Benefits of competition

Competition is when many producers try to sell similar goods to the same set of consumers. The producers need to “compete” to try to attract more consumers, usually by lowering prices, offering better versions of the goods or services, or through marketing. Competition is the core concept of the Market Economy.

Competition generally leads to lower prices, more choice, and better qualities of products for consumers than other types of economies. The reason for this is that with competition, there is very little “central planning” of the economy, while producers and consumers are able to act in their own self-interest.

For a producer, this means that they want to attract as many customers as possible, and earn the highest profit. In an ideal setting, there are thousands of potential producers for any good.

Lets say that a new market has opened – there is a street full of people who want to buy ice cubes. On this street is a building full of people who have freezers and tap water, so they are able to make ice cubes, and sell them.

Immediately, one person makes and sells 100 ice cubes for $10, with no cost other than time. Because of Supply and Demand, very few of the consumers are willing to buy at this price (see our article on Supply and Demand Examples in the Stock Market for details).

Seeing this profit, everyone else in the building starts making and selling ice. To get more profit, they also lower their price to attract more customers. Since there is no difference in the ice made by each of the producers, all of the consumers always take the lowest possible price, which forces the producers to keep matching the lowest price offered by anyone else.

At this low price, some of the producers decide that it is not worth their time and effort to keep producing, and so they drop out of the market. This means that the remaining producers can raise their prices a bit, since there is no longer as big of a market surplus.

The Price War caused the market price to fall by a huge amount (70% at one point), and caused some of the less efficient producers to drop out of the market. In the end, the consumers finished with a large reduction in the overall market price.

The remaining sellers still want to attract more buyers and earn higher profits, but at this point it is not possible while they are selling identical products. The result is product differentiation, or making their ice slightly different from the competition.

Product Differentiation is a form of innovation that requires investment, this can include things like new machines or processes that reduce cost, or new features or product advantages that make it more attractive to consumers.

For our Ice Sellers, lets say that some of the sellers used their profits to invest in new higher-capacity and energy-efficiency freezers that make it cheaper and easier for them to produce the same ice.

At the same time, some of the other sellers used their profits to research methods to make “Luxury Ice“, like ice spheres and crystal-clear large cubes, which they can then sell at a higher price.

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