Wednesday, March 2, 2016

AEF Spring 2016 #1--Hayek's "The Meaning of Competition"

For the spring semester at NC State University, we decided to continue to look at some of the more foundational articles in Austrian Economics.  One of the more famous is F.A. Hayek's "The Meaning of Competition."  It was originally presented as a lecture at Princeton University on May 20, 1946.

Our session took place on January 29, 2016.  It was attended by several graduate and undergraduate students.  Roy Cordato and I (Paul Cwik) were the hosts.  Cordato presented the article this week and outlined four major points in Hayek's article.

  1. There are major conceptual flaws in the model of Perfect Competition (PC).
  2. The use of Perfect Competition (PC) as a Normative Benchmark is misleading and dangerous.
  3. Hayek presents a proper role in which to view competition.
  4. Hayek creates a brief outline of the Austrian Theory of Monopoly.
Let's take a closer look at each.

The major conceptual flaws in the PC model begin with the assumption of Perfect Knowledge.  By making the assumption of perfect knowledge, the economist is essentially assuming away the problem.  In fact with the assumption of perfect knowledge the entire need for competitive behavior disappears.  It is the absence of competitive activities.  Why?  It is simply due to the fact that all of the supply curves (cost curves) and demand curves are fully known.  If all of the curves are known then the problem is one of simply grinding through a mechanical process.  The problem reduces to "given these two lines, please compute where they cross."  Austrians define "competition," which we will see in Point #3 below, as a rivalrous process.  Furthermore, the question of how the market actually works in the real world is never really investigated.  The perfectly competitive model is a static (no time) and competition is a sequential series of equations to be solved.

The second point that Cordato presented was using the PC model as a benchmark.  The PC model was originally designed to be a tool to show a sequence of cause and effect.  For example, suppose that a firm or an industry was using steel as an input.  If we see that the price of steel rises, what will the effects of this change have on the industry?  The PC model does a good job of tracing out the cause and effects of this question.  Unfortunately, the tool has become the entire toolbox.  It was originally supposed to look at very narrow questions.  However if you walk into a mainstream International Trade class, one of the very first assumptions that is made is to assume perfect competition.  This assumption is the beginning of the building of the Heckscher-Ohlin model.  (I just pulled my old International Trade textbook off my shelf and it literally says, "First, we assume that perfect competition prevails in both output and factor markets."  When every model starts with the PC model, it creates a false standard.  On one end of the spectrum is perfect competition and on the other end is monopoly.  Everyone knows that monopoly is bad and so the thing on the other end must be good.  What's that thing?  Why it is nothing less than perfect competition.  And if we even look at the name, we know that it is something to desire--it's even called PERFECT.  What's not to like?

Actually, there is a lot not to like about using the PC model as the benchmark.  The rules and regulations that government policies create set the PC model as the goal.  This goal setting is misleading and dangerous.  Let's take a look at a simple example.  In the PC model, there are many, many sellers.  In fact there are so many that not a single one of them can influence or affect the price; they are "price takers."  If a company is larger than simply being a mere price taker, then to get us closer to perfect competition, the government needs to intervene and make it smaller.  Think of how silly this standard truly is.  When I go to work I drive past two gas stations and one's price is a penny lower than the other.  Clearly, one of them is not a price taker.  So they are too big!  When I look for used DVDs, I see that there are several prices.  Clearly these sellers are also not price takers.  The idea of setting "price taking" as a goal is confusing an assumption of the PC model with an outcome.

The third point that Cordato brought up was on how we should look at competition.  Competition is a rivalrous process.  Why do sports teams play the game?  They do so because regardless of what the teams looks like on paper, any one team can beat another team on a given day.  Furthermore, how many are needed to have competition?  When I ask my students this question, most will say at least two.  However, I ask how many run or swim.  I then ask if they ever keep time.  Why would they do that?  With whom are they competing?  They are competing with themselves.  The minimum number needed for competition is one.  Even if you are the only producer in a market, there are always potential rivals.  Leonard Read once said that getting rid of competition was like standing in a stream with a broom trying to sweep the water away.  With one stroke, the water is gone for a moment, but then it comes rushing back in.  To be a natural monopolist, it means that one must out compete everyone else on every single vector of competition there can be.  That means one must have better prices, better quality, better hours, better location, better customer service, and so forth.  It must be better in absolutely everything.  If one area slips, say customer service, then that opens the door for a niche competitor to get into the market.  And besides, how would a customer view such a monopoly? If it has better everything, then consumers would be very happy.  However, the PC model says that only small price taking companies are good for customers.  How counter-intuitive!  In the real world, the companies that please the customers by doing a better job grow larger.

Hayek says that competition is the mechanism that allows entrepreneurs to acquire the knowledge that the PC model assumes to be known.  Competition tells us who will serve us well.  It is a "Discovery Process."

Finally, Hayek presents an Austrian Theory of Monopoly.  Cordato was surprised at how well Hayek and Rothbard line up on this point.  For them, the only barrier is government.  In contrast to this point are Mises and Kirzner.  They allow for the possibility of a resource monopoly.  While this might seem to be a minor technical point that never occurs in the real world (and it truly is), it is one of the few instances where Rothbard and Hayek are not on the same side as Mises.

And finally, finally, we do have fun in these sessions.  One of the fun things that arose (at least to a geeky economist such as myself) was this turn of phrase:

Private Sector:
"Where there's a problem, that's where the money is."

Public Sector:
"Where there's money, that's where the problem is."


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