Economists have a concept called perfect competition but as a business owner it won’t sound perfect to you.
What is Perfect Competition?
Perfect competition is a world where markets are in equilibrium and none of the firms who are competing make a profit, they just cover their cost of capital.
This is the enemy to an entrepreneur where the goal is to reap super profits from innovating and taking risks.
The Attributes of Perfect Competition
Perfect competition is a world where there are many competitors. New competitors are free to move into the industry if companies start to make profit and to move out quickly if returns fall below the cost of capital.
Perfect competition is a world where there is no product differentiation. Everyone knows how to make the same product or service to the same standard and in the same time periods.
In perfect competition there are many buyers of similar sizes and they all have perfect information of their buying options. Information is free and there aren’t any transactions costs which make it easier or cheaper to deal with one supplier than another.
Opportunities For Profit Exist When Perfect The Competition Assumptions Don’t Apply
This is the important point – it is when these assumptions are broken that create the opportunity for sustained profit or loss within an industry:
- When there are few buyers
. - When there are few suppliers
. - When products and services are different from one firm to another
. - When new competitors find it difficult to enter an industry
. - When existing competitors find it difficult to leave
. - When information isn’t freely available to customers about the best prices and deals
. - When information isn’t available to competitors about the best methods to market, sell and supply their products
. - When there are transactions costs which create a connection between particular buyers and sellers and a disincentive to trade with others.
Strategy professor Michael Porter took the insights from industrial economics to create possibly the most famous strategic planning model, the Five Competitive Forces.
Markets Continue To Move & Transform
When those factors change in your favour, then the market offers profitable opportunities.
But the factors can move against you.
Big customers are strong negotiators and demand low prices combined with expensive service arrangements when they see a range of suppliers offering a product that they consider to be a commodity. And to put you under pressure, they’ll tell you that it’s a commodity.
They can force you close to your marginal costs and even though you’re busy, you could be losing money.
Even worse, there may be exit barriers which make it difficult for the loss making business to get out quickly. Being able to exit is a key feature that keeps the perfect competition model in equilibrium and doesn’t create situations where supply is greater than demand.
But in industries where there are exit barriers – physical, contractual or emotional – loss making businesses linger and even worse, in their desperation to improve their situation, they mess it up for everyone else.
This is why differentiation is so important.
Differentiation Creates Your Own Little Market
As soon as your product or service is different, it stops being a commodity in the general market and instead has its own little special market where you’re able to control supply. You create your own little monopoly situation – what economists call monopolistic competition.
There are close substitutes so you don’t have absolute pricing power but you can charge more than cost and therefore make a profit.
And that profit rewards entrepreneurs for taking risk, innovating and finding ways to give customers extra value.
