Text by Hakob Hakobyan. Originally published on Enlight July 1st, 2017.
Competition has an important role in the system of a free-market economy. In fact, it is the basis of market development. Adam Smith was the first scholar to speak about the competition in the economic system in his work (1776) entitled “An Inquiry into the Nature and Causes of the Wealth of Nations.” Smith presented a decentralized, competitive field, not regulated by the state with many small participants, none of which had enough influence on the overall market performance.
In the second chapter of his work (Of the Principle which gives Occasion to the Division of Labor), Smith speaks about a situation where each participant of the competing field forms its behavior based on its needs: “He (a man) will be more likely to prevail if he can interest their (other people’s) self-love in his favor, and show them that it is for their own advantage to do for him what he requires of them. Whoever offers to another a bargain of any kind, proposes to do this. Give me that which I want, and you shall have this which you want, is the meaning of every such offer.”[i]
In fact, Smith’s theory of competition entails that each subject endeavors to have a maximum gain, and as a result, not only the market participant benefits but also the society in general. In this system free competition helps to reduce production expenditures, optimizes the distribution of resources inside the economy and each of its branches.
Theoretically, the manifestation of the behavior suggested by Smith could lead to better results for society in general if the system, where many small participants had no opportunity to influence the market system, worked. In practice, however, the competitive abilities of certain subjects are different, and along with the development of the economic infrastructures, objectively, a situation comes forth, when certain participants obtain a predominant role in the market due to their competitive advantages and can influence both the market structure and social development in general.
Smith’s ideas on competition have also been reflected in international trade theories. It was called the “theory of absolute advantage,” which was based on the notion of “invisible hand” (Laissez-faire), according to which international trade is regulated through price factor, and certain products will be produced in those countries, where their production is more beneficial. Continuing Smith’s idea, David Ricardo formed the theory of “comparative advantage,” which is based not only on price factor and the regulation through it but also on the advantages of competing parties (in this case, countries) compared to other countries. This enables countries to search for alternatives for trade activities and consider the experience, specialization and other factors that will give a comparative advantage in competition.
The principles in Ricardo’s theory are similar to the model and ideas of the competitive behavior underlying the “game theory.” The “game theory” principles were first introduced by well-known Merrill Flood, Melvin Dresher and Albert Tucker. Later these ideas were practically defined by an American mathematician John Nash. He presented the idea of the formation of competition, considering not the strategy of individual subjects and their logic of action but the behavior of the market participants in the overall system. This theory is based on the following principle: “every participant acts considering the possible strategies of other participants.” A vivid example of Nash’s theory is “the prisoner’s dilemma,” according to which each participant chooses the optimal option based on the other participant’s possible steps and logic of acting.
Let us assume a competitive situation, where there are two companies, and each has two options for defining the price threshold – “high” and “low” prices. In this case, the following behaviors are possible: both companies set “high” prices, both companies set “low” prices, and two more options: one of them sets “high” prices, the other one – “low” prices.
| The second company: “high” prices | The second company: “low” prices | |
| The first company:“high” prices | The profit of each company is8 million.[ii] | The profit of the first company is 10 million, that of the second one is 1 million. |
| The first company:“low” prices | The profit of the first company is 1 million, that of the second one is 10 million. | The profit of each: company is 5 million. |
Suppose both companies act reasonably and take into consideration the other’s behavior. In that case, the following scenario will be the case: if the first company sets high prices, then the other one also benefits from charging high fees, but if the first company sets low prices, then in this case too, the other company will benefit from setting high prices. As a result, both companies should set a high price threshold to get maximum profit if acting reasonably in this competitive situation.
If, according to the logic of A. Smith’s theory, every subject acts for his interests and considers this option as an optimal solution, then, according to Nash, the decision-making process depends not only on one’s interests but also on the particular behavior of other participants. The latter is demonstrated in the model suggested by him.
Thus, according to Smith’s approach, the theory of competition and the logic of competitive decision making have an absolutely “self-centered” nature, while D. Ricardo’s approach is more inclusive and takes into account the competition progress and the participants’ behavior in the long term, as well as non-price factors of competition. In the case of Nash, the competitive struggle does not depend solely on the conditions evolved. It is not only the decisions of individual entities that are taken into account but also the impact of their decisions on each other.
References
[i] Adam Smith “An Inquiry into the Nature and Causes of the Wealth of Nations”
Chapter 2 “Of the principle which gives occasion to the Division of Labor” http://e-libra.ru/read/179321-.html
[ii] In this case, high prices from both companies can lead to the reduction of demand, thus decrease of profit.
Bibliography
- Adam Smith “Research on the nature and causes of the wealth of nations” http://e-libra.ru/read/179321-.html
- http://www.studfiles.ru/preview/6329014/
- http://fb.ru/article/199282/ravnovesie-po-neshu-teoriya-igr-dlya-ekonomistov-djon-nesh#image879206
- Martirosyan A. R. “Ricardo’s ‘theory of comparative advantage’ by defining the evolutionary priorities of economic thought.”
