The Results Of Perfectly Competitive Capitalism

We are now ready to wind up the institutions of theoretical capitalism and watch their simultaneous performance under ideal conditions. The ideal conditions are fairly restrictive, but they are necessary to demonstrate the economic efficiency achieved by theoretical capitalism. In later chapters we will investigate the claim that theoretical socialism can achieve an equiv­alent degree of efficiency if similar ideal conditions are postulated.

The conditions can be stated in five brief categories. More rigorouf and elegant statements could be used, especially in mathematical form, but we are using economic theory to highlight economic systems, not the other way around. The five conditions are:

1. Consumers maximize their total utility or satisfaction instan taneously and without cost; firms likewise maximize their total profits and factor owners their incomes.
2. Consumers, firms, and factors of production can enter or exit from any market without cost or penalty.
3. There are sufficient numbers of firms, customers, and owners of factors of production in each market so the activities of any individual buyer or seller are too inconsequential to affect the prevailing market price. Individuals are price takers, not price makers, in the market.
4. Consumers experience declining marginal utility, meaning
that as they consume more and more of any given product they get smaller and smaller doses of additional satisfaction. Firms experience increasing marginal costs, meaning that as they produce more and more of any given product they incur larger increments of additional cost.
5. There are no technological or organizational economies of scale within the firms, no barriers to price flexibility in either di­rection, no governmental interference, and no other conditions that would impede the operation of perfectly competitive markets.

Product Markets

The market mechanism allows each consumer, operating in his own self-interest, to determine the unique combination of goods and services that provides the greatest achievable satisfaction within his spendable income. Like the system used by Boy Scouts at a jamboree, this process could oc­cur through bartering or swapping in the absence of price signals.; After a mutually advantageous swap, the law of diminishing marginal utility decrees that each partner attaches lower utility to the last unit of the item he acquires and higher utility to the last remaining unit of the item he gives up. Eventually his remaining supply of the bartered commodity be­comes too "valuable" to part with relative to what he can get for it, and further trade ceases.

Prices perform exactly the same function as repetitive bartering, with­out the monumental confusion that would exist if a complex capitalist economy had to rely extensively on face-to-face exchange through barter. Consumers divert their dollars away from goods giving little additional satisfaction and toward goods yielding more additional satisfaction at pre­vailing market prices. Diminishing marginal utility again sets a stopping place—an individual equilibrium in which the marginal utility per dollar expended is the same for each commodity. Each consumer, in effect, bar­ters away potential purchases of less preferred goods.

Perfectly competitive firms also operate within a framework of prevail­ing product prices. Firms maximize their profits by producing a level of output in each product line so that the additional cost of the last unit of each product is precisely equal to the price received from its sale. If price is above marginal cost for some products and below in others, the firm will shift the resources at its command into producing more of the prof­itable goods and less of the unprofitable ones. The law of increasing mar­ginal costs ensures that the individual firm will use this process of internal barter to stop at a profit-maximizing equilibrium in its production mix.

Since it is assumed that consumers and producers are unable to affect prices by solitary actions, it is evident that prices will change only through the cumulative effects of a change in underlying demand conditions (re­flecting consumer tastes) or supply conditions (reflecting production costs). Once any price in the product universe changes, all consumers and pro­ducers face the task of adjusting their activities to achieve equilibrium once again. Included in this adjustment process is the entry or exit of some firms and some consumer markets for particular products.

Factor Markets

Factor markets under theoretical capitalism parallel product markets in responding to supply and demand conditions, but for some reason students have more trouble understanding how factor markets work. First, even in the absence of a price system in factor markets, firms could swap fac­tors just as consumers could swap products if it were mutally advantageous to do so. Firms using identical factors of production would test to see whether they could gain more additional production (called marginal phy­sical product) by acquiring more of one factor than they would lose by giving up the required amount of another factor. Barter would occur when a firm with relatively more productive potential uses for one of two factors found a firm in the opposite situation. Moreover, if marginal physical product declines as more and more of a factor is added, the bartering will halt when the ratio of marginal products is the same in each firm.

Factor prices, like product prices, circumvent the inconvenience of bartering. Each firm, facing an array, of factor prices that it cannot influ­ence, chooses to acquire additional units of factors whose additional con­tribution to output per dollar expended is high and to divest itself of factors whose marginal product per dollar of factor cost is relatively low. 'A little thought will show that a firm minimizes its total costs, under conditions of declining marginal physical product, when it chooses an equilibrium in which the marginal product per dollar spent on each factor is equal. A firm following this rule of maximum output per dollar of costs is also minimizing additional costs per unit of output, thus ensuring that the pat­tern of marginal costs for each product is as low as possible. A profit-maximizing firm must logically also be a cost minimizer.

Demand for factors of production is thus related to their relative ef­fectiveness in producing final products. What determines the supply of factors of production? If factors are conceived of in the broadest cate­gories of land, labor, and capital, then the supply is pretty much fixed at any moment and changes only in response to slow changes in population behavior or land-settlement patterns. If, however, factors of production can choose among alternative occupations, then a higher factor price will bring forth a greater quantity of that factor. For example, workers con­fronted with prevailing wage rates in various occupations choose according to their earning skills and the attractiveness or unattractiveness of work­ing conditions in each.

Since no single buyer or seller can influence factor prices under con­ditions of perfect competition, a prevailing set of equilibrium factor prices will change only if the basic supply or demand conditions change. And again, as in the case of product prices, a change in one or more factor prices means that all participants must at least check to make sure that they are demanding or supplying the individually optimal pattern of resources.

Income Distribution

Economists studying capitalist economic systems are often accused of neg­lecting the topic of income distribution. Their defense is that under theo­retical capitalism there is little to discuss—perfectly competitive markets determine factor prices and hence factor earnings. Often a value judgment is slipped in at this point, stating that incomes determined by competitive markets are "fair" and that therefore individuals at the lower end of the income scale have no legitimate complaint about their economic status.

This argument is inadequate in at least two respects. First, it says nothing about how the ownership of productive resources is distributed. If land, physical capital, and human capital are concentrated in a small sector of the total population, it follows that income from those factors will be similarly concentrated so that effective demand for commodities will be tilted toward recipients of nonwage income. An economic theory that has so little to say about how the distribution of factor ownership came about in the first place is vulnerable to criticism.
Second, political power often parallels concentrations of economic power. Theoretical capitalism assumes that government does not interfere in competitive markets. This noninterference is, at the very least, likely to preserve existing concentrations of economic and political power or even to facilitate a trend toward greater concentration. These are issues to con­sider even in the most abstract discussions of theoretical capitalism. When we relax our assumptions to allow imperfections and interferences in fac­tor markets, they will assume major importance.

We should also keep in mind that the abstract factor of production called labor is made up of flesh-and-blood human beings whose rational powers of observation make them aware of their economic situation. While it might be economically rational to withhold one's labor at a low pre­vailing market wage, it might not be realistic in terms of survival.

Economic Balance and Pareto Optimality

We have demonstrated the solution provided by perfectly competitive capi­talism for each of the major questions that every economic system must answer: what to produce, what factor combinations or techniques of pro­duction to use in producing it, and how to divide up access to what is produced. It remains to show how the final proportions of goods produced are selected and how the perfectly competitive economy is economically efficient.

Imagine an extreme case in which all factors of production are fully employed in producing a single product—ashtrays. Under these circum­stances it is more than likely that the marginal utility derived by the typical consumer from his last ashtray is very low. Likewise, the marginal cost of producing the last ashtray is very high because some factors of produc­tion are very ill-suited for ashtray production. To shift some of these fac­tors to another product, say doughnuts, would sacrifice few ashtrays and would involve a gain in consumer satisfaction due to the high marginal utility of the new product for doughnut-starved consumers. In the process the income of factors specially suited to doughnut production rises and that of factors stuck in ashtray production falls.
As doughnuts and other new products are introduced, the marginal utility gained from additional units will decline and the marginal costs con­nected with their production will rise. An equilibrium will be established where the ratio of marginal utility to marginal cost for the last unit of each product, including ashtrays, is equal. One of the strongest claims for competitive markets is their ability to relate the mental preferences of individual consumers and the facts of relative factor scarcity (as reflected in the cost curves of individual firms) in one global, simultaneous, friction-less system.

The system is -also economically efficient in the sense that no individ­ual can be made better off without reducing the total satisfaction of some other individual. The sources of potential slack—a reallocation of goods among consumers, a reallocation of factors among firms, a change in the consumer's own product mix or the firm's own factor mix—are all ruled out when the competitive system achieves equilibrium prices and quanti­ties in every market. This situation, called Pareto Optimality, is a standard of comparison for judging other theoretical systems. It is also a basis for discussion of the effects of market failure in causing the capitalist system to fall short of the potential output achievable under efficient conditions.