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."

Austrian Economics Forum Fall '11 #3--Competition and Monopoly

This week’s forum focused on the third chapter “Competition and Monopoly” in Kirzner’s book.  Much of the chapter was not controversial to an Austrian audience and so there wasn’t the sort of discussion surrounding it as one might expect with a larger mix of mainstream economists.

In traditional theory, economists envision a continuum in which we place “perfect competition” on one end and “monopoly” on the other.  This method of organizing our thoughts says that the most important aspect of markets is the number of firms.  On the monopoly end, there is one firm, while on the other end there are so many firms that they all face horizontal demand curves.  (As an aside, we really need to get rid of the term “perfect competition” and replace it with “perfect equilibrium,” because there is no competition in that model. It’s an equilibrium-only model.)

Kirzner completely rejects this approach to defining competitive markets.  He wants to use “competition” in the same manner that the average person uses it: as a rivalrous process.  Competition describes actions.  It is a verb.  The mainstream uses competition to describe states of markets.  It is a noun.  The result is that the mainstream cannot communicate to laymen, which Kirzner says has been a “disservice.”

With competition defined as a process, we can then apply it to the entrepreneur.  When the entrepreneur recognizes a market opportunity, he is able to act.  He applies means to achieve ends.  If others wish to use those same means, a rivalry emerges.  In a market, a bidding process arises and the one who outbids the marginal rival is able to employ those means.  It is this process that coordinates the economy.  The move toward equilibrium is an unintended consequence.  The mainstream lacks this function in that the Robbinsian maximizer does not compete.  Kirzner states

Purely Robbinsian economizing activity is never competitive; purely entrepreneurial activity always is.  In other words, I am asserting, that entrepreneurship and competitiveness are two sides of the same coin: that entrepreneurial activity is always competitive and that competitive activity is always entrepreneurial (rather than Robbinsian). (p 94)

The Robbinsian maximizer merely chooses the course according to a given framework and a given set of economic relationships.  In contrast the Kirznerian entrepreneur looks at the unseen and chooses based upon some factors that may be hidden or absent.  The entrepreneur strives for profits and does so by out-competing his rivals.  The “pure Robbinsian decision-maker is not seeking to outdistance his rivals—he is not intent on learning what opportunities they are about to available to the market in order to attempt to make available still more attractive opportunities.” (p 95)

Later (p 108) Kirzner states, “As soon as we draw the cost and revenue curves facing the firm, no matter what their shape, we have created a theoretical case in which all competitive behavior has by definition been ruled out.  What is left is neither competitive nor monopolistic (in the process sense), but a problem in allocation.”  This means that as soon as we assume the structure of the cost curves or the type of demand curves, we have transitioned away from anything competitive and entered into the world of the Robbinsian maximizer.  I think that this analysis goes too far.  In one sense I see exactly what Kirzner is attempting to draw attention to, however I do not see why a sufficiently generic supply and demand graph has to be that way.  If we follow Kirzner, then even imagining curves sends us into the maximizing world.  I think that an economist can look at a static graph and recognize that it is an imperfect representation of a dynamic process.

Kirzner then examines how competition can be limited.  “[F]or us to speak freely of a lack of competitiveness in a market process, we must be able to point to something which prevents market participants from competing. … What is it, …, which might halt the competitive process? … Competition, …, is at least potentially present so long as there exist no arbitrary impediments to entry.” (p 97)  As we can tell, there are several reservations and qualifications in his definition.  Furthermore, we doesn’t define the areas of monopoly in a positive sense, e.g., “you’ll know monopoly when….”  Instead, he defines a potential absence of competition in a negative sense and assumes that the result is monopoly.  Personally, I do not like this approach.  It seems that there is too much hedging.  Is there a reason to be overly cautious?  I do not know.

Later on (p 99), Kirzner gives us a better definition: “When we assert that purely entrepreneurial activity is always competitive, we are then asserting that with respect to purely entrepreneurial activity no possible obstacles to freedom of entry can exist.  We can see this by recalling that purely entrepreneurial activity involves no element of resource ownership. … [B]lockage of entry into a particular activity must arise from restricted access to the resources needed for that activity. … All imaginable obstacles to entry can be reduced, in basic terms, to restricted access to resources.”

To summarize Kirzner’s position, the pure entrepreneur is a metaphysical concept.  It is simply the recognition of a profit opportunity.  There is no way that we can stop a person from recognizing an opportunity.  As a result, all entrepreneurship is competitive and short of direct brain control, it is impossible to curtail this recognition.  Thus, all anti-competitive restrictions have to occur on the level of access to resources.  The restriction of access to resources is a decrease in competition.  A complete restriction is a monopoly.

We talked about the implications of these concepts.  There arise two types of monopolies: one created by a government action and one created through the sole ownership of a resource. While we agreed with the first, the group debated the second concept.

As an aside, it arose that private property is a legal restriction to the access of resources.  I therefore have a monopoly over my car.  While Kirzner does argue that monopoly “diverts the entrepreneurial-competitive process into” other markets, I know that he would not argue that we should abolish private property. (p 107)  Kirzner states, “For us monopoly means the position of a producer who is immune from the threat of other entrepreneurs’ doing what he does.” (p 106)  However, it seems that for Kirzner, monopoly is not necessarily a bad thing.  I suspect that he will cover this in more detail later in the book.

Mises argues that intervention in the market distorts the market.  When the government buys pencils, it is not disrupting the normal market process and thus this is merely a shifting in supply and demand curves.  When the government imposes rules that prevent the market from doing its job, we have permanent discoordination.  For example, a maximum price set below the market price will create a permanent shortage.  I see Kirzner using the same logic in the background of his analysis.  When a monopoly exists due to legal barriers, we see the market unable to perform its job and this is bad.  If there is a monopoly that arises from ownership, then the market curves shift and the market adjusts.

The next item that we discussed was the idea of monopoly rent.  This is the return that a monopolist gains because he is a monopolist.  It is an addition to the return on the other factors of production, in which we are including entrepreneurial profit.  We found it difficult to separate these rents from the concept of entrepreneurial profit.  Luckily, Kirzner does not use it in his welfare appraisal of the monopoly.  Instead, he uses “the speed and smoothness with which misallocations can be discovered and corrected” (p 112) as his basis of comparison.  This definition directly parallels Mises’ definition on interventionism, where the focus (for monopoly) is directed to the obstacle to entry.

We then touched on some relatively random points.  We found them thought provoking and interesting enough to comment on.

Kirzner states, “for our notion of monopoly the shape of the demand curve facing the firm is of little significance. … [T]he significance of monopoly does not relate to the theory of the firm at all. (It is because of this that the shape of the demand curve is irrelevant.)” (p 108)  The importance of this comment is that the mainstream focuses on the firm (and the industry) and the consequent shape of the curves that the firms face.  Austrians have long rejected this static view of Industrial Organization.  Instead, we focus on the competitive process, on the action, on the verb.

Kirzner has a discussion on Monopolistic Competition, in which we basically throw the concept out.  In characteristic Kirzner fashion he cannot make a strong, direct statement and instead says, “The position developed thus far in this book makes it impossible for me to accept this approving judgment on the theory of monopolistic competition.” (p 113)  More directly he states, “the theory of monopolistic competition was on balance a decidedly unfortunate episode in the history of modern economic thought.” (p 114)  The problem was, of course, the fact that when it threw out the old perfect competition model, it left out the competition (in the Austrian sense).

Kirzner then has a nice discussion (pp 115-117) on how only in disequilibrium does product differentiation exists.  There is no reason to change product quality in a world of equilibrium.

Kirzner then delivers the one-two punch to monopolistic competition:

Thus far my criticism of the monopolistic competition view of the market has charged it (a) with overlooking the simplest available explanation of such phenomena as product differentiation …, and (b) with gratuitously advancing an alternative explanation ascribing these phenomena to the presence of monopolistic elements. … The explanation provided by the theory of monopolistic competition not only fails to recognize the disequilibrium character of the phenomena it seeks to explain, it fails even as an equilibrium theory. (p 117)

Nice.

Finally Kirzner compares his concept of the entrepreneur with that of Schumpeter’s concept. They both reject the model of perfect competition.  Schumpeter does so on the grounds that entrepreneurs are disruptive to all equilibria.  They create something new which then explodes all the old economic relationships.  Kirzner does not deny that this occurs, but is merely a subset of his “alertness to hitherto unnoticed opportunities.”  The difference then rests on Kirzner’s emphasis.  He says that the primary function of the entrepreneur is to coordinate resources, the result of which is the movement towards equilibrium.  For Schumpeter, the coordination process is secondary and mundane.

The next meeting has been changed. Instead of meeting in 2 weeks (October 14th), it will convene in 3 (October 21st).  This development is unfortunate for me since that is the day that we have scheduled the trip to the hospital for the new (girl) baby’s arrival.  Since the surgery is scheduled for the morning, in theory I could make it to the afternoon meeting. (Yeah, right!)  So I will try to recruit someone to write up a summary for that session.  We’ll see.

Austrian Economics Forum Fall '11 #1--Competition & Entrepreneurship

We have finally kicked-off the new semester of the Austrian Economics Forum at NCSU.  About a dozen of us decided that the best thing to do at 4:30pm on a Friday afternoon was discuss Austrian Economics.  (I know that this is not normal behavior, but I still find that I have an overwhelming need to be there.)

We are reading Israel Kirzner's Competition and Entrepreneurship (1973).  There are six sessions scheduled for this semester and there are six chapters.  (That was just fortunate.)  The first chapter "Market Process versus Market Equilibrium" was this week's focus.  I found that I needed to remind myself several times that this is only the introductory chapter.  There are a number of points that need further clarification and refinement, but Kirzner doesn't (and shouldn't) go into an in depth explanation in the introductory chapter. 

The next point that I needed to remind myself was who the target audience was for Kizner.  Professor Cordato gave a brief overview of the state of the profession in 1973.  This was a time when General Equilibrium (price) theory reigned supreme and that all firms were either perfectly or imperfectly competitive.  So the target of this book is not me.  I was "raised" Austrian.  I was taught from the beginning competition is a verb and not a noun.  The target of the book is obviously not those professors who are locked into their ways.  Then who is the target?  My guess is that the targets are graduate students in economics.  They are still forming their opinions on which school is correct and will be more open-minded about the different approaches.

Kirzner sees the profession completely focused on equilibrium.  The dominant view is that we should be in equilibrium and, if reality differs from it, then there is an imperfection that needs to be studied and corrected (usually by government).  Kirzner suggests that there is an alternative.  Competition should not be studied as a state of being, for example, "the XYZ Market is in a state of perfect competition."  Rather the normal, vernacular, usage of "competition" as a rivalrous process should be adopted.  Competition is a verb and not a state of being.  Therefore, equilibrium, while an important tool, should not be the focus of the economist.  Instead the questions of "Why is there a change in prices?" and "What are the forces behind the price changes?" should dominate the economist's thinking.

Economists too often use phrases such as "market forces" to describe the market process.  "Market Forces" move the market to equilibrium.  Professor Margolis challenged the group by asking us to describe exactly what we mean by "market forces"?  He stated that we all like to tell a story that illustrates an example of market forces, but we tend to leave "market forces" as a fuzzy concept.  My thoughts are that it is shorthand for explaining how individuals have some sort of "felt uneasiness" (to use Mises' phrase) and think about how they can replace that state for a better one.  Then they act.  Within this analysis we are implicitly assuming time and ignorance (to use the title from Rizzo and O'Driscoll's book).

As buyers and sellers enter into the market they bring with them knowledge.  As the desires of the buyers confront scarcity, a price is generated and ignorance is lessened.  It is in this step-by-step manner that the market will equilibrate.  Contained in this notion is an implicit ceteris paribus assumption.  We need to realize that tastes, preferences, expectations, etc. need to be held constant.  When we (economists using this thought experiment) start to relax the ceteris paribus assumption, we are allowing supply and demand to change and thus equilibrium prices and quantities change.  Despite the fact that the equilibrium point (intersection of supply and demand curves) changes, the market forces are chasing that point around.  So while equilibrium is an important theoretical concept, we might never, ever be in equilibrium.  The important concept to focus on is that competition is always driving us toward equilibrium.

These driving forces then require the interaction of individuals with limited knowledge.  They require that this process takes time, meaning that we do not simply jump from equilibrium point to equilibrium point.  Finally, this is not an automatic or mechanical process; it requires actual people to move the market.  That person is called the entrepreneur. 

The Kirznerian pure entrepreneur is an ideal type.  This archetype has no physicality.  It is an observation of a profit opportunity.  This construction is fairly controversial within Austrian circles.  To me it seems strange to push it this far.  Without physicality, there is no action and it then falls outside of praxeology and is therefore not a market force.  (It is at this point I need to remind myself that this is the introductory chapter and there is a whole book to follow.) 

We argued about the implications of the pure entrepreneur.  A traditional manner of characterizing the Kirznerian entrepreneur is someone stumbles across money lying on the ground.  (If this is the case, then my son is a Kirznerian entrepreneur because he found 12-cents on the ground today!)  However, the act of picking up the money is a physical act and thus is not a pure entrepreneur.  After much discussion, the consensus of the group was that the pure entrepreneur is an observer and accumulates knowledge.  The action is separate and distinct.  An interesting question was raised and so I'll throw it out to you to ponder and comment...  "Is an entrepreneur only a person who finds Pareto Superior moves?"

The last issue that we discussed was the point on resource monopoly.  While he defines most monopolies are a "barrier to entry" problem, Kirzner argues that resource monopolies are "very real and significant."  In other words, a single owner of a resource can be a monopolist and this has consequences that are "very real and significant."  I disagree.  Rothbard disagrees.  In fact most of the people in the room disagreed.  (Some didn't vocalize one way or another, which was fine.)  We thought about who else (Austrian) thinks that a single resource owner is a real and significant problem, and the only one that anyone could think of is Sandy Ikeda, at SUNY - Purchase.  I like Sandy and he is usually fairly solid in his economics so I will have to ask him about this point.  Furthermore, this is still just the first chapter and there is a whole chapter on monopolies coming up and so we will see how "real and significant" this problem really is.

Unfortunately, we ran out of time and closed the meeting there.  If you are reading along (or even if you aren't) please feel free to post your comments and continue the discussion.

Austrian Economics Forum Spring 2011 #5--Intro. to Austrian Monopoly Theory

The final session of our Austrian Economics Forum took place at Dr. Cordato's house.  He and his wife, Dr. Karen Palasek, made a really nice dinner for us, but the ground rules were that we had to talk economics before anything else.  (Were they afraid we wouldn't talk economics while eating?  Clearly an unfounded fear!)

This session's reading was "A Critique of Neoclassical and Austrian Monopoly Theory" by Dominic Armentano, found here http://oll.libertyfund.org/title/106/6041.  This is a chapter in the book New Directions in Austrian Economics edited by Louis Spadaro (1978).

The Armentano reading was a straight forward, introductory article to monopoly theory from an Austrian perspective.  Cordato added several personal comments about Armentano.  The one anecdote that struck me was that Armentano had formulated much of his criticism of the Neo-Classical Monopoly Theory long before he became (or even really studied) Austrian(ism).

The major, traditional Austrian criticism of standard Monopoly Theory rests upon the definition of the market.  Monopolies are defined as a single seller without any close substitutes.  However according to Austrian theory, a substitute can only be defined in the mind of the user of the goods.  When Saran Wrap first came out there was nothing else like it.  So were there any substitutes?  Actually yes, there were many because the relevant market was "What can I put my sandwich in so I can take it to school/work?"  The substitutes were wax paper, tin foil, aluminum foil, paper bags or even Tupperware.  None of them look like Saran Wrap, but they are all substitutes.  Or an example I use in my class is that helicopters and closed-circuit cameras are substitutes.  Of course, physically they are nothing alike.  However, if we are trying to learn about traffic congestion during our morning commute, then they are substitutes.

Furthermore when it comes to defining the market, we can define it in such a way that we are all monopolists.  I am the only one who supplies my labor.  Or if we broaden the definition, then there is no such thing as a monopolist. 

At the end of our abbreviated discussion (we were hungry), we agreed that the Rothbardian definition of monopoly was the best.  Rothbard uses the old definition of a government created monopoly privilege.  If there is a law, legal restriction, etc. that forcibly prevents others from competing, then that is a monopoly.  Otherwise, there is no monopoly.  There are two objections to this.  The first is a natural resource monopoly.  I find this problematic.  If there was such a monopoly, as soon as it sells some to anyone else, there arises a potential competitor.  From this point we start to get into some rather strangely concocted hypothetical situations.  "Suppose under the following circumstances...blah, blah, blah."  If we need to resort to such narrow assumptions, then we are not really describing the world around us and have started to play mental games.  There's nothing wrong with mental games.  In fact most of the leading economic journals are full of such things.  Just please don't waste my time on them.

The second objection is that of a natural market monpoly where a firm is so good at what it does, no other firm can compete.  To which I ask, "What's the problem with that?"  From a consumer's point of view this is great!  They offer better prices, better quality, better locations, better service, etc.  On every single vector of competition, this firm is better.  If it lags in any one of these areas, then a niche market can arise. 

Neo-Classical economic theory relies far too much on counting the number of firms that are competing.  To them "competition" is a state of being.  It is a noun.  Austrian Theory rejects this view and says that competition is a rivalrous process.  The only way that relative scarcities (prices) can be discovered and determined is through competition--real competition.  It only takes one producer and an open market for there to be competition.  The supposed monopolist must compete against potential competitors, otherwise, they will soon appear.  Leonard Read once said that trying to stop competition in a free market is like standing in a river with a broom, trying to sweep the water away.  For an instant, the water is brushed aside, but then it comes rushing back in.

Austrians view competition differently.  We view it in the same way that sports teams do.  In order to know the outcome, we need to play the game.  This is why Austrian Economics has been gaining so much attention in other business fields like Strategic Management.

Cordato is hoping that the next semester (Fall) will follow the course of more Microeconomic stuff.  I'm thinking that we should look at Mises's Theory of Money and Credit so that we can finish it in 2012, the 100th anniversary of its publication.  I don't know the direction, but I am sure that it will be a fun ride.