What Is a Competitive and Free Marketplace?
Is Business Ethics Missing in Action from the Marketplace?
This Hub will examine: The ethics of anti-competitive practices; the underlying rationale for prohibiting them, and the moral values that market competition is meant to solve. Several years ago, I taught an MBA class on business ethics at a highly respected private university in Houston. This is one of the topics that I always made sure was researched in depth, updated, and examined thoroughly every semester, by me and my students.
A perfectly competitive free market is one in which no buyer or seller has the power to significantly affect the prices at which goods are being exchanged. The Sherman Antitrust Act was passed by the United States Congress in 1890, and it was passed to address unethical business practices. It was the first national legislation of its kind created to end anti-competitive activities that were being perpetrated by America’s largest corporations.
Trusts were created by big business as corporations, to manage the stock of cooperating corporations. This process was used for the first time in history, in 1882, to help Standard Oil; at the time the world’s largest corporation. John D. Rockefeller, its founder, chairman, and major stockholder, needed a way to improve organization and control of his very large business.
A legal entity, trusts were originally created to consolidate the power of large American businesses. The word “trust” became tainted, however, when it became associated with abusive business practices that discouraged competition in the marketplace.
In the 1880’s, public outcry in America led to the need for anti-trust legislation at a time when Great Britain dominated the world’s economy. At the time, American business was controlled by wealthy industrialists like J.P. Morgan and John D. Rockefeller, those history would label as “robber barons,” men who used questionable business practices to acquire massive wealth.
The robber barons paid workers extremely low wages so that they could make and sell their products cheaper than competitors. Then, once competitors were hurting, they bought them out, and then raised product prices higher than ever before. At one time in history, under a trust called the Northern Securities Corporation of New Jersey, Morgan and Rockefeller controlled 112 corporations and over $22 billion in assets.
Flash forward to modern times. A survey of major corporate executives indicated that 60 percent of those sampled believe that many businesses still engage in price fixing. One study found that in a period of two years, over 60 major firms had been prosecuted by federal agencies for anti-competitive practices.
In 2012, California Attorney General Kamala D. Harris, along with the offices of seven other states’ attorneys general, reached settlements totaling $571 million with three manufacturers that engaged in price fixing of flat screen LCD (Liquid Crystal Display) panels (these panels are found in monitors, laptops and televisions).
Also in 2012, MasterCard, Visa, and major banks, including JPMorgan Chase and Bank of America, agreed to pay more than $6 billion to settle an anti-trust suit accusing them of engaging in anticompetitive practices in credit-card payment processing.
Is It Possible to Have Perfect Competition?
A free-market system thrives only as long as it operates in ways that are just. A competitive and free market must maximize the economic utility of society’s members and it must respect the (right to) freedom of choice of both buyers and sellers. These are the moral aspects of the free-market system. Moral aspects, however, depend on the competitive nature of the system. Anti-competitive activities work to undermine and to dismantle the competitive nature of the system.
Collusion, which means firms are joining together and using their combined power, is an anti-competitive activity that weakens a free-market system by driving out competitors. Price fixing is a form of collusion that gives participating firms an unfair advantage in the marketplace. When firms engage in collusion, the marketplace is no longer competitive.
When the marketplace is no longer competitive, it is no longer “free.” Once a marketplace is no longer “free,” competitors can be driven out, and potential new entrants can face barriers to entry that will not allow them to compete in the marketplace at all. Consumers have no “freedom of choice” because price fixing keeps prices level, and therefore, social “utility” in the marketplace will decline.
Seven Features of Perfect Competition
What does a free and perfectly competitive marketplace look like? What are its major characteristics? Following are seven features that a free marketplace should exhibit:
1. There are numerous buyers and sellers, none of whom has a substantial share of the market.
2. All buyers and sellers can freely and immediately enter or leave the market.
3. Buyers and sellers all have access to full and perfect knowledge of what every other buyer and seller is doing, including knowledge of prices, quantities, and quality of all goods being bought and sold.
4. Goods sold are homogenous; of comparable quality. No one cares from whom each buys or sells because products are indistinguishable from each other, perfect substitutes.
5. The costs and benefits of producing or using the goods being exchanged are borne entirely by those buying or selling the goods and not by any other external parties.
6. All buyers and sellers are “utility maximizers.” This means each is trying to get as much as possible for as little as possible.
7. No external parties (such as government) are needed to regulate the price, quantity, or quality of any of the goods being bought and sold in the market.
Does a perfectly competitive market exist anywhere in the world. The best answer is, "No," because the idea of perfect competition is an "ideal." It is not reality. The question ultimately becomes how far from the ideal is a particular market system?
Where is the Equilibrium Point?
In a perfectly competitive market, prices and quantities always move toward what is called the equilibrium point: The point at which the amount of goods buyers want to buy exactly equals the amount of goods sellers want to sell. Every seller finds a willing buyer and every buyer finds a willing seller. According to our social norms, perfect competition is moral. It satisfies three of American culture’s moral criteria, including justice, utility, and rights. Perfect competition, therefore, is just (deserved based on contribution to society); it is right (protective of freedom of choice), and it is utilitarian (concerned with the greatest good for the greatest number).
In economics, there is something called the marginal utility of a good (a product) or a service. The marginal utility refers to the gain (or loss) a consumer experiences based on an increase (or decrease) in the consumption of a good or service.
There is something else called the principle of diminishing marginal utility. This economic principle states that each additional item a person consumes is less satisfying than each of the earlier items the person consumed: That is, the more we consume the less utility or satisfaction we will get from consuming more. The buyers’ demand curve begins to slope downward because the principle of marginal utility ensures that the price consumers are willing to pay for a good diminishes as the quantity they buy increases. It indicates the value consumers place on each unit of a product as they purchase more units.
The principle of increasing marginal costs states that after a certain point, each additional item the seller produces costs him more to produce than earlier items (because our world’s productive resources are limited). The supply curve rises upward to the right because it depicts the point at which sellers must begin to charge more per unit to cover the cost of supplying additional units.
In a perfectly competitive free market, prices, the amounts of a good or service supplied, and the amounts demanded by consumers all tend to move toward the point of equilibrium. Why? Because the market wants to be “perfect!” A perfectly competitive market is self-correcting because it wants to be perfect for all involved.
In the land of perfect competition . . .
If the perfectly competitive market produces or supplies too much, then, production will create surplus levels, and prices will fall. When prices fall, production will decrease and producers will get out of the market, finding other more lucrative markets to invest in. With fewer producers, in time, equilibrium prices and amounts will be reached.
Then, if prices drop below the equilibrium point, producers will begin to lose money, so they will begin to supply less than consumers want at that price. This will cause excessive demand, and shortages. Shortages will cause buyers to bid up the price, prices will rise, and more producers will be attracted to the market. Supplies will then rise—and the cycle will begin again.
Is this example of “perfect competition” realistic with regard to our economy in the United States? In actuality, there are only a few agricultural markets (such as grain and potato) that come close to exhibiting the characteristics just talked about. The model, therefore, is a “theoretical construct” of economists that does not really exist.
Is Our Marketplace One of Perfect Competition?
Perfectly competitive free markets incorporate forces that inevitably drive buyers and sellers toward the “point of equilibrium.” This causes the achievement of three major moral values:
(1) Buyers and sellers are led to exchange their goods in a way that is just (in a certain sense of just);
(2) The utility of buyers and sellers is maximized, leading them to allocate, use, and distribute their goods with perfect efficiency; and
(3) These achievements are brought about in a way that respects both the buyers’ and sellers’ right of free consent.
What is a Monopoly?
When a business has a monopoly in the marketplace, it means there is no competition. A monopoly is the exact opposite of a “perfectly competitive” market. It is easy to see that a monopoly would not possess all seven characteristics of a perfectly competitive market. In a monopoly, there are not “numerous sellers,” there is only one seller. Other sellers cannot “freely enter and leave the market” under monopolistic conditions. In fact, barriers to entry keep would-be competitors from even entering the marketplace. Example: American Telephone and Telegraph (AT&T) was a monopoly before, in 1983, when the courts opened up competition in the market for long-distance telephone calling.
Monopolies are unjust. They charge much more than their cost of production. They represent a decline in social utility because there is a decline in the efficiency with which goods are allocated and distributed, and with the quantity of resources used. In addition, they can cause “artificial” shortages in order to raise prices and profits.
Monopolies restrict freedom of choice for would-be competitors (barriers to entry cause them to have to invest in other non-monopoly markets that might already have an adequate supply of goods), and for consumers. They have no incentive/motivation to reduce production costs, no competing firms, no need for a “competitive edge.” They can manipulate prices and force some buyers to pay a higher price for the same goods, or they can make it so that if you want to purchase product A, then must also purchase product B.
Although Microsoft Corporation was once ruled as having a monopoly power with regard to its Intel-based personal computers operating system, a consent decree in U.S. v. Microsoft expired in 2011, officially removing Microsoft from antitrust scrutiny by the United States Department of Justice. Today, monopolies exist, primarily, only in markets controlled by governments. Civic services, such as sewage disposal, are controlled by local government entities or municipal corporations.
What is an Oligopoly?
The oligopoly operates very much like the monopoly, but is considered to be the “middle ground” between a monopoly and a “free market.” Instead of there being many sellers, there are several, and only a few significant ones. Market share can range from 25-90%, and controlling it may range from 2 to 50, depending on the industry. In the music industry, for example, 80% of the market is controlled by four companies—Sony Music Entertainment, EMI Group, Warner Music Group, and Universal Music Group.
Other sellers cannot freely enter an oligopolistic market because the competitors create barriers to entry. Some of the barriers can include long-term contracts tying all firms in an industry with buyers or distributors; a high cost to start a business in the industry, or even advertising that creates brand loyalty to such a degree, others cannot successfully compete. The more highly concentrated the system, the more profit the firms can extract.
Examples of oligopolies include:
- The automobile industry (there are very few auto manufacturers in America and around the world, and usually, when one company reduces financing rates, others will follow).
- The airline industry (an “imperfect” oligopoly, airlines provide a good example of how there is still competition within an oligopoly, because competitors match air fares when they share routes).
- As of the last quarter of fiscal year 2008, four companies controlled 89% of the US cellular phone market: Verizon, AT&T, Sprint, and T-Mobile.
Members of concentrated oligopolies find it relatively easy to join forces and act as a unit in order to do the following: Set product prices at the same levels; restrict their output; act like a single, giant firm; use barriers to entry to keep others out of the market, and charge high prices while keeping low supply levels just like monopolies. Just as is the case with monopolies, oligopolies also are:
- Not just–they take out a lot more than they put in.
- They are anti-social utility–they are concerned about the greatest good for the smallest numbers, not for the greatest numbers.
- They are anti-basic economic freedom (rights) because consumer choice is limited to what the O’s want to produce. Also, companies desiring to enter these markets are effectively kept out through entry barriers.
Is Freedom and Justice the American Way in the Marketplace?
If justice, freedom, and social utility are important values for a society, then oligopolies have to stop (or be stopped) from engaging in practices that restrict competition. They have to be stopped from collusive activity that reproduces the effects of monopoly markets. The following sorts of market practices have been identified as unethical:
- Price fixing – Agreeing to set prices at certain levels, usually artificially high; manipulation of supply–agreeing to limit production creating shortages so that prices rise to levels higher than those would result from free competition.
- Exclusive dealing arrangement – A firm sells to a retailer on condition that the retailer will not purchase any products from other companies and/or will not sell outside of a certain geographic area. Since these arrangements can sometimes enhance competition, they need to be examined closely to determine whether their overall effect is to dampen or promote competition.
- Tying Arrangements – A firm sells a buyer a certain good only on condition that the buyer agrees to purchase certain other goods from the firm.
- Retail Price Maintenance Agreements –When a manufacturer sells to retailers only on condition that they agree to charge the same set retail prices for its good. This dampens competition between retailers and removes competitive pressure to lower prices from the manufacturer.
- Price Discrimination – Charging different prices to different buyers for identical goods or services.
- Extortion – An employee is engaged in extortion if the employee demands a consideration from persons outside the firm as a condition for dealing favorably with those persons when the employee transacts business for his or her own firm.
- Bribes –An employee is engaged in bribery if he or she accepts a consideration given or offered by a person outside the firm with the understanding that when the employee transacts business for his or her company, the employee will deal favorably with that person or that person’s firm.
Is Regulation Needed?
Many who favor regulation still believe oligopolies should not be broken up because their large size has beneficial consequences that would be lost if they were decentralized (mass production, economies of scale, cheaper—more plentiful products). Many others feel, however, that regulatory agencies and legislation should be set up to restrain and control the activities of large corporations, because they cannot be trusted to control themselves.
Those who support antitrust legislation say that prices and profits are higher than they should be in concentrated industries. They believe the solution is to reinstate competitive pressures by forcing the large companies to divest themselves of their holdings, thereby breaking them up into smaller firms.
Then, there are still others who believe it is best just to “do nothing.” They say nothing at all should be done about the economic power of oligopolies because another "force" is taking care of things. They say that competition within industries has been replaced by competition between industries with substitutable products, and this takes care of the problems.
John Kenneth Galbraith, once a leading proponent of American liberalism, was the world’s best-known economist during his lifetime (1908-2006). Galbraith believed the economic power of oligopolies could be balanced by “countervailing powers,” including government and unions, as well as equally large and powerful buyers.
Is it even possible to "play fair" in the marketplace? Why? Or why not? What do you think?
© 2012 Sallie B Middlebrook PhD
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