Competition as Rivalry in a Race

Historically, the first notion of competition developed in modern economic literature is that of free competition or competition without restraint. Competition is viewed as a kind of rivalry in a race.

Classical economists generally base their analysis of competition on Book I, chapter vii of The Wealth of Nations (Smith 1776 [1976], hereafter WN). The data from which the Smithian argument starts are the natural rates of wages, profits and rents which, secto­ral specificities apart, basically depend on the conditions of prosperity of the economic system under scrutiny, its “advancing, stationary, or declining condition” (WN I.vii.1). The natural price of (re)production of the various commodities springs from the summa­tion of these three elements. Accordingly, the natural price is a magnitude whose genesis lies outside the market, but that, given some well-specified conditions, may come true in the market.

The natural price, therefore, is, as it were, the central price to which the prices of all com­modities are continually gravitating. Different accidents may sometimes keep them suspended a good deal above it, and sometimes force them down even somewhat below it. But whatever may be the obstacles which hinder them from settling in this center of repose and continuance, they are constantly tending towards it. (WN I.vii.15)

In particular, natural prices play the role of market price floors in the sense that market prices cannot remain for long below their natural level without seriously jeopardizing commodity reproduction:

The competition of the different dealers obliges them all to accept of [the natural price]; but does not oblige them to accept of less.... The natural price, or the price of free competition... is the lowest which can be taken, not upon every occasion, indeed, but for any considerable time together... is the lowest which the sellers can commonly afford to take, and at the same time continue their business. (WN I.vii.11 and 27)

To study the genesis of market price and its relationship with natural price in a given market Smith introduces the concept of effectual demand, that is, “the demand of those who are willing to pay the natural price of the commodity”. It is to be stressed, first, that the match between the quantity brought to the market and the effectual demand deter­mines only the market price of a commodity and not its natural price and, second, that “demand” and “supply” are treated by Smith as given quantities and not as functional relationships between price and quantity characterized by well-defined formal properties (Garegnani 1983).

Given the unplanned nature of market economies, classical analysis requires the specification of an adjustment mechanism powerful enough to bring about an effective convergence to a situation in which the produced quantity coincides with the effectual demand: in the absence of such a mechanism, natural prices would hardly constitute a reliable guide to explain market prices dynamics.

The assumed tendency of market values towards their respective natural values is based on two broad assumptions: (1) economic agents choose where to allocate their economic resources taking into account, inter alia, their opportunity costs and (2) there are but negligible barriers to the intersectoral mobility of economic resources:

When the price of any commodity is neither more nor less than what is sufficient to pay the rent of the land, the wages of the labour, and the profits of the stock employed in raising, preparing, and bringing it to market, according to their natural rates, the commodity is then sold for what may be called its natural price. The commodity is then sold precisely for what it is worth, or for what it really costs the person who brings it to market; for though in common language what is called the prime costs of any commodity does not comprehend the profit of the person who is to sell it again, yet if he sells it at a price which does not allow him the ordinary rate of profit in his neighbourhood, he is evidently a loser by the trade; since by employing his stock in some other way he might have made that profit Though the price, therefore, which leaves him this profit is not always the lowest at which the dealer may sometimes sell his goods, it is the lowest at which he is likely to sell them for any considerable time; at least where there is perfect liberty, or where he may change his trade as often as he pleases. (WN I.vii.4-6, emphasis added)

The above quotation shows that Smith devotes much care to the determination of natural values and to the explanation of the gravitation process of market magnitudes towards their natural counterparts. The same cannot be maintained as concerns the question of market price determination, particularly in the presence of market imbal­ances. Taking stock of Smith’s sparse hints on this subject it is possible to point out what follows. Where competition is free and industrial secrets absent, price-undercutting starts as soon as at least two competitors are present in the market.

The quantity of grocery goods, for example, which can be sold in a particular town is limited by the demand of that town and its neighbourhood. The capital, therefore, which can be employed in the grocery trade cannot exceed what is sufficient to purchase that quantity. If this capital is divided between two different grocers, their competition will tend to make both of them sell cheaper than if it were in the hands of one only; and if it were divided among twenty, their com­petition would be just so much the greater, and the chance of their combining together, in order to raise the price, just so much the less. (WN II.v.5)

By contrast, in those markets in which competition is not free (for example, because of a legal monopoly and/or the presence of a guild, a collusive agreement, a rule that somehow reduces economic agents’ freedom as to the intersectoral allocation of their resources) or where there are industrial secrets, entrepreneurs voluntarily curb the pro­duced quantity so that the market is left understocked and the market price may stay artificially high even “for ages”:

A monopoly granted either to an individual or to a trading company has the same effect as a secret in trade or manufactures. The monopolists, by keeping the market constantly under­stocked, by never fully supplying the effectual demand, sell their commodities much above the natural price, and raise their emoluments, whether they consist in wages or profit, greatly above their natural rate The exclusive privileges of corporations, statutes of apprenticeship, and

all those laws which restrain, in particular employments, the competition to smaller number than might otherwise go into them, have the same tendency, though in a less degree. They are a sort of enlarged monopolies, and may frequently, for ages together, and in whole classes of employments, keep up the market price of particular commodities above the natural price, and maintain both the wages of the labour and the profits of the stock employed about them some­what above their natural rate.

Whenever the agents on one side of the market are few (for example, thanks to an entry barrier artificially created by the law) and able to communicate (for example, because they operate in the same place such as a town) while the agents on the other side of the market are many and unable to communicate (for example, because they are scattered in the countryside) the bargaining from which the market price springs will obviously be more favourable to the former. Thus, the relative number of the sellers in relation to the buyers, their relative ability to make a binding agreement and the presence and signifi­cance of entry barriers may be crucial elements determining a market price permanently above its natural level. The classical notion of competition is percolated into modern literature with the label of “Bertrand competition” (Salvadori and Signorino 2013).