This is the final part in the guided reading of Friedrich Hayek’s classic paper, The Meaning of Competition. I recommend reading part one and part two before jumping into this post, but it isn’t necessary. Here’s Hayek:
Only what we have not foreseen and provided for requires new decisions. If no such adaptations were required, if at any moment we knew that all change had stopped and things would forever go on exactly as they are now, there would be no more questions of the use of resources to be solved.
A person who possesses the exclusive knowledge or skill which enables him to reduce the cost of production of a commodity by 50 per cent still renders an enormous service to society if he enters its production and reduces its price by only 25 per cent — not only through that price reduction but also through his additional saving of cost.
Of course, this is a line in Government procurement often quoted and little appreciated, probably because it cannot be known in advance when negotiating a contract.
But it is only through competition that we can assume that these possible savings of cost will be achieved. Even if in each instance prices were only just low enough to keep out producers which do not enjoy these or other equivalent advantages, so that each commodity were produced as cheaply as possible, though many may be sold at prices considerably above costs, this would probably be a result which could not be achieved by any other method than that of letting competition operate.
I think Hayek is getting at the point that Israel Kirzner drills: that competition is the process by which firms attempt to gain profit opportunities by lowering costs or offering better service. This comes only from recognizing information not obvious to other participants, which we call innovation or simply awareness of our surroundings. When a firm lowers costs 50% and prices by 25%, they are benefiting consumers at the same time that they are reaping huge profits. But it signals other firms: hey, there’s a real opportunity here. If you can get in this market, or learn this production method, then you can share in those profits.
As more firms enter by copying the leader, they will start undercutting him and whittle away the profits. As information about the product or methods spreads, the profits get competed back down to zero (zero economic profits, that is). Competitors might also create new innovations that supplant the leader, thereby closing off his profits and gaining their own, until other firms enter or innovate. This whole process benefits the consumer in the competition to provide value.
That in conditions of real life the position even of any two producers is hardly ever the same is due to facts which the theory of perfect competition eliminates by its concentration on a long-term equilibrium which in an ever-changing world can never be reached. At any given moment the equipment of a particular firm is always largely determined by historical accident, and the problem is that it should make the best use of the given equipment (including the acquired capacities of the members of its staff) and not what it should do if it were given unlimited time to adjust itself to constant conditions.
For the problem of the best use of the given durable but exhaustible resources the long-term equilibrium price with which a theory discussing “perfect” competition must be concerned is not only not relevant; the conclusions concerning policy to which preoccupation with this model leads are highly misleading and even dangerous.
The idea that under “perfect” competition prices should be equal to long-run costs often leads to the approval of such antisocial practices as the demand for an “orderly competition” which will secure a fair return on capital and for the destruction of excess capacity. Enthusiasm for perfect competition in theory and the support of monopoly in practice are indeed surprisingly often found to live together.
This is an amazing insight of Hayek’s that certainly rings true for the defense market today. If you want perfect competition, you really are trying to control the content of the market, such as through standardization. You decide exactly how much is needed of what such that production methods are tightly constrained. Now that we have defined our market and methods, you want an “orderly competition” where you pay a price that equals production cost plus a “fair return.”
Obviously, different firms will have different costs is only because of their place and scale. A bigger firm with a bigger production base can produce, usually, at a lower marginal cost. Therefore, you monitor their production bases, and manage them to be similar in size — at “peak efficiency.” This means little excess capacity and a dwindling of participants. Really, it means that there is only a single producer if economies of scale never flip into diseconomies (such as though administrative burden).
Profits are not, in this context, determined by innovation and bringing value to the customer. All methods of value production are known, as is their cost. Profits do not signal higher-valued uses of resources, they signal economic rent, or recoupment of sunk capital costs. When this situation occurs, you are leading toward a monopoly. Again, it is a static situation. Competition by innovation is not allowed.
This is, however, only one of the many points on which the neglect of the time element makes the theoretical picture of perfect competition so entirely remote from all that is relevant to an understanding of the process of competition. If we think of it, as we ought to, as a succession of events, it becomes even more obvious that in real life there will at any moment be as a rule only one producer who can manufacture a given article at the lowest cost and who may in fact sell below the cost of his next successful competitor, but who, while still trying to extend his market, will often be overtaken by somebody else, who in turn will be prevented from capturing the whole market by yet another, and so on.
It’s not obvious that a homogeneous commodity with perfect information will inevitably be reduced to a single firm (monopoly). If economies of scale continued regardless of quantity produced, then it would be true. The lowest cost production method is the one that only a single firm can achieve. That is not clearly true for most economic goods and services. For example, one giant factory assembling all the world’s cars can easily be thought of as inefficient. But if we think closer, usually that is because we are considering different types and qualities of cars, and the important differences of geography or consumption tastes. Perhaps if the whole world only bought one static car design, then a single plant would be the most efficient assembler.
Such a market would clearly never be in a state of perfect competition, yet competition in it might not only be as intense as possible but would also be the essential factor in bringing about the fact that the article in question is supplied at any moment to the consumer as cheaply as this can be done by any known method.
When we compare an “imperfect” market like this with a relatively “perfect” market as that of, say, grain, we shall now be in a better position to bring out the distinction which has been underlying this whole discussion — the distinction between the underlying objective facts of a situation which cannot be altered by human activity and the nature of the competitive activities by which men adjust themselves to the situation.
Where, as in the latter case, we have a highly organized market of a fully standardized commodity produced by many producers, there is little need or scope for competitive activities because the situation is such that the conditions which these activities might bring about are already satisfied to begin with. The best ways of producing the commodity, its character and uses, are most of the time known to nearly the same degree to all members of the market.
The knowledge of any important change spreads so rapidly and the adaptation to it is so soon effected that we usually simply disregard what happens during these short transition periods and confine ourselves to comparing the two states of near- equilibrium which exist before and after them.
But it is during this short and neglected interval that the forces of competition operate and become visible, and it is the events during this interval which we must study if we are to “explain” the equilibrium which follows it.
It is only in a market where adaptation is slow compared with the rate of change that the process of competition is in continuous operation. And though the reason why adaptation is slow may be that competition is weak, e.g., because there are special obstacles to entry into the trade or because of some other factors of the character of natural monopolies, slow adaptation does by no means necessarily mean weak competition.
When the variety of near-substitutes is great and rapidly changing, where it takes a long time to find out about the relative merits of the available alternatives, or where the need for a whole class of goods or services occurs only discontinuously at irregular intervals, the adjustment must be slow even if competition is strong and active.
This is a nuanced point. There will always be change so long as people can think freely and discover new scientific, engineering, artistic, business, or other ideas. But the market may or may not adjust to that change. Really, the two are intertwined. But just because there is change, economic adaptation may not occur due to Government licensing or price fixing. But even a highly competitive market may adapt slowly.
For example, when the combustion engine was invented, it took many years to the economy to reorganize around it, such as the system of trucking and distribution, the interstate highways, and so forth. The invention of the car sparked a hundred year transformation.
The confusion between the objective facts of the situation and the character of the human responses to it tends to conceal from us the important fact that competition is the more important the more complex or “imperfect” are the objective conditions in which it has to operate. Indeed, far from competition being beneficial only when it is “perfect,” I am inclined to argue that the need for competition is nowhere greater than in fields in which the nature of the commodities or services makes it impossible that it ever should create a perfect market in the theoretical sense. The inevitable actual imperfections of competition are as little an argument against competition as the difficulties of achieving a perfect solution of any other task are an argument against attempting to solve it at all, or as little as imperfect health is an argument against health.
In conditions where we can never have many people offering the same homogeneous product or service, because of the ever-changing character of our needs and our knowledge, or of the infinite variety of human skills and capacities, the ideal state cannot be one requiring an identical character of large numbers of such products and services.
The economic problem is a problem of making the best use of what resources we have, and not one of what we should do if the situation were different from what it actually is. There is no sense in talking of a use of resources “as if” a perfect market existed, if this means that the resources would have to be different from what they are, or in discussing what somebody with perfect knowledge would do if our task must be to make the best use of the knowledge the existing people have.
Many people think that when economic assumptions like perfect knowledge and homogeneity do not hold, that markets lead to bad outcomes. “Market failure” is the word often used, necessitating Government interference. This has spawned a whole discipline of behavioral economic theory that seeks all the ways real people deviate from economic assumptions.
Hayek points out, however, that the market is a process by which people mutually adjust such that they overcome these “market failures.” Saying that humans are fallible is obvious. What is not obvious is the various indirect ways that the market makes the multitudinous masses act as though they were rationally coordinating. The market is the process where errors are recognized, information spreads, and adjustments are made, which opens up a new set of errors that must be recognized.
To assume that we have the foresight to recognize all errors before they occur and eliminate them is missing the point entirely. It assumes we have reached finality in scientific knowledge, engineering application, and human tastes.
The argument in favor of competition does not rest on the conditions that would exist if it were perfect. Although, where the objective facts would make it possible for competition to approach perfection, this would also secure the most effective use of resources, and, although there is therefore every case for removing human obstacles to competition, this does not mean that competition does not also bring about as effective a use of resources as can be brought about by any known means where in the nature of the case it must be imperfect.
Even where free entry will secure no more than that at any one moment all the goods and services for which there would be an effective demand if they were available are in fact produced at the least current6 expenditure of resources at which, in the given historical situation, they can be produced, even though the price the consumer is made to pay for them is considerably higher and only just below the cost of the next best way in which his need could be satisfied — this, I submit, is more than we can expect from any other known system.
Firms are for the most part a historical accident. Many times we see a firm start in one area and migrate around to others. They did not pre-plan their entire operation.
The decisive point is still the elementary one that it is most unlikely that, without artificial obstacles which government activity either creates or can remove, any commodity or service will for any length of time be available only at a price at which outsiders could expect a more than normal profit if they entered the field.
The practical lesson of all this, I think, is that we should worry much less about whether competition in a given case is perfect and worry much more whether there is competition at all. What our theoretical models of separate industries conceal is that in practice a much bigger gulf divides competition from no competition than perfect from imperfect competition.
Yet the current tendency in discussion is to be intolerant about the imperfections and to be silent about the prevention of competition. We can probably still learn more about the real significance of competition by studying the results which regularly occur where competition is deliberately suppressed than by concentrating on the shortcomings of actual competition compared with an ideal which is irrelevant for the given facts.
I say advisedly “where competition is deliberately suppressed” and not merely “where it is absent,” because its main effects are usually operating, even if more slowly, so long as it is not outright suppressed with the assistance or the tolerance of the state.
The evils which experience has shown to be the regular consequence of a suppression of competition are on a different plane from those which the imperfections of competition may cause. Much more serious than the fact that prices may not correspond to marginal cost is the fact that, with an entrenched monopoly, costs are likely to be much higher than is necessary.
A monopoly based on superior efficiency, on the other hand, does comparatively little harm so long as it is assured that it will disappear as soon as anyone else becomes more efficient in providing satisfaction to the consumers.
Hayek points out that monopoly isn’t always bad. So long as there is free entry, a monopoly generally can only be maintained so long at the firm is creating more value than other firms — it has “superior efficiency.” This seems to be what was happening at the end of the 19th century. As big firms were able to use railroad transportation and mass manufacturing methods, they simply outcompeted the mom and pop establishments. Anti-trust backlash in certain cases was a way for inefficient suppliers to use Government to suppress competition.
Free entry seems to be the only condition necessary to competition. Even if monopolists are created, usually their ability to dominate a market segment at that time makes them poorly placed to innovate the next big thing. As Clayton Christensen found, the big incumbent firms have many disadvantages when it comes to creating disruptive innovation, even when they have ample cash for R&D.
By their very size, a monopolist is not able to “see” the errors of its own misallocation, which provides signals for small entrepreneurs to come in and exploit. This is why Cisco will send a team out of the company to go innovate before it rejoins the company, so that its culture and processes don’t restrain innovation.
In conclusion I want for a moment to go back to the point from which I started and restate the most important conclusion in a more general form.
Competition is essentially a process of the formation of opinion: by spreading information, it creates that unity and coherence of the economic system which we presuppose when we think of it as one market. It creates the views people have about what is best and cheapest, and it is because of it that people know at least as much about possibilities and opportunities as they in fact do.
It is thus a process which involves a continuous change in the data and whose significance must therefore be completely missed by any theory which treats these data as constant.
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I hope this has been a useful guided reading of Hayek’s “The Meaning of Competition.” Its relevance for defense acquisition has not been stressed here, but the themes will reoccur on this blog many times.
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