1000 words Econ essay 10 hrs

AnAlternativeApproachtoBusinessCompetition.pptx

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An Alternative Approach to Business Competition

Jamee K. Moudud

Spring 2021

As discussed in this note, one can discern in the readings pertaining to Adam Smith, Friedrich Hayek, and Joseph Schumpeter a very different analysis of competition.

This approach is radically different from that in neoclassical economics.

Note that neoclassical economics, with its distinctive approach to the study of markets, established itself in the later 19th century.

Thus perfect competition and its opposite, imperfect competition, are purely neoclassical inventions. Neither approach to competition existed among the classical political economists such as Smith, Ricardo, and Marx.

One can however see in the writings of not just Smith but also two major influential 20th century economists – Hayek and Schumpeter—an approach to competition that is inconsistent with neoclassical economics.

Laissez Faire

In neoclassical economics perfect competition is the highest state of market competitiveness  the conventional public policy to “make markets more competitive and efficient” has perfect competition and Pareto optimality as the benchmark.

Price in Perfect Competition

No firm has the ability to set prices in perfect competition: each firm is a passive price-taker.

Thus each firm takes the market price as exogenously given and cannot change  the market price is parametric as McNulty says.

Adam Smith

But in Smith’s framework the price is not parametric as each firm seeks to cut prices and costs to undercut rival firms and expand its market share at the latters’ expense. Of course it may or may not be successful in this endeavor.

Quotes from McNulty (1967) on Smith’s Theory of Competition

“But the concept of competition upon which nineteenth-century economists came to rely so heavily was not the concept which had earlier been employed by Adam Smith…Smith's concept of competition was decidedly not one in which the firm was passive with respect to price but was, rather, one in which the market moved toward equilibrium through the active price responses of its various participants…

McNulty on Smith

Smith's concept of competition was competition "in the sense of rivalry in a race-a race to get limited supplies or a race to be rid of excess supplies" (Stigler, 1957, pp. 1-2). This is fundamentally different from the concept of perfect competition which, as Frank Knight has often stressed, implies "no presumption of psychological competition, emulation, or rivalry, and ... [from which] 'bargaining‘ is also excluded" (Knight, 1946, p. 102).”

McNulty on Smith

“Not only did Smith fail to see competition as a "situation in which P does not vary with Q-in which the demand curve facing the firm is horizontal“ (Stigler, 1957, p. 5); he did not conceive of competition as a "situation" at all but, rather, as an active process leading to a certain predicted result. The Smithian concept of competition is essentially one of business behavior which might reasonably be associated with the verb "to compete.“ The essence of that behavior was the active effort to undersell one's rival in the market, although, to be sure, Smith was not unaware of the organizational and technological elements in competition, as when he

McNulty on Smith

that lowered prices and increased demand "encourages production, and thereby, increases the competition of producers who, in order to undersell one another, have recourse to new divisions of labour and new improvements of art, which might never otherwise have been thought of" (Smith, 1937, p. 706).” [Emphasis added]

Friedrich Hayek

Hayek too emphasizes the utterly unrealistic notion of perfect competition.

His article primarily focuses on the fact that product differentiation (absent in perfect competition) is a normal feature of real-world business competition.

Quotes from Hayek (1948), p. 92

Hayek (1948), p. 96

Hayek on Competition

In other words, Hayek is describing what real-world competition is: it’s a process rather than a static attained-and-held equilibrium (think of the equilibrium state under perfect or monopolistic competition.

This ongoing process of competition necessarily implies active efforts by firms to dislodge rivals via price-cutting, product differentiation, and advertising all of which are absent in perfect competition.

Hayek (1948), p. 97

Hayek (1948), p. 98

Product differentiation is quite natural for many reasons including the common sense one that firms are physically located in different places and thus are likely to have different production costs (value of land etc.)

In short real-world competition has nothing to do with any putative “perfection” or “imperfection” of markets.

Joseph Schumpeter

Schumpeter rejects the notion that there was some bygone romantic era when perfect competition (with small-sized firms) prevailed which eventually gave rise to large-sized “imperfectly” competitive ones (monopolistic or oligopolistic firms).

Schumpeter (1943), p. 81

Schumpeter is here challenging the claim that the growth of big business since the 1890s (when major mergers did occur) led to the appearance of excess capacity (a key feature of “imperfect competition” models in neoclassical theory) and thus production ineffiencies.

There was as he says no golden age of perfect competition with full production capacity at minimum cost.

Creative Destruction

In contrast to the static equilibrium view of neoclassical economics Schumpeter emphasizes its dynamic evolutionary nature in which firms try to adopt new technologies, organizational forms, new sources of raw materials etc. in order to expand their market shares.

“Backward” firms are weeded out in this process which Schumpeter calls creative destruction.

Schumpeter (1943), p. 83

Schumpeter (1943), p. 84

In contrast to perfect competition…

Firm as a Going and Growing Concern

Dean, Erik et al. 2016. Principles of Microeconomics: Scarcity and Social Provisioning. OpenStax Economics, Principles of Economics. OpenStax CNX. May 18, 2016. Chapter 14 ("The Rise of Big Business"), chapter 15 ("Introduction to Costs and Prices"), chapter 16 ("The Megacorp").

The neoclassical models of competition (whether of the perfect or monopolistic kinds) require that the average total cost (ATC) be U-shaped which (a) in the short-run assumes diminishing returns and (b) in the long-run when the firm grows assumes another type of diminishing returns: supposed bureaucratic inefficiencies from being large.

As discussed in class, these assumptions are required in order to get U-shaped cost curves and thus upward-sloping marginal cost (MC) curves.

The sum total of the MC curves of all firms gives the upward-sloping market supply curve. Coupled with the downward-sloping demand curve (itself derived from rational choice principles) the upward-sloping supply curve gives the automatic self-equilibrating version of the “invisible hand” in neoclassical economics and thus the promise of laissez faire.

The U-shaped cost-curve also gives the static equilibrium condition of both perfect and monopolistic competition, as we saw.

But as pointed out in a previous lecture it is difficult to see how a firm can grow in perfect competition.

Unless one makes the extreme assumption that all firms in an industry grow at the same rate so that each firm’s market share remains miniscule: but then their fixed costs will grow, generating barriers to entry. Zero entry barriers are a key feature of perfect competition.

So you have an unexplained paradox in perfect competition theory: U-shaped cost curves over the long-run arise from “managerial inefficiencies” in large firms but it’s not clear why perfectly competitive firms should or can grow while being passive price-takers.

Empirical Reality

As Dean et al point out, all the empirical studies of cost curves (by neoclassical economists like Alan Blinder and others) show virtually no evidence that real-world businesses have U-shaped cost curves.

Instead real-world ATC curves generally tend to be of the form in the next slide (i.e. there are no diminishing returns to scale of any type but rather increasing returns to scale):

Output

ATC and Price

Net Profit Margin

ATC

Strategic Behavior

Real-world firms of all sizes strategize: that’s the essence of how they try to grow or be wiped out.

But as neoclassical theory itself recognizes (see Hall & Lieberman on oligopolistic competition), strategic behavior destabilizes demand curves and thus marginal revenue (MR) curves. Thus, as the textbook correctly points out, MR = MC is not possible under strategic behavior.

Real-world business firms do not use the MR = MC formula to get the desired market price and output (P* and Q* in the above figure).

Typically firms will attempt to maximize their output and minimize costs (i.e. attain economies of scale) by setting prices that will allow them to recoup costs and generate sufficient cash flow in order to grow.

Firm as a Going and Growing Concern

The firm wishes to be a going and growing concern: it wants to be able to stay in business and grow.

It does so by either engaging in full-cost pricing or target rate of return pricing as discussed in section 15.2 of Dean et al. The numerical examples on pp. 423-424 will be discussed in class.

Such an approach can be called an investment theory of pricing (a termed coined by Alfred Eichner): the firm sets a price in order to generate sufficient cash flow to pay current costs and grow (invest).

So there is price and cost minimization but the prices are set in light of market demand and competition from other firms.

The key goal is to survive and grow at other firms’ expense  that’s the central goal of real-world competition.

Such injury to other firms is generally considered legal although that may vary from one context to the next.

A legal injury quite simply means that a firm is allowed to take other firms’ market shares away without compensating them.

Damnum Absque Injuria

This was basis of the principle of damnum absque injuria.

Creative Destruction and Damnum Absque Injuria

Recall from this reading regarding the above legal principle undergirding competition:

Moudud, Jamee K. 2019. “Distributional Struggles Always Operate Under the Background Laws That Determine Property, Contracts, and Torts.” Law and Inequality: A Journal of Theory and Practice XXXVII. (Special Issue on “Eleven Things They Don’t Tell You About Law & Economics: An Informal Introduction to Political Economy and Law”. Guest Editor: Frank Pasquale).

Creative Destruction and Damnum Absque Injuria

In short damnum absque injuria can be considered the legal foundations to Schumpeter’s notion of creative destruction.

How Does Competition Work in Practice?

Suppose an incumbent firm A faces a new entrant B that has all- round lower ATC, e.g. Japanese automakers in the 1970s or Chinese solar panel producers in the current context (lowest-cost producers) (https:// www.scientificamerican.com/article/why-china-is-dominating-the-solar-industry).

Firm A

Firm B

A’s Practicable Optimum Output

B’s Minimum Practicable Output

ATC and Price

Strategic Competitive Behavior

Let kA = unit cost at practicable optimum of Firm A ($1)

Let kB = unit cost at practicable optimum of Firm B ($0.5)

Let pA = unit price at practicable optimum of Firm A before B’s entry = $1.50

Let pB = unit price at practicable optimum of Firm B after entry = $1 = p*

How will A react to the lower selling price?

Strategic Competitive Behavior

In the first instance A will lower its own selling price to match B’s price  in the process it makes no profits and B makes handsome profits.

If B sets a price below A’s costs of production ($1), say $0.75, A will have to follow suit and thereby sustain losses.

Competition necessarily involves strategic behavior because the future is fundamentally unknown (Keynes on uncertainty and Hayek in “voyage of exploration into the unknown”).

Uncertainty: Keynes

“By, uncertain knowledge, let me explain, I do not mean merely to distinguish what is known for certain what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.”(Keynes, 1937, 213-214. Emphasis added)

Keynes, “The General Theory of Employment,” Quarterly Journal of Economics 51 (1937): 209–223.

(See also: http://socialdemocracy21stcentury.blogspot.com/2011/05/skidelsky-on-keynesian-uncertainty.html)

Examples

American auto makers in the 1950s and 1960s did not, in their investment plans, factor in the cheaper and more fuel-efficient Japanese cars in the 1970s and 1980s.

Or American and Japanese firms in the 1980s and 1990s did not anticipate cheaper Chinese-made products (often by foreign multinational corporations exporting from China) eating into the former’s market shares.

Some Dark Humor

“[T]here are known knowns; there are things we know we know….”

[Each firm knows that there are potential rivals out there]

“We also know there are known unknowns; that is to say we know there are some things we do not know….”

[Each firm does not know what new products will appear and at what price or when]

“But there are also unknown unknowns – the ones we don't know we don't know.”

[Each firm does not know about future innovations in technology; organizational restructuring such as outsourcing; institutions such as powerful developmental states that stimulate the production of new products etc.]

—United States Secretary of Defense Donald Rumsfeld

Uncertainty and Competition

Such an uncertain turbulent economic environment implies that firms’ pricing behavior is strongly regulated by their labor and non-labor costs of production

They set prices on the basis of attaining the maximum profit they can get given ongoing competitive pressures

Thus the prices they set are not necessarily the prices they want but the ones they can get away with.

There is no perfect information as in perfect competition!

Smith, Hayek, and Schumpter emphasized the dynamic expanding nature of the business enterprise. Firms set prices in order to grow and will use product differentiation, organizational restructuring, cheaper sources of raw materials, and of course newer technologies in order to grow. This necessarily involves strategic and price-setting behavior and growth becomes an imperative as firms attempt to benefit from economies of scale (maximum output at minimum unit costs).

In perfect competition there is price and cost minimization but on the basis of a whole set of unrealistic assumptions:

(a) See those detailed in the Hayek (1948) reading

(b) U-shaped ATC curve: see the critique above.

Under monopolistic competition the equilibrium involves output and price above minimum costs. But there is no mechanism in this framework to cut price and unit costs because that equilibrium is on the basis of MR = MC and thus, yet again, no strategic behavior. Given MR = MC the incumbent firm in an industry cannot also lower its price and attempt to increase in market share if a lower-cost new entrant threatens it .

So the firm under monopolistic competition can set its price (as the textbook states) but it is peculiarly passive in terms of its lack of ability to face threats from lower-priced actual or potential new entrants.

Real-world Business versus Neoclassical Business Models

Real-world firms do not have U-shaped cost curves but rather ATC curves that slope downwards.

Each (real-world) firm attempts to exploit economies of scale by maximizing output and minimizing its selling price and unit cost.

That price is set on the basis of the goal to recoup costs and get the maximum rate of profit to finance growth and investment. This is the investment theory of pricing and the firm can be characterized as a going and growing concern.

Full-cost and target pricing: neither of which is consistent with MR = MC.

The going and growing concern is consistent with the insights of Smith, Hayek, and Schumpeter regarding the nature of the firm.