Competition and The Market Process

Competition and The Market Process

As a result of the combined influence of many economic theorists, but especially Cournot and Walras, "competition" took on a meaning in the nineteenth century quite apart from the practical but ambiguous sense it was given in classical economics. Early use of the term meant simply rivalrous behavior (e.g., in Adam Smith); in other words, two or more parties seeking the same prize, which usually meant economic profits. The subtle but lasting influence of Cournot and Walras was to change this notion from what may basically be described as a process to what may be described as a situation. Emphasis turned away from the institutional setting and the person­alities involved and toward the conditions that must be fulfilled in order to yield an equilibrium result. Thus the notion of "perfect competition" emerged, a notion that encapsulated the following conditions: (1) perfect knowledge of every relevant util­ity function of both buyers and sellers and of all relevant prices, (2) an infinitely large number of buyers and sellers, (3) complete and open entry and exit of all firms, (4) constant expectations, and (5) homogeneous products. When these conditions are op­erative, the "competitive equilibrium" results—that is, a uniform price for each good, a "normal" level of profits for each producer, utility maximization for each consumer, and no further tendency for things to change. The assumptions of competition are, therefore, nothing else but the conditions necessary to make equilibrium "determinate."

The "competitive model" so briefly sketched here has performed yeoman service in the evolution of economic theory because it has made it possible to give an exact account of the course of economic events solely with the aid of scientific general­izations. In any analytical study, forces whose operations are known must be sepa­rated from those that exhibit no uniform principles. The only satisfactory way of rec­ognizing and accounting for the influence of the latter in the real world is to assume them away and observe what happens in their absence. This method of omission and comparison also offers the best hope that we can gradually extend the range of phe­nomena over which we can make generalizations. But it should be obvious that this technique requires constant awareness of its limitations as well as its strengths.

It has never been easy to convince people that the way to discover reality is through unreality—yet that is what the neoclassical competitive model requires. Modern Austrians offer an alternative that purports to be more realistic because it attempts to incorporate aspects of the human personality excluded from the neo­classical, "mechanistic" model. In particular the Austrian approach seeks to deal ex­plicitly with individuals': (1) knowledge about their own tastes and the opportuni­ties available, (2) interpretations of current events and others' actions, (3) expectations about future events and behavior, and (4) alertness to new opportuni­ties previously unrecognized. In the Austrian view the key insight into competition is that different people know different things. The market is a process whereby scat­tered and often contradictory bits of information are assimilated and transmitted to individual market participants; in Hayek's phrase, the competitive market process is a discovery procedure. Competition—not in the technical sense of "perfect com­petition," but in the older sense of rivalry—is the engine that drives the market process down the road to coordination of individual plans (the Austrian conception of equilibrium).

Hayek has never tired of pointing out that if all that needed to be known was al­ready known, then every market decision would correctly anticipate every other de­cision and the market would automatically have attained full equilibrium. The mar­ket is necessary precisely because it is an institutional device for mobilizing existing knowledge and making it available to market participants who are not omniscient. Tak­ing the argument one step further, Austrians argue that the competitive market process is needed not only to mobilize existing knowledge but also to generate awareness of new opportunities. The discoverers of these new opportunities are the entrepreneurs, who take on a far more crucial role in the Austrian paradigm than was previously as­signed to them by classical or neoclassical economics. Indeed, in the Austrian frame­work, the competitive process is by its very nature an entrepreneurial process.

The standard neoclassical theory employs the concept of "economizing," or max­imizing utility subject to given tastes and prices, which is inadequate to explain the search for new opportunities, whether they consist of new products or variations on existing ones. Likewise, the terms "prices" and "profits" have a more restricted de­finition in standard use. Conventional theory assumes that the firm confronts known and given cost and revenue possibilities. Profit maximization does not entail discovery of a profit opportunity; it merely requires calculative action to explain already existing and recognized opportunities. In the Austrian view, this takes too much for granted. The Austrian approach views prices as (disequilibrium) exchange ratios rep­resenting the incomplete discoveries and current errors made up to the moment by profit-seeking entrepreneurs. Thus market prices offer opportunities for pure profit, and it is up to the alert entrepreneurs to sniff out these opportunities and act on them. This view of profit, significantly, has nothing to do with monopoly power. It is merely the reward for noticing some lack of coordination in the market. As such, it is a necessary incentive for the discovery of new knowledge, not, as in the standard theory, a minimal payment to a disembodied economic agent to stand pat.