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Despite the potential benefits from economic interactions, markets do not always operate to generate positive outcomes. Instead markets can become distorted and can end up serving one group of people at the expense of others. For example, some market conditions result in producers gaining the most from market exchange, while consumers end up with fewer benefits (from a consumer surplus/producer surplus analysis). In such cases, the government may deem it necessary to intervene in the market to achieve a more balanced outcome, from a public-policy perspective. Such intervention can take the form of removing restrictions on, for example, quantity restrictions on supply, on prices or on foreign trade. Arguments for interventions also come from lobby groups or vested interests whose focus is on maximizing their own benefits and depending on the lobby group will adopt either a public-policy or business perspective.

When governments intervene in markets truly open, competitive free markets do not exist. There are many examples of how competition is limited by the entry of new firms being blocked or in some way made more difficult. Government intervention is by no means the only way in which entry can be restricted but it is one example of restricting competition by setting a limit on the number of competitors in an industry – a case in point is the pub industry where competition is limited as pubs require licences from the government to operate in that market. Naturally occurring restrictions also occur where a firm has access to the sole supply or knowledge required to produce a good, and examples include oil, and coke, for different reasons. Barriers to entry can arise due to the type of product (standardized or differentiated), the existence of economies of scale, initial or ongoing capital requirements or cost disadvantages independent of size, such as access to distribution channels.

Standardized products: products for which many substitutes are available and which use readily available technology in their production.

Differentiated products: products for which several different varieties are provided (e.g. cars). Differentiation between varieties depends on producers’ choices of the product attributes for which consumers are willing to pay.

Competition, therefore, is a complex concept that is often not fully understood in terms of what it actually means and its implications in the marketplace, for prices and supply, and therefore for economic growth and employment.

6.2.1COMPETITION AS A PROCESS

One view of competition is that it is a process whereby through learning over time, economic units on the demand and supply sides of the economy reach a state where

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their plans become mutually consistent. Hayek, in particular, and the Austrian School of Economics in general, would subscribe to such a view where competition is a discovery procedure, where people discover knowledge on an ongoing basis. Competition is perceived as being similar to a game of gathering knowledge and exploiting that knowledge for economic gain. The concept of competition as a game has several useful implications. For example, in any game, we do not know the results beforehand, skill is required to influence the outcome and the outcome is unpredictable. The following quote from Hayek (1978) illustrates this point: ‘Competition is valuable only because, and so far as, its results are unpredictable and on the whole different from those which anyone has, or could have, deliberately aimed at.’ (p. 180)

Unlike in standard games where there are winners and losers (also called zero-sum games), competition often generates greater gains than losses or costs. For example, the result of a new more efficient competitor entering a market and charging lower prices might be to put some other firms out of business, but consumers gain from the lower prices charged and more efficient use of society’s resources is made.

An important implication of Hayek’s description is that we cannot set out to create an outcome that is in itself unpredictable. If competition is a discovery procedure, then we cannot know beforehand what is to be discovered. In addition, the outcomes of a game can only be temporary because as new knowledge is discovered and used, new outcomes are likely to emerge. Therefore, rather than analysing whether competition has achieved a particular outcome, we should instead focus our attention on making comparisons across similar markets, across industries and/or across countries and consider which outcomes are economically superior.

This concept of competition is appealing because the knowledge that exists and that is developed over time within a marketplace is unlikely to be generated as efficiently through any other mechanism. Therefore the miracle of the marketplace is that it allows the market system to achieve results that are not only unpredictable but are also the ‘best’ outcome possible.

In a similar vein to Hayek, Schumpeter offered us the notion of competition as creative destruction (discussed in the treatment of business cycles in Chapter 5). Schumpeter viewed competition as a dynamic process that is based on innovation and change, arguing that in the process of economic growth and in the development and expansion of new products, technological change results in the displacement of old products and old technologies by new products, jobs and technologies. Old jobs and factories become obsolete and defunct and are no longer productive within the economic system.

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Knowledge and the use of this knowledge are central to this process-view of competition. As outlined in Chapter 2, such knowledge is dispersed throughout the economic system and its application is central to the functioning of this system. Prices become signals of this knowledge. Again Hayek (1978) illustrates this point:

Utilisation of knowledge widely dispersed in a society with extensive division of labour cannot rest on individuals knowing all the particular uses to which well known things in their individual environment might be put. Prices direct their attention to what is worth finding out about what a market offers for various things and services. This means that the, in some respects always unique, combinations of individual knowledge and skills, which the market enables them to use, will not merely, or even in the first instance, be such knowledge of facts as they could list and communicate if some authority asked them to do. The knowledge of which I speak consists rather of a capacity to find out particular circumstances, which become effective only if possessors of this knowledge are informed by the market which kinds of things or services are wanted, and how urgently they are wanted. (p. 257)

Hayek highlights several useful ideas worth noting. Knowledge plays a central role in the view of competition as a process, where each individual knows something but nobody knows everything. The existence of tacit knowledge is also recognized, as is the role of the entrepreneur in discovering and using knowledge in a profitable way.

Tacit knowledge: is highly personal, not easily visible or expressible and cannot easily be copied. It usually requires joint, shared activities in order to transmit it. Examples of tacit knowledge include subjective insights, intuitions and hunches.

Finally, the concept of demand is referred to in terms of things or services wanted and ‘how urgently they are wanted’.

6.2.2ENTREPRENEURSHIP, DISCOVERY AND THE MARKET PROCESS

At the heart of the use of knowledge in market economies lies the entrepreneur.

Entrepreneurs exploit knowledge by converting knowledge discovered into profitable gain.

Crucial to entrepreneurs’ ability is the freedom to enter existing markets or develop new markets so discovery is fundamental to the notion of an entrepreneur. The

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entrepreneur’s skill lies in discovering knowledge and then using the market process to exploit it for profitable gain.

Entrepreneurship is about being alert to a set of opportunities, having a subjective expectation as to the value of such opportunities in the market and having the resources (or ability to generate them) to realize this value.

This may be no more than exploiting a price difference in two markets by buying cheap in one market to sell at a higher price in another market. Such an entrepreneurial discovery will eventually result in the disappearance of the price difference (consider the role of the speculator as described in Chapter 7) thereby bringing continual change to the market. The notion of equilibrium in the Austrian view of competition can only be temporary since new opportunities continually arise that cause future change. Entrepreneurship can also involve combining resources in a unique way that represents value to the consumer – something for which consumers are willing to pay.

Entrepreneurship, by definition, cannot be predicted. It brings chaos to markets in the sense that it generates price movements and resource allocation and reallocation decisions and all this is done in the search for economic profit. In the process ‘mistakes’ can be made either by incorrectly interpreting knowledge or by incorrectly judging the value consumers would place on such knowledge. Hence, we have some unsuccessful product launches, unsold inventories and bankruptcies. But through the discovery process more knowledge is gained which feeds back into entrepreneurial decision-making and so the cycle continues.

Competition in the context of entrepreneurship means one thing – free entry into any market. This is also known as contestable markets.

Contestable markets: markets where entry costs and exit costs from markets are low.

Without this free-entry condition, discoveries cannot be made and so entrepreneurship is restrained. Discoveries could take the form of new technology, resulting in lower production costs (lower average cost curves), or new product attributes, resulting in more value to consumers (reflected in new or higher demand functions). Such discoveries would lead to resources being redirected in the economy to where their productivity is highest, and the impact of changes in markets would be reflected in changes in prices.

Discoveries might include a perception on changing consumer tastes. If consumers demand more computers and fewer typewriters then, through the market

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mechanism, the price of computers rises while the price of typewriters falls. As the equilibrium quantity changes so too can profits, and increasing profit levels would provide incentives for more producers to engage in the production of computers and fewer producers to engage in the production of typewriters. Changing profit opportunities result in increased computer production. As more computers are produced the price of computers will eventually start to decrease, whereas falling demand for typewriters will result in less production and falling prices in that market.

This outcome reflects society’s change in preferences and it unfolded as individuals pursued their own self-interest without anyone or any government directing them to do so. Moreover, the market mechanism also operates as a check on individual self-interest. Any increases in price by one entrepreneur to take advantage of an additional profit opportunity may well be met with prices actually being bid down by more efficient entrepreneurs entering the market or through a switch to substitute goods.

Markets are organized by a self-regulating process and what may seem at the first instance to be chaotic and disorderly is, in fact, not.

The marketplace by its very nature is constantly changing with knowledge being discovered, and any equilibrium state is only transitory. A major factor in causing such change is innovation.

Adam Smith explained that as markets increase in size, this leads to more specialization as producers seek better ways to produce goods and more ways to improve existing products. So both product and process innovation can be as a result of increased specialization. This is consistent with Schumpeter’s views, introduced above, that market forces push down profits on existing goods, incentives are created to introduce new products and processes and avail of greater profit opportunities.

Accordingly innovation is a critical feature in the marketplace and again the entrepreneur is central to this process. This has led to debate on how best to increase the level of innovation and its by-product – economic prosperity. Patents are one way to increase innovation activity by providing the entrepreneur with added security through a system guaranteeing protection from imitation, thus encouraging them to undertake costly research and development expenditures searching for knowledge to be exploited in the market. Consumers gain immediately from patent-protected innovations in terms of the availability of previously unavailable products or processes. Consumers may also gain over time as the discovery embodied in patents eventually becomes dispersed more widely in the economic system once the patent runs out.

A limit to competition in the theory of entrepreneurship is the monopoly control of unique resources. This control can occur naturally, through ownership rights (that

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is, property rights) or through government regulations and the issuing of patents, for example, both of which have the effect of restricting entry to markets. The presence of patents in some markets indicates the precedence given to benefits from innovation over potential costs from greater market competition. There is a trade-off and decisions must be made on how the greatest benefit is provided to society.

Other types of barriers to entry that can limit competition are government regulations including licensing agreements. This is again related to what role governments should play in the marketplace. Depending on political ideology, some argue for an extensive role for government involvement in the market. Others, such as the Austrian school, believe that government involvement should be kept to an absolute minimum on the basis that any government intervention to prevent a free-market solution attempts to devise alternative allocation mechanisms that are rarely, if ever, better than the free-market solution. The role of government in this latter case would then be limited to supplementing the market process, to facilitate its smooth functioning.

6 . 3 A L T E R N A T I V E M O D E L S

O F C O M P E T I T I O N A N D M A R K E T S T R U C T U R E

Traditional models of competition evolve around four types of market structure, each of which is examined separately below in terms of its implications for a firm’s ability to earn profits, which we see is related to a firm’s market power.

Market structure refers to certain characteristics of an industry, such as the level of concentration, the extent of entry barriers and the extent of product differentiation.

Market concentration refers to the number of firms in a specific market and their relative market share.

Market power exists when firms in a market hold a sufficiently large market share that their actions can change the market price of a product – producing more results in a falling equilibrium price, producing less leads to a rise in equilibrium price, ceteris paribus.

At one extreme there can be just one firm in a market and we call this monopoly. At the other extreme a market can be characterized by many firms; each small, relative to the overall size of the market – this is called perfect competition. All examples

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of market structure apart from perfect competition come under the heading of imperfect competition.

Between the extremes of monopoly and perfect competition there are two additional forms of market structure: monopolistic competition and oligopoly. Monopolistic competition is characterized by many firms each with some power to set the price of their product, which they hold because they supply a particular brand of product – they differentiate their product. Oligopoly is characterized by a few firms of large size relative to the total market, so each firm has some degree of market power.

Market concentration is often used as the primary measure of market structure. To calculate the level of concentration in a market, a concentration ratio (CR) can be calculated.

A concentration ratio measures the market share of the biggest firms in the market. For example a CR4 calculates the market share of the largest four firms.

Even though a concentration ratio only counts the top firms this can be quite accurate since if the purpose is to calculate the degree of market power in an industry, it is assumed the biggest firms have the most power. The Herfindahl Index is a more accurate measure of concentration.

The Herfindahl Index measures the market share of all firms in the industry by summing the squares of each individual firm’s market share:

N

H = Si2

1

where Si denotes each firm’s market share and summation is from firm 1 to N , the total number of firms in the market. The squared term indicates that firms with large market shares will have higher weight.

Market share can be measured in terms of, for example, total sales, net output, numbers employed or capital asset values. However, depending on the measure used, the calculation of market share will differ.

In the airplane manufacturing industry, different measures resulted in different results. Boeing and Airbus have both claimed to be the largest in the industry. With just two firms in this industry it should have been obvious that both