The main purpose of competition among firms is to gain market share. But depending on whether the competition is price-based or innovation-based, the economic implications are very different.
Price-based competition usually involves mature products in a saturated market.
Since there are no new features to attract customers, the only way to gain or maintain market share is to undercut or match the price of competitors. The number of competitors depends on the capital requirement. When the capital requirement is small, there are a lot of small firms (perfect competition). And when the capital requirement is big, there are a few large firms (oligopoly).
When price-based competition is accompanied by single-pricing, most of the economic surplus1 goes to consumers as consumer surplus. The zero-profit firms have little resources to innovate or to maintain service quality. Surprisingly, this state of market entropy is regarded as the model of market efficiency in conventional economic theory because price of the last unit sold is close to or equal to marginal cost.
But this kind of market efficiency is at best static. The economy will stagnate if the market trades only mature products. A dynamic economy requires innovative products that change the competitive landscape. Innovation-based product competition introduces dynamic market efficiency.
Innovative products command premium prices for early adopters and capture most of the economic surplus in the form of profit. But prices will be lowered successively over the product cycle to attract more customers with less urgent needs as most of the R & D costs have been paid for by the early adopters. By practicing such longitudinal price discrimination, the successful firm can use the captured economic surplus to improve the products and come up with additional innovative products. Such innovations may be encouraged by temporary patent protection to slow down copycats.
Some major innovations may destroy or marginalize entire categories of old products. But because old needs are better satisfied and latent needs are now satisfied by innovative products, consumer welfare as a whole is improved. To decry the temporary monopoly conferred on innovative products as statically inefficient is to deny the dynamic role played by innovative products.
As the innovative products mature, entry of competitors will usher in a period of price-based competition where most of the economic surplus will be shared with the consumers.
Within innovation-based competition, there is a whole range of strategies to prolong the dominance of the innovative products. For example, there is the fight for standards and brand dominance, the lock-in effect of networked products, and the extension of market dominance in one product to complementary products, and the gradual introduction of upgrade features to already acceptable products, etc.
- Economic surplus is the difference between the reservation price (highest price one is willing to pay) and the marginal cost of a good.