This paper attempts to provide a critical theoretical perspective on the effects of competition on universities, using historical data pertaining to the American higher education system as the main empirical base. Through archival research and a synthesis of critical findings in recent secondary literature, it attempts a long-term historical analysis and theoretical modeling to produce a typological understanding of the effects of competition on universities. It argues that competition does not necessarily have the same effects on universities as on business corporations, and can in fact lead to surprising, even paradoxical results. Namely, the alleged virtues of competition such as encouraging innovative spirit and a large variety of services offered applies to the higher education industry only to a limited extent. This is because, the paper explains, when the main object of competition is prestige, as in the case of the higher education industry, institutions avoid risky experiments that could jeopardize their prestige and tend to imitate more successful institutions, which results in institutional convergence, rather than a divergence in services offered. The paper goes on to argue that while numerous countries around the world have in recent years focused on making universities “competitive”, this world-wide trend in higher education reforms—often pursued as a matter of higher priority for the development of the knowledge economy—is based on flawed assumptions. Building on the theoretical discussion, the paper finally attempts to analyze some of the specific problems which have become prominent in recent higher education reforms.