Thursday, 30 October 2014

Nobel Winner Jean Tirole’s Faulty Views on Monopoly

This guest post by Frank Shostak explains that Nobel Prize-winning economist Jean Tirole comes from that school of economists who consider when reality doesn’t fit their faulty models of the economic system, they demand laws written to change the reality.

Frenchman Jean Tirole of the University of Toulouse won the 2014 Nobel Prize in Economic Sciences for devising methods to improve regulation of industries dominated by a few large firms. According to Tirole, large firms undermine the efficient functioning of the market economy by being able to influence the prices and the quantity of products.

Consequently, in the game according to Tirole, the well-being of individuals in the economy is undermined.

On this way of thinking the alleged inefficiency emerges as a result of the deviation from the “ideal state” of the market as depicted by mainstream economics’ idealised model of“perfect competition.”

The “Perfect Competition” Model

In the idealised world of “perfect competition” so idolised by the mainstream, a market is characterised by the following features:

  • There are a perfectly infinite number of buyers and sellers in the market (or, at least, so many that none can affect outcomes)
  • Products traded are all homogeneous – that is, they are all perfectly alike
  • Buyers and sellers are all perfectly informed
  • Obstacles or barriers to enter the market are all perfectly non-existent.

This describes an economic system that never was, ignoring everything that makes economics an actual system.

In this Walter Mitty-like dream world of perfect competition, neither buyers nor sellers have any control at all over the price of the product. They are all simply price takers.

The assumption of perfect information and thus absolute certainty implies that there is no room left for entrepreneurial activity. For in the world of certainty there are no risks and therefore no need for entrepreneurs.

And if this is so,then who introduces new products? How do they go about it? And why would they?

Such questions do not worry proponents of perfect competition.  According to the proponents of the perfect competition model, any real situation in a market that deviates from this model is regarded (by their models) as “sub-optimal” to consumers' well being. It is then recommended that the government intervene whenever such deviation occurs.

The model is fundamentally flawed.

Contrary to this way of thinking, competition is not at all a function account of a large number of participants as such, but as a result of a large variety of products.

Competition in Products, Not in Firms

The greater the variety is, the greater the competition will be and therefore more benefits for the consumer.

Once an entrepreneur introduces a product — the outcome of his intellectual effort — he acquires 100 per cent of the newly-established market.

Following the logic of the popular way of thinking, however, this situation must not be allowed for it will undermine consumers' well being. If this way of thinking (i.e., the perfect competition model) were to be strictly adhered to, no new products would ever emerge. In such an environment, people would struggle to stay alive.

Once an entrepreneur successfully introduces a product and makes a profit, he attracts competition. Notice that what gives rise to the competition is that consumers have endorsed the new product. Now the producers of older products must come with new ideas and new products to catch the attention of consumers.

The popular view that a producer that dominates a market could exploit his position by raising the price above the truly competitive level is erroneous.

The goal of every business is to make profits. This, however, cannot be achieved without offering consumers a suitable price.

It is in the interest of every businessman to secure a price where the quantity that is produced can be sold at a profit.

In setting this price the producer-entrepreneur will have to consider how much money consumers are likely to spend on the product. He will have to consider the prices of various competitive products. He will also have to consider his production costs.

Any attempt on behalf of the alleged dominant producer to disregard these facts will cause him to suffer losses.

Further to this, how can government officials establish whether the price of a product charged by a dominant producer is above the so-called competitive price level?

How can they know – how can they and nobody else know – just what the allegedly competitive price is supposed to be?

Not only does this imply knowledge no-one else allegedly has, but if government officials attempt to enforce a lower price this price could wipe out the incentive to produce the product. [Not to mention the jail time threatened on producers if they find themselves becoming “too dominant” as defined by these government officials – Ed.]

So rather than improving consumers’ well-being, government policies will only make things much worse. (On this, no mathematical methods, no matter how sophisticated, could tell us what the competitive price level is. Those who hold that game theories could do the trick are on the wrong path. If models could tall us what prices arise, we wouldn’t need a market to discover them.)

Again, contrary to the perfect competition model, what gives rise to a greater competitive environment is not a large number of participants in a particular market but rather a large variety of competitive products. Government policies, in the spirit of the perfect competition model, however, are destroying product differentiation and therefore competition.

Products are Heterogeneous

The whole idea that various suppliers can offer a homogeneous product is not tenable. For if this was the case why would a buyer prefer one seller to another? (The whole idea to enforce product homogeneity in order to emulate the perfect competition model will lead to no competition at all.)

Since product differentiation is what free market competition is all about, it means that every supplier of a product has 100 percent control as far as the product is concerned. In other words, he is a monopolist.

What gives rise to product differentiation is that every entrepreneur has different ideas and talents. This difference in ideas and talents is manifested in the way the product is made, the way it is packaged, the place in which it is sold, the way it is offered to the client, etc.

For instance, a hamburger that is sold in a beautiful restaurant is a different product from a hamburger sold in a takeaway shop. So if the owner of a restaurant gains dominance in the sales of hamburgers should he then be restrained for this? Should he then alter his mode of operation and convert his restaurant into a takeaway shop in order to comply with the perfect competition model?

All that has happened here is that consumers have expressed a greater preference to dine in the restaurant rather than buying from the takeaway shop. So what is wrong with this?

Let us now assume that consumers have completely abandoned takeaway shops and buying hamburgers only from the restaurant, does this mean that the government must step in and intervene?

The whole issue of a harmful monopoly has no relevance in an unhampered market. A harmful monopolist – an actual coercive monopoly – is only likely to emerge when the government puts its powers of coercion behind selected businessmen; by means of permits, for example,  restricting the variety of products in a particular market (the government bureaucrats decide what products should be supplied in the market); or means of occupational licensing, restricting the number and scope of tradesmen or professionals in a particular market (the government bureaucrats decide what tradesmen or professionals may do, and what restrictions to impose on becoming one).

By imposing restrictions and thus limiting the variety of goods and services offered to consumers, government curtails consumers' choices, thereby lowering their well-being.

Lowering their well-being in fact, not just in the hyperbolic projections of these perfectly arid theorists.

Summary and conclusion

We suggest that the whole idea of government regulating large firms in order to promote competition and defend people’s well-being is a fallacy. If anything, such intervention only stifles market competition and lowers living standards.

Alfred Nobel’s goal was to reward scientists whose inventions and discoveries bettered people’s lives and well-being. However, enhancing government controls of markets runs contrary to that spirit.


Photo of Frank    ShostakDr Frank Shostak is the head of Australian research firm Applied Austrian Economics Ltd, and one of the world leaders in the applied Austrian School of Economics. An adjunct scholar at the Mises Institute in the US, Dr Shostak has been an economist and market strategist for MF Global Australia (previously Ord Minnett) since 1986. During 1974 to 1980 he was head of the econometric department at the Standard Bank in Johannesburg South Africa. During 1981 to 1985 he was head of an economic consulting firm Econometrix in Johannesburg.
This post first appeared in its original form at the Mises Daily. It has been lightly edited.

2 comments:

  1. One of the things I like about this blog site by PC, is that I can be part of it, I can take it at my own pace.
    And that is slow
    Over at Matt Nolan TVHE [ the visible hand in economics , how absurd ] and Eric Crampton from Manitoba
    there is no room for reconsideration, they know. Come in here Eric and Matt

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  2. I don’t see it quite like that. You get taught in economics 101 or whatever that a free market is pareto optimal subject to some conditions, and maybe the lecturer says something along the lines that the conditions never hold exactly but hey its close enough. And then I think many people go through life remembering the bit about the free market being optimal and forget the conditions. Or if they are of the other persuasion remembering that the conditions don’t hold and rejecting free markets. Frank says that a world where the conditions for an optimum hold is ‘walter mitty’esque but that is the world that the pure free marketers inhabit. To observe that the conditions do not hold in some cases is surely to acknowledge reality. I thus do not understand the byline of the piece. It is the next step, acting to correct the problem that is the issue, and here I might agree with Frank. Any intervention must meet the standard test – does the benefit from the intervention exceed the costs, and if the ‘benefit’ is not quantified but is simply a belief in the superiority ‘perfect competition’ as he avers, it may well fail for the reasons he cites. Nevertheless I do believe that recognising and understanding the reasons for market failure is worthwhile and I believe that in some markets a case for intervention can be made. I will give a couple of examples – digital recording and transmission has made the marginal cost of recordings near zero violating the ‘constant returns to scale’ assumption for market optimality. Economists would tell you that social net benefits would be maximised if the price of recordings were zero. Governments upholding social benefits might encourage recording companies to move to a different distribution model, but to date have instead tried to enforce copyright provisions. I am not advocating a solution here, but understanding the nature of the market failure might illuminate the debate. In the public bus industry, rising car ownership in the third quarter of last century led to falling public transport patronage. Because the industry has benefits to users from scale, attempts to meet the loss of patronage by cutting services accelerated the patronage loss and a vicious downward spiral was triggered. This was seen as a market failure and previously privately owned services were taken over by states and municipalities. By and large the cure was worse than the problem and losses ballooned while services continued to decline. Reform of the sector has allowed private companies to re-enter the market to provide contracted services that do provide net benefits although the nature of the problem is still not well understood by politicians. The point is that without intervention, the level of service would be sub-optimal, but in this case it is possible to intervene in a way that generates net benefits.

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