I don't know. I've reported shops of people I know personally who are reselling, as well as other shops where I can give them a link to alibaba.com
where there are factories offering the same products, and it still doesn't stop them. There's even someone selling basically an Apple accessory, something he could never make on his own without highly specialized equipment, and I even linked my report to his kickstarter where he talks about them being manufactured, and he's still on.
So how does Etsy control it? I don't think they really do. How to compete? There are plenty of people out there who value handmade. Find them. Because they are going to be angry if they buy something and find out it's factory-made, and you will be there to get them what they really wanted. :D