Why does competition work for capitalism?

Question

As far as I know, capitalism is based on competition: If two(or more) companies produce similar products that compete against other, these companies are in a competition. Because the objective of a company is to earn as much money as possible, the company will try to maximise the selling of their product. However, because normally there are more than a single company, every company has to sell their best possible product for the lowest price without making enough profit. That leads to a situation where the consumer gets a very good product for a very fair-realistic price.

My problem here is, that this only works if every company only can make the decision about what price they make for what quality once. Like in the prisoner's dilemma. The prisoner (the company) will (usually; if he is sane) make the decision to betray his member (->Game Theory). The point is the ideal strategy changes if this 'game' will be repeated forever (is identical to a situation where nobody knows, when the game ends). The strategy any sane prisoner would take is to not betray his gang-member, however, if his member betrays him he will betray him, too, until his member does not betray him anymore. Because this is a simplified version of a real competition, real companies should act like the prisoners: make a high price until the competitor make a low price. However, no company would make a low price because although they would make better profit in short term, the company would make better in longterm if they made the unspoken deal with the other companies.

So why is it not like this in real world, or is it like this and I haven't noticed that yet?

Answer 1

When two companies produce commodities and/or services that are substitutes then they are simply producing for a market that allows the presence of two or more substitutes.

"...If two (or more) companies produce similar products that compete against other, these companies are in a competition"

Two firms do not necessarily compete with each other when they are supplying substitutes in the market.

What needs to be clear is that qualifying a market as competitive amounts to making a series of statements about the way the participants in the market behave, their numbers, how potential new participants can interact with the market, the relevant time scale etc.

Narrowing the focus on two members of a market and claiming that they are in competition is not warranted by the assumptions. Nothing has been said about the structure of the market they are embedded in. They could eg be simply trying to flood the market with alternatives to a third commodity so as to narrow the market share of a third producer; the possibilities are really unbounded.

"...Because the objective of a company is to earn as much money as possible, the company will try to maximise the selling of their product."

The objectives of firms are really as diverse as is the number of industries and producers immense. "Making money" is not always a single operative constraint. Firms have a plurality of goals and obtaining liquidity is one of them. How binding that goal is depends on a host of issues like the market they are embedded in, the firm's size and relative position in the market, probably its access on financing etc.

Profit maximization is an assumption about the behavior of firms which is historically relevant and analytically useful but it is not always the case that firms are maximizing profits. They may be going for market share, or they may be simply optimizing some other metric. And, of course it could very well be the case that they are just winging it!

"...However, because normally there are more than a single company, every company has to sell their best possible product for the lowest price without making enough profit..."

Again, this claim is not universally true. The number of firms in the market is not always a guarantee of 'quality' and 'affordability'. What matters is the cost structure of the industry, the technology and the assumptions about the market structure. Also, profits that vanish to zero is, again, a feature of the competitive model; not what 'really' obtains.

Now, as far as the 'Prisoner's dilemma' is concerned: In an one-shot game the best thing to do is to 'defect'. In a repetitive setting, that is also open-ended (no predetermined end date) I think that anything goes. You would have to make more assumptions about the number of players and their strategies over time (and in response to others') in order to arrive at definitive conclusions.

The short and non-definitive answer to the question of why don't firms collude when involved into price-competition with each other would be that there are laws that prevent them from that ie the fundamental cost structure of the game is different than what the 'dilemma' posits.

Answer 2

Competition "works" in capitalism in the sense that society, as a whole, is provided with the maximum possible quantity of goods for a price which gets close to the cost of producing the good.

Microeconomics studies how this works theoretically, and uses a series of assumptions to make the "mathematics" simpler, such as that everyone in the market is rational (they want the maximum goods for the cheapest price), and that the goods are homogeneous (all the same, like potatoes in a veggies market for example).

To understand the benefits of competition, I'll compare a monopoly, where the company has a lot of power, to the perfect competition, where sellers have little power.

Selling water in the desert

Imagine a seller of bottled water in the desert. Let's call her Carmel. The seller has a cost of 1$ to buy the bottle and bring it to the desert. She also knows that 28 people pass the desert by day, and she made a study on how much each person would pay to buy water, what economists call demand. The results are here:

A quick read of the chart tells her that no one will buy water for a price higher than 14, and everyone will buy it at 1. We can read all the other quantities sold for prices between 14 and 1: for instance, at a price of 6, 18 people would buy.

Knowing this, the water seller Carmel calculates the profit at each quantity in a table:

She starts selling water for 8$ a bottle the next day, making the maximum profit possible: 98 dollars.

For that money, I can also sell water!

After a few days the word comes to the close-by village of Oasisville that Carmel is making 98$ a day selling water bottles to travelers in the desert.

Knowing that other travelers would buy bottle for lower prices, another seller decides to show up. Let's call her Dromedaria. Dromedaria sets the price at 6, taking all the sales from Carmel. With the loss from buying the water bottles, Carmel sets the price at 2 the next day, taking all the sales from Dromedaria. They both undercut each others' prices until the price becomes close to 1. At the end all the travelers get water and the sellers get a small profit.

When you think of the number of people benefiting from fresh water in the desert, the competition is giving a better outcome to society. This was achieved without government intervention (price setting), and is the simplified theoretical background for defending the free-market competition.

Of course this is a simplification, and in real life things would take more time, or they could collude, etc.

Two additional points:

• The capitalism has as a key principle the freedom for sellers (capital owners) to freely trade at privately-set prices. Competition is just a consequence of that. The opposite would be a centralised pricing approach (planned economy), such as the USSR experienced in the after 1922
• Game theory would be the next step to try to predict what others do: how Dromedaria and Carmel would take each decision and react to each other's pricing

Answer 3

I want to provide a more political aspect to the discussion by differentiating between a market economy, i.e. an economy where competition through markets is the main mechanism of creation and distribution of wealth/income, and that of a capitalist economy, defined as one where the ownership of means of production (ultimately, financial capital and equity) is mainly exercises through public limited companies.

I think the distinction is relevant, both from a theoretical and historical point of view. Theoretically, a market economy can exist within a pluralist range of forms of production (for example, there is a thing called Market Socialism). A market economy is perfectly compatible with a legal structuring of firms as cooperatives. Just look at how the other answers were silent to the legal organisation of firms.

Historically, because it is a misconception from the liberal and conservative defendants of capitalism (rooted surely in Adam Smith's conception of the Invisible Hand) that competition is a natural tendency within capitalism. Evidence indicates time and time again that capitalism engenders monopolies, oligopolies, and capture of political and cultural power. It is only organised labour movements plus state intervention (many times inspired on such movements, and not emerging from capitalists self-restrain and benevolence) which put checks on capital inherent desire for power and control.

Thus, what I am saying is that, yes, competition works for market economies, but competition does not work for capitalism.