This is part two in a three part guided reading of Friedrich Hayek’s classic paper, The Meaning of Competition. I recommend reading part one before jumping into this post, but it isn’t necessary. Here’s Hayek picking up again:
The peculiar nature of the assumptions from which the theory of competitive equilibrium starts stands out very clearly if we ask which of the activities that are commonly designated by the verb “to compete” would still be possible if those conditions were all satisfied.
Perhaps it is worth recalling that, according to Dr. Johnson, competition is “the action of endeavouring to gain what another endeavours to gain at the same time.”
Now, how many of the devices adopted in ordinary life to that end would still be open to a seller in a market in which so-called “perfect competition” prevails? I believe that the answer is exactly none.
Advertising, undercutting, and improving (“differentiating”) the goods or services produced are all excluded by definition — “perfect” competition means indeed the absence of all competitive activities.
Hayek now addresses the assumption of product homogeneity. In economic theory of perfect competition, the actors have complete information about a single product.
This concept could make sense. You might consider competition only relevant if, for example, the players are competing in the same sport, like basketball. If someone else starts playing volleyball on the court, well, they aren’t really competing.
Yet the sports analogy is idealistic. The market has no clear boundaries between different products. They all compete against one another in some way. Products always have complements and substitutes. There is always more than one way to skin a cat.
In other words, the market is a single uninterrupted whole. It has stronger and weaker pathways throughout the network, but all elements compete against each other whether directly or indirectly, even if only because dollars spent on one product can’t be spent on another. All firms compete for revenues.
This is also true in “perfect” competition, but there firms compete for revenues more narrowly — revenues from a single commodity where no new information can be learned. Yet the whole point of economic progress is creating new products and services. The whole difficulty of weapon systems choice is deciding what the technology will be and how it should be used. This information isn’t available before-the-fact.
Especially remarkable in this connection is the explicit and complete exclusion from the theory of perfect competition of all personal relationships existing between the parties.5 In actual life the fact that our inadequate knowledge of the available commodities or services is made up for by our experience with the persons or firms supplying them — that competition is in a large measure competition for reputation or good will — is one of the most important facts which enables us to solve our daily problems.
The function of competition is here precisely to teach us who will serve us well: which grocer or travel agency, which department store or hotel, which doctor or solicitor, we can expect to provide the most satisfactory solution for whatever particular personal problem we may have to face.
I find this to be one of the most profound points of Hayek’s paper. When uncertainty is great, and the desired product is something new — it solves new problems and gives us a new advantage — then we cannot rely on market prices. The price simply doesn’t exist. The information about technical feasibility (e.g., does the ship design float) and economic feasibility (e.g., a ship built out of platinum is technically feasible, but perhaps not economically so), these types of information are not yet available to anyone.
Even if the product or service is simpler, but there is just a huge variety of substitutes and other considerations out there — or if you cannot determine the quality up front (e.g., lemons problem of used cars) — then what do you do? You cannot rely on price information. You could try to obtain detailed contract plans about production costs and engineering schematics to compare the various alternative choices. But even if you could get quantitative support and evaluate it correctly — something the DOD likes to think it can do — it takes a great deal of time and effort, dramatically increasing transaction costs.
So trust based on reputation is also market information, not just prices. Reputation saves a great deal on transaction costs because if one side gets cheated, that information spreads quickly. The cheater losses business not just from the cheated, but may also be ostracized from the market completely. Trust has the added benefit of integrating not just explicit knowledge in production costs and schematics, but in tacit knowledge about what ideas could be revolutionary; about alternative uses; about future business opportunities and network communication.
Hayek finds competition for reputation is one of the factors leading to product differentiation and improvement. There is a benefit to the firm if consumers have a high opinion about their ability to provide new and innovative designs. And it is from that differentiation that we have a kaleidoscope of overlapping products and services that mean firms always find themselves in competition when viewed through one lens or another.
Evidently in all these fields competition may be very intense, just because the services of the different persons or firms will never be exactly alike, and it will be owing to this competition that we are in a position to be served as well as we are.
The reasons competition in this field is described as imperfect have indeed nothing to do with the competitive character of the activities of these people; it lies in the nature of the commodities or services themselves. If no two doctors are perfectly alike, this does not mean that the competition between them is less intense but merely that any degree of competition between them will not produce exactly those results which it would if their services were exactly alike.
This is not a purely verbal point. The talk about the defects or competition when we are in fact talking about the necessary difference between commodities and services conceals a very real confusion and leads on occasion to absurd conclusions.
While on a first glance the assumption concerning the perfect knowledge possessed by the parties may seem the most startling and artificial of all those on which the theory of perfect competition is based, it may in fact be no more than a consequence of, and in part even justified by, another of the presuppositions on which it is founded.
Basically, perfect information presupposes a single, homogeneous, product. Otherwise, how could information stand still in an otherwise dynamic environment where classes of products are continually growing and changing? Hayek explains:
If, indeed, we start by assuming that a large number of people are producing the same commodity and command the same objective facilities and opportunities for doing so, then indeed it might be made plausible (although this has, to my knowledge, never been attempted) that they will in time all be led to know most of the facts relevant for judging the market of that commodity. Not only will each producer by his experience learn the same facts as every other but also he will thus come to know what his fellows know and in consequence the elasticity of the demand for his own product.
The condition where different manufacturers produce the identical product under identical conditions is in fact the most favorable for producing that state of knowledge among them which perfect competition requires. Perhaps this means no more than that the commodities can be identical in the sense in which it is alone relevant for our understanding human action only if people hold the same views about them, although it should also be possible to state a set of physical conditions which is favorable to all those who are concerned with a set of closely interrelated activities learning the facts relevant for their decisions.
Like the physicist, the economist likes to think in terms of equilibrium. Yes, when firms first start producing a homogeneous commodity, there will be a period of transition and supply and demand equilibrate. But it quickly settles into a static equilibrium where there is no more change. If a firm tries to sell at a higher price, then consumers wouldn’t bite. Firms cannot sell at lower prices, because the most efficient means of producing the commodity is known. A lower price can only be attained through production innovation, which was strictly excluded in the assumptions.
But in reality, there are numerous overlapping markets which are always in disequilibrium. Sure, there is a tendency toward equilibrium, and in the very long run, we might get there. But all that is interesting in the world comes from dynamics adjustments to changing equillibrium conditions, pushing forces of supply and demand in non-deterministic ways.
By the way, it turns out that equilibrium conditions are not so interesting in physics either. Entropy is inherently a transient phenomenon, but it is entropy (and “negative” entropy) that gives our planet its structure and conditions for life. (See Ilya Prigogine.)
Hayek returns to the absurd concept of a homogeneous commodity.
However that be, it will be clear that the facts will not always be as favorable to this result as they are when many people are at least in a position to produce the same article. The conception of the economic system as divisible into distinct markets for separate commodities is after all very largely the product of the imagination of the economist and certainly is not the rule in the field of manufacture and of personal services, to which the discussion about competition so largely refers.
In fact, it need hardly be said, no products of two producers are ever exactly alike, even if it were only because, as they leave his plant, they must be at different places. These differences are part of the facts which create our economic problem, and it is little help to answer it on the assumption that they are absent.
The belief in the advantages of perfect competition frequently leads enthusiasts even to argue that a more advantageous use of resources would be achieved if the existing variety of products were reduced by compulsory standardization.
Now, there is undoubtedly much to be said in many fields for assisting standardization by agreed recommendations or standards which are to apply unless different requirements are explicitly stipulated in contracts. But this is something very different from the demands of those who believe that the variety of people’s tastes should be disregarded and the constant experimentation with improvements should be suppressed in order to obtain the advantages of perfect competition.
It would clearly not be an improvement to build all houses exactly alike in order to create a perfect market for houses, and the same is true of most other fields where differences between the individual products prevent competition from ever being perfect.
This is an extremely relevant point to weapon systems. Congress loves joint programs because of “economy of scale” considerations: If the system performs several missions for different customers, the price can come down lower and lower due to “learning by doing” and “production rate” effects. Basically, the Costco idea that if you buy in bulk the item is cheaper.
This is one kind of standardization. It also leads to the idea that you will not just have one R&D program leading to a standardized production line. It will also give standardized maintenance and repair procedures, leading to even lower costs during the most expensive phase.
Now, from a weapon system point of view, a single design means that it will be easier for an enemy to countermeasure. Resilience of force structure depends on many various designs that provide insurance in case one or another gets countered.
But Hayek argues that standardization to get “perfect competition” results is a bad idea even in consumer products. Just like the military, which has a huge number of potential missions and environments, consumers have a huge number of tastes. If a firm tried to take advantage of economies of scale by focusing on one design, then it opens up huge opportunities for other firms to exploit all the needs that were necessarily neglected in the single design.
Just because perfect competition achieves its efficiency when there is a high degree of standardization doesn’t mean that the world that humans actually operate in becomes any less complex. The world is not so simple as to have all its needs fulfilled by singular objects. There will inevitably be a huge continuum of goods and services that can solve new and unique problems.
We shall probably learn more about the nature and significance of the competitive process if for a while we forget about the artificial assumptions underlying the theory of perfect competition and ask whether competition would be any less important if, for example, no two commodities were ever exactly alike.
If it were not for the difficulty of the analysis of such a situation, it would be well worthwhile to consider in some detail the case where the different commodities could not be readily classed into distinct groups, but where we had to deal with a continuous range of close substitutes, every unit somewhat different from the other but without any marked break in the continuous range. The result of the analysis of competition in such a situation might in many respects be more relevant to the conditions of real life than those of the analysis of competition in a single industry producing a homogeneous commodity sharply differentiated from all others.
Or, if the case where no two commodities are exactly alike be thought to be too extreme, we might at least turn to the case where no two producers produce exactly the same commodity, as is the rule not only with all personal services but also in the markets of many manufactured commodities, such as the markets for books or musical instruments. For our present purpose I need not attempt anything like a complete analysis of such kinds of markets but shall merely ask what would be the role of competition in them.
Although the result would, of course, within fairly wide margins be indeterminate, the market would still bring about a set of prices at which each commodity sold just cheap enough to outbid its potential close substitutes — and this in itself is no small thing when we consider the insurmountable difficulties of discovering even such a system of prices by any other method except that of trial and error in the market, with the individual participants gradually learning the relevant circumstances.
It is true, of course, that in such a market correspondence between prices and marginal costs is to be expected only to the degree that elasticities of demand for the individual commodities approach the conditions assumed by the theory of perfect competition or that elasticities of substitution between the different commodities approach infinity.
This is an interesting point. An elasticity of demand is basically the willingness of consumers to change products or quantity demanded in response to a change in price. For example, smokers addicted to nicotine have a relatively high elasticity of demand for cigarettes. This means that you can expect cigarette smokers to continue buying the same amount of cigarettes even if you raised the price substantially. It will take very large price changes for them to substitute into other nicotine consumption methods, or quite nicotine. Similarly, if you cut the price of cigarettes they won’t then double the number they smoke a day. Many smokers are “a pack a day” if the price of cigarettes is $3 or $10.
On the other hand, a low elasticity of demand product would see big changes in quantity demanded for a small change in price. For example, if you increased the price of a single class of wheat in a dense commodities market, the amount you sell can quickly go to zero because the buyers could get a lower price for the same good elsewhere.
You can have perfect competition not only in a homogeneous product market. But Hayek finds that perfect competition can exist in a heterogeneous market so long as consumers are ready to switch across substitutes. If I raise the price a penny, then the demand still goes to zero. Every buyer will shift into a substitute good until the supply/demand conditions raise the price there. Only that stems the tide of demand outflow. But if there is an infinite range of substitutes and buyers are infinitely elastic in their demand, then raising the price a penny would lead to a 100% decline in demand. With so many substitutes, your buyers can only represent a small part of the whole, whose outflow will be absorbed with little impact. All firms are again, “price takers.”
While this is interesting, Hayek finds it irrelevant because it assumes a world of static information. Everyone has their own unique good in a heterogeneous market, but everyone knows everything about product attributes, they ways they can be substituted across each other, and all the ways buyers will use it. But as we have learned in tech platforms like Twitter, most of the interesting behavior of the platform is created by the users in ways the firms didn’t expect.
But the point is that in this case this standard of perfection as something desirable or to be aimed at is wholly irrelevant. The basis of comparison, on the grounds of which the achievement of competition ought to be judged, cannot be a situation which is different from the objective facts and which cannot be brought about by any known means. It ought to be the situation as it would exist if competition were prevented from operating. Not the approach to an unachievable and meaningless ideal but the improvement upon the conditions that would exist without competition should be the test.
In such a situation how would conditions differ if competition were “free” in the traditional sense from those which would exist if, for example, only people licensed by authority were allowed to produce particular things, or prices were fixed by authority, or both? Clearly there would be not only no likelihood that the different things would be produced by those who knew best how to do it and therefore could do it at lowest cost but also no likelihood that all those things would be produced at all which, if the consumers had the choice, they would like best.
There would be little relationship between actual prices and the lowest cost at which somebody would be able to produce these commodities; indeed, the alternatives between which both producers and consumers would be in a position to choose, their data, would be altogether different from what they would be under competition.
This, by the way, is exactly the problem overlooked in a lot of Government procurement. When officials are buying a commodity, the lowest cost is generally known because many producers have attempted many methods to arrive at the lowest cost. But for unique goods demanded by agencies like the Department of Defense, Dept. of Energy, Homeland Security, and NASA, this correspondence between prices and lowest costs can easily be broken.
When you have a single buyer that tries to exclude redundancy and overlap in programs — e.g., tactical air fighters — then the various alternative ways of producing the good were never actually tried. Only one production method and concept design was pursued. Even if others had strong beliefs in huge advantages of alternative designs, they were not tried out, and thus, knowledge of their quality, prices, and costs cannot be known.
Thus, when we have limited ourselves through standardization and other methods, we cannot see how our welfare could be hugely increased by committing to an alternative method.
This is basically the problem Hayek points to. If a central authority chooses who supplies a good, or the prices that it will sell at, then the lowest cost method will not be found. Selection bias will limit experimentation. Price fixing will provide no incentive to do so. But making price equal marginal cost isn’t the biggest issue. Hayek finds that
The real problem in all this is not whether we will get given commodities or services at given marginal costs but mainly by what commodities and services the needs of the people can be most cheaply satisfied. The solution of the economic problem of society is in this respect always a voyage of exploration into the unknown, an attempt to discover new ways of doing things better than they have been done before. This must always remain so as long as there are any economic problems to be solved at all, because all economic problems are created by unforeseen changes which require adaptation.
We are always adjusting to each other in a dynamic context. One person explores a concept, and another explores a different concept. One learns something about his own concept, which may surprise him, and then he may be even more surprised by what the other person found when exploring their different concept. We learn and react and adapt. The first person didn’t know before the fact that the other was exploring a second concept, much less how it would turn out. Even more likely, the first person never knew of the second’s existence until after news of his discovery.
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That’s it for part two. Check back in a couple days for the final part to the guided reading.
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