This is part one in a three part guided reading of Friedrich Hayek’s classic paper, The Meaning of Competition. Let’s jump right into it:
There are signs of increasing awareness among economists that what they have been discussing in recent years under the name of “competition” is not the same thing as what is thus called in ordinary language…
If all this affected only the use of the word “competition,” it would not matter a great deal. But it seems almost as if economists by this peculiar use of language were deceiving themselves into the belief that, in discussing “competition,” they are saying something about the nature and significance of the process by which the state of affairs is brought about which they merely assume to exist. In fact, this moving force of economic life is left almost altogether undiscussed.
I do not wish to discuss here at any length the reasons which have led the theory of competition into this curious state. As I have suggested elsewhere in this volume,2the tautological method which is appropriate and indispensable for the analysis of individual action seems in this instance to have been illegitimately extended to problems in which we have to deal with a social process in which the decisions of many individuals influence one another and necessarily succeed one another in time.
Hayek more or less jumps to his conclusion at the beginning, that competition is a process of discovering information such as production methods and consumer taste, information that otherwise wouldn’t have been available with which to optimize, fully adjust plans, and settle into an equilibrium. We will return to this later.
Hayek then calls the analysis of individual action “tautological”. This is because the choice made by an individual depends on that individual’s subjective notion of “utility”. It is self-referential to the individual involved. It appears that this gives us a flexible enough account of individual action, because we can say the individual is seeking “more utility” subject to his cost constraints without really ever being able to explicitly model that with data.
It provides a deductive framework for making pattern predictions without ever being able to make point predictions about what the individual’s optimal course of action is. We on the outside cannot know, because we cannot measure subjective utility or the information available to that individual, even if we could know the resources available to him or her.
Hayek basically says taking this model of the individual and expanding it to cover society — a social welfare function — used to optimize social action was misguided. Let’s see why:
The economic calculus (or the Pure Logic of Choice) which deals with the first kind of problem [individual action] consist of an apparatus of classification of possible human attitudes and provides us with a technique for describing the interrelations of the different parts of a single plan. Its conclusions are implicit in its assumptions: the desires and the knowledge of the facts, which are assumed to be simultaneously present to a single mind, determine a unique solution. The relations discussed in this type of analysis are logical relations, concerned solely with the conclusions which follow for the mind of the planning individual from the given premises.
When we deal, however, with a situation in which a number of persons are attempting to work out their separate plans, we can no longer assume that the data are the same for all the planning minds.
The problem becomes one of how the “data” of the different individuals on which they base their plans are adjusted to the objective facts of their environment (which includes the actions of the other people).
Here is the fundamental problem. The information about production, distribution, tastes, technologies, and so forth are dispersed across all the people in the economy. The information each of them has is only a part of the whole picture. The information cannot be aggregated into a single mind, much like the subjective “utilities” of different people cannot be aggregated into a social welfare function. The problem Hayek identifies (and elaborates on in Uses of Knowledge in Society) is how the economic system can synthesize information beyond the comprehension of any individual.
One problem with aggregating information is that there is no common unit (e.g., “utils”). This is the problem of incommensurables. What complicates it further is that human desires and happiness is inarticulate. The information we know comes in all forms (explicit and implicit), about the location of raw materials, the process of battery production, the aircraft design lessons from turbulence, the next fad in clothing or entertainment. Relevant information necessary to decide upon alternative courses of action cannot be simply reduced to numbers sequences.
Each market participant has a different endowment of this special knowledge, even if it is just knowledge of time and place rather than engineering and tastes. That knowledge cannot be assumed to be aggregated through a database and analyzed to make optimal decisions. Only certain things, like the number of machine tools, the quantity of coal mined, the amount of shoes produced, only these simple figures can be aggregated. And they necessarily abstract from minor differences that matter big-time to decision-makers. There are many types of machine tools for specific purposes, there are various grades of coal, and there are many size and quality aspects to shoes.
Although in the solution of this type of problem we still must make use of our technique for rapidly working out the implications of a given set of data, we have now to deal not only with several separate sets of data of the different persons but also — and this is even more important — with a process which necessarily involves continuous changes in the data for the different individuals. As I have suggested before, the causal factor enters here in the form of the acquisition of new knowledge by the different individuals or of changes in their data brought about by the contacts between them.
The relevance of this for my present problem will appear when it is recalled that the modern theory of competition deals almost exclusively with a state of what is called “competitive equilibrium” in which it is assumed that the data for the different individuals are fully adjusted to each other, while the problem which requires explanation is the nature of the process by which the data are thus adjusted.
In other words, the description of competitive equilibrium does not even attempt to say that, if we find such and such conditions, such and such consequences will follow, but confines itself to defining conditions in which its conclusions are already implicitly contained and which may conceivably exist but of which it does not tell us how they can ever be brought about.
Or, to anticipate our main conclusion in a brief statement, competition is by its nature a dynamic process whose essential characteristics are assumed away by the assumptions underlying static analysis.
Hayek gets to the point. Even if information were dispersed across a large number of people, over time, the methods by which peoples tastes were satisfied at the lowest production cost would be equally known to all participants engaged. The information spreads and eventually everyone would work from a common set of knowledge. In this way, production will be optimized. No supplier can deviate from the optimal course or he will be undercut by another. In this way, we reach a static equilibrium.
Of course, information does not stay still. Hayek says there is near “continuous change” in the data — in the information set. Different people are constantly learning new and different things. The high-energy physics researcher is learning new information that is not known at all to the production-line engineer working on new methods to minimize defects. When we allow for new information — innovation — we cannot assume static knowledge about production possibilities and consumer tastes.
That the modern theory of competitive equilibrium assumes the situation to exist which a true explanation ought to account for as the effect of the competitive process is best shown by examining the familiar list of conditions found in any modern textbook. Most of these conditions, incidentally, not only underlie the analysis of “perfect” competition but are equally assumed in the discussion of the various “imperfect” or “monopolistic” markets, which throughout assume certain unrealistic “perfections.”3 For our immediate purpose, however, the theory of perfect competition will be the most instructive case to examine.
While different authors may state the list of essential conditions of perfect competition differently, the following is probably more than sufficiently comprehensive for our purpose, because, as we shall see, those conditions are not really independent of each other. According to the generally accepted view, perfect competition presupposes:
- A homogeneous commodity offered and demanded by a large number of relatively small sellers or buyers, none of whom expects to exercise by his action a perceptible influence on price.
- Free entry into the market and absence of other restraints on the movement of prices and resources.
- Complete knowledge of the relevant factors on the part of all participants in the market.
We shall not ask at this stage precisely for what these conditions are required or what is implied if they are assumed to be given. But we must inquire a little further about their meaning, and in this respect it is the third condition which is the critical and obscure one.
The standard can evidently not be perfect knowledge of everything affecting the market on the part of every person taking part in it. I shall here not go into the familiar paradox of the paralyzing effect really perfect knowledge and foresight would have on all action.4 It will be obvious also that nothing is solved when we assume everybody to know everything and that the real problem is rather how it can be brought about that as much of the available knowledge as possible is used.
Hayek focuses on the third assumption of perfect competition, that all participants have complete and identical knowledge. He references an Oskar Morgenstern paper when saying that if everyone had perfect knowledge and foresight, then there would be a familiar paradox. The paper was in German and wasn’t familiar to me. Here’s the reference. In it, Morgenstern considered Sherlock Holmes and Professor Moriarty:
Sherlock Holmes, pursued by his opponent, Moriarty, leaves for Dover. The train stops at a station on the way, and he alights there rather than travelling on to Dover. He has seen Moriarty at the railway station, recognizing that he is very clever, and expects that Moriarty will take a special faster train in order to catch him at Dover.
Holmes’ anticipation turns out to be correct. But what if Moriarty had been still more clever, had estimated Holmes’ mental abilities better and had foreseen his actions accordingly? Then obviously he would have travelled to the intermediate station. Holmes, again, would have had to calculate that, and he himself would have decided to go on to Dover. Whereupon Moriarty would have “reacted” differently.
Because of so much thinking they might not have been able to act at all or the intellectually weaker of the two would have surrendered to the other in the Victoria Station, since the whole fight would have become unnecessary. Examples of this kind can be drawn from everywhere. However, chess, strategy, etc. presuppose expert knowledge, which encumbers the example unnecessarily.
It seems that the problem Hayek pointed to was that if everyone knew everything, then they would all want to race first into a competitive market to earn the profits first before others crowded him out into a static equilibrium. But he also knows that everyone else knows where the markets are. It would appear that either everyone has already competed away the profits in every market already, or no one will act because once they do their profits will have been competed away so markets that everyone knows about remain open. Morgenstern concluded:
From the whole exposition, it follows that the assumption of perfect foresight is to be cut out from economic theory… it is clear that there must result variations of expectations — because of variations of one or more of these components — which in turn must show in the price structure and, consequently, in the productive structure.
That “variation of expectations”, which implies variation of information, was central to Hayek’s point about competition. If people’s expectations differ, and they can’t reference some great aggregater of information that holds the whole “truth,” then there’s no way to know whose expectations turn out to be right without trying them out and competing in the real sense. So who is picking the winners and losers? Hayek says it depends not on foresight but on institutions:
This raises for a competitive society the question, not how we can “find” the people who know best, but rather what institutional arrangements are necessary in order that the unknown persons who have knowledge specially suited to a particular task are most likely to be attracted to that task.
The way to bring out the special knowledge most likely to be correct is not through optimized talent evaluation — which for good reason has really gained steam in the last decade — but through institutional arrangements that allow for different evaluation schemes. This is perhaps reflected in how, for example, business were funded first through bank loans, and as the structure of production is changing from industrial to information, we see the institution shift toward venture capital style equity investments that better suits tech talent evaluation.
Back to the main theme, Hayek asks what kinds of information are assumed known in a perfectly competitive equilibrium:
But we must inquire a little further what sort of knowledge it is that is supposed to be in possession of the parties of the market.
If we consider the market for some kind of finished consumption goods and start with the position of its producers or sellers, we shall find, first, that they are assumed to know the lowest cost at which the commodity can be produced. Yet this knowledge, which is assumed to be given to begin with, is one of the main points where it is only through the process of competition that the facts will be discovered.
This appears to me one of the most important of the points where the starting point of the theory of competitive equilibrium assumes away the main task which only the process of competition can solve.
The position is somewhat similar with respect to the second point on which the producers are assumed to be fully informed: the wishes and desires of the consumers, including the kinds of goods and services which they demand and the prices they are willing to pay. These cannot properly be regarded as given facts but ought rather to be regarded as problems to be solved by the process of competition.
Hayek is reiterating the point that we cannot start by assuming everyone knows what will be produced and how. In reality, when you set up a production line, you don’t know at the outset what the prices will be that you need to recover your cost. And neither do you know what the prevailing prices of other producers will be, not to speak of knowledge of new product differentiation. This is information you learn along the way.
Hayek often speaks in generalizations or abstractions. But consider Mark Zuckerberg when creating Facebook — he didn’t realize until well into software development that he needed a relationship status feature. The way the movie the Social Network made it appear, he didn’t think up the feature until someone asked him whether a girl was single or not just moments before product launch. And it very well might be that the relationship status was the feature that put Facebook into the leading position when the iPhone came out (the natural platform for social media).
Hayek said the same thing is true of consumers. We didn’t know we wanted the relationship status feature until Facebook showed it to us. The same is true of many features and products, and it is often true that consumer surveys of what they think they want are way off the mark. For example, when people were asked about whether they wanted broadband internet with faster speeds, they said no, because they were thinking, “why do I need my email any faster?” They were not thinking about all the other services that could be enabled like streaming video.
Hayek explains:
The same situation exists on the side of the consumers or buyers. Again the knowledge they are supposed to possess in a state of competitive equilibrium cannot be legitimately assumed to be at their command before the process of competition starts. Their knowledge of the alternatives before them is the result of what happens on the market, of such activities as advertising, etc.; and the whole organization of the market serves mainly the need of spreading the information on which the buyer is to act.
Future conditions cannot be known perfectly. The market spreads information available to different people about current and future conditions. The information is reflected in the price. Because information is constantly changing and updating with new developments that affect the future, we cannot assume that the information available today is that which will be relevant tomorrow.
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That’s it for part one. Check back in a couple days for updates with parts two and three.
“If I had asked customers what they wanted, they’d have said a faster horse.” – Henry Ford