Competition: Classroom Theory vs. Business Reality

Mr. Peterson is a graduate student in economics. He also has served as a summer research assistant at the Federal Reserve Board.

Punitive antitrust. Over-regulation of business. The "break-up-GM" and "break-up-IBM" syndrome. Deep-rooted suspicion of business. All this and more are in a large way traceable to Eco. 101, the undergraduate course in microeconomics, including basic competition and price theory.

I submit that a key reason why competition is so widely misunderstood is because of the way it is generally taught in colleges and universities.

In my judgment, the essential source of the confusion between theory and reality is a static view of a dynamic world: the model of "perfect competition" and its related model of "pure competition." Perhaps nothing in our social realm is perfect or pure, of course, but most academic economists still use perfect competition as a static yardstick with which to measure dynamic competition in the real world.

For example, Nobel Prize winner Paul A. Samuelson in the eighth edition of his best-selling textbook, Economics, states: "The competitive model [of perfect competition] is extremely important in providing a bench mark for appraising the efficiency of an economic system."

He adds: "Once the rules of perfect competition are left behind, there is no Invisible Hand principle which sets up a presumption that the working out of laissez faire is likely to be in the direction of satisfying wants most efficiently."

The standard treatment of perfect competition by Professor Samuelson and other textbook writers usually sets up four requirements:

1.         Perfect knowledge of market conditions and instantaneous resource mobility (a requirement usually dropped as obviously unattainable and thereby resulting in "pure competition" — and it is pure competition to which Samuelson refers when he treats "perfect competition")

2.         A large number of sellers in an industry (so large that none supposedly has any influence on price)

3.         A standardized or "non-differentiated" product throughout an industry (thus, no brand names nor advertising)

4.            Free entry (meaning relatively costless admission of a new operating company into an established industry)

Having thus defined perfect competition, Eco. 101 textbooks generally describe the other models of lesser competition in terms of their failure to meet these four requirements. Thus "monopolistic competition" is basically pure competition without the standardization requirement met. Also, "oligopoly" (from the Greek, meaning "few sellers") is basically pure competition without the many sellers requirement met.

Naturally, the polar opposite of perfect competition is monopoly in Eco. 101 textbooks. Monopoly is said to consist of one seller selling a unique product (the product has to be unique because there is only one seller). And it also is said to be "protected" by high costs of entry, of which more later.

The Number-of-Sellers Requirement

So much for the textbook treatment of perfect competition and its corollaries. Sadly, the treatment is not just an ivory tower matter.

Consider, for example, the number of sellers requirement as it is applied outside the classroom. This requirement is largely the focus of modern antitrust policy. Indeed, Chief Justice Earl Warren stated in the landmark Brown Shoe decision (1962):

"It is competition, not competitors, which the [Clayton] Act protects. But we cannot fail to recognize Congress’ desire to promote competition through the protection of viable, small, locally-owned businesses. Congress appreciated that occasional higher costs and prices might result from the maintenance of fragmented industries and markets. It resolved these competing considerations in favor of decentralization."

Thus, modern antitrust policy, borrowing from classroom theory, prefers to maintain a relatively large number of sellers even at the expense of efficiency.

This conflict between numbers and efficiency points up the essential weakness of the number of sellers requirement under pure competition: Little is said about the determinants of the number of sellers. But consumer sovereignty, management ability, and economies of scale are important factors affecting the number of sellers. The presence of few sellers may well be a sign of significant efficiency benefits for the consumer from mass production, mass distribution, and mass research.

For example, the auto industry, called an "oligopoly" in virtually all textbooks, is actually quite competitive, despite the presence of a few domestic producers. GM, Ford, Chrysler, and AMC. In the early years of the twentieth century, there were literally hundreds of small sellers. But the consumer — through Henry Ford drove out many sellers, as Ford steadily reduced his costs through mass production techniques and dramatically lowered his price. Surely this was competition, and the most basic kind — price competition.

Alas, however, Henry Ford would today probably be considered an imperfect competitor by most students taking Eco. 101. Now he would also be faced by a gamut of antitrust suits, both public and private (from competitors), much as is IBM today.

Apart from efficiency considerations, other factors, which are omitted by the numbers requirement, enter into actual competition — i.e., dynamic competition. For example, there are also uncountable potential sellers not quite able to enter an industry — entrepreneurs, usually in related industries, who are waiting for a rise in demand, a technological breakthrough, or some ineptitude on the part of the existing suppliers, before joining the established sellers. Rohr, an aerospace producer supplying San Francisco’s BART rapid transit system, is a case in point of a potential seller converting into an actual.

Competition is Market-Wide, Not Confined to a Given Industry

Another example of an omission in perfect competition theory is competition among individual industries. Interindustry competition exists because for any product there is usually a range of substitutes. To his credit, Samuelson explains that pure competition theory excludes competition between industries such as steel and aluminum.

Perhaps this omission by perfect competition theoreticians can be explained as the confusion of an industry for a market. The point of view of an "industry" is generally that of the seller; the point of view of a "market" is generally that of the buyer.

But the consumer, not the producer, is sovereign. In the market place, it is the consumer’s view that prevails. The buyer’s market perspective includes a full range of choices available to him in all competing industries (and even in noncompeting industries in the sense that all industries compete for the consumer’s dollar). Witness, for example, the demise of the once blue-chip streetcar industry, which fell prey to the motor car, i.e., to the sovereignty of the consumer.

Or consider a personal example. Not long ago I had to get from Newark, New Jersey to Washington, D.C. I considered three options: driving a rented car, taking the air shuttle, or riding the Metroliner. To me, the sovereign consumer, the three were very much in competition—interindusty competition. This is but another example of how in the eye of the consumer a market inevitably transcends an industry or even several industries.

The Forgotten Consumer

But under the doctrine of perfect competition inherent in modern applied antitrust policy, the consumer plays second fiddle to the Justice Department. The consumer, for example, built up IBM, democratically; now the Justice Department seeks to tear it down, arbitrarily.

Thus, the number of sellers requirement in perfect competition variously conflicts with actual dynamic competition. The other requirements do, too. Product differentiation, for instance, is considered wasteful by many economists. They deplore the cornucopia of choices available to the consumer, although they might inconsistently deplore the lack of choice in, say, some development housing.

Here, again, theory is at odds with reality. A producer who strives for product innovation — for quality competition, as opposed to price competition — is branded as an imperfect competitor. But are not attempts to improve products salutary? Many economists may not like quality competition, but consumers do. Take King Gillette and his revolutionary safety razor of a half century ago, for instance. Here, technology and quality competition seemingly launched a "monopoly." But did it?

Further, is it feasible for an economist of the imperfect competition school to enter the market place himself, so to speak, and declare with all the weight of his academic credentials that this product or that is or is not wasteful? Is it really in this economist’s domain to pass a scholarly opinion on whether, say, the deodorant soaps of today, or even the tailfins of the 1950′s, constitute "waste?" The individual consumer can better decide such questions, for only the consumer knows exactly what he or she wants. (And this proposition holds true for the sovereign corporate consumer as well — e.g., General Motors is a consumer of U.S. Steel and vice versa.)

The requirement of free entry also does not correspond with competition in the real world. Any entry involves cost, of course, as does all economic activity. But to posit a model of perfect competition in which the costs of entry are very low, runs against common sense.

According to this low-cost argument, economies of scale create a protectionist "barrier to entry" because of the heavy investment involved. Thus, mass production is doubly evil in the eyes of perfect competition: it reduces the number of sellers, and creates barriers to entry. But the contribution of economies of scale to lower prices tends to be played down, along with the fact that many firms with economies of scale can be overtaken (such as Ford by General Motors in the 1920′s and Sperry Rand by IBM in the 1950′s).

Another example of a barrier to entry cited by quite a few economists is advertising. These economists pick on advertising — apart from its "wastefulness" — because new entrants must pay more in advertising costs than established sellers. True, but they must do so in order to win the consumer’s acceptance. For new entrants, advertising is frequently a vital means of gaining acceptance. Restrictions on advertising, which are recommended by some economists, would hurt new entrants and potential competitors.

Thus, all the requirements of perfect competition have severe shortcomings. In a word, all these requirements and their regulatory and other repercussions reflect a concept of competition that is essentially static.

But actual competition is dynamic, not static. The dynamics include the reduction of costs b mass production techniques and new technology, the competition from substitute products, the competition from potential sellers, and the incentive of sellers to improve their products — all under the most dynamic factor of all, the watchful eye and hard decision of the consumer, individual and corporate.

In sum, the conflict between classroom theory and business reality in our understanding of competition is anything but academic.