1756-2171.12487 

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