capitalism

Competition 85
efforts between sellers to cooperate in setting prices above
competitive levels would invariably end in failure. This
argument is consistent with Smith’s view that monopolies
were nothing more than government-granted privileges.
During the early 20th century, the concept of perfect
competition was put forward by economists; it referred to
competition as it would exist under the following five conditions:
first, that there were a large number of buyers and
sellers trading a uniform product; second, that the market
had free entry and exit; third, that all market participants
were fully informed regarding all opportunities for trade;
fourth, that bargaining and price changes cost nothing; and
fifth, that enforcing the terms of a transaction is costless.
Under these conditions, individuals will engage in trades
that bring about perfection in the allocation of existing
resources. This static view of competition treats it as an end
state or goal, rather than an ongoing process.
Some economists have used the theoretical results of
perfect competition as a standard in judging the performance
of real-world markets and found the market system
lacking. In this view, private businesses wield “market
power” to set prices above perfectly competitive levels.
These economists argued that governments could improve
upon actual competition with policies that bring about perfectly
competitive results.
Harold Demsetz has countered these conclusions by
arguing that perfect competition is too high a standard for
either real-world markets or the government to meet. This
argument is true because there is a positive cost to operating
any economic system. Because both competitive
market systems and planned economies cost something to
operate, neither will allocate resources perfectly. These
operating costs create imperfections in both private markets
and the public sector. Demsetz maintained that economists
who condemn the free market on these grounds fail to
account for the possibility that government intervention
aimed toward correcting market imperfections is imperfect.
Thus, when the government intervenes to correct the market,
there always exists the possibility that it might make
matters worse. Demsetz further demonstrated that abnormally
high profit rates tend to disappear over time, thus
negating the purposes of government intervention.
Similarly, Friedrich Hayek argued that the concept of perfect
competition misconstrues the true nature of competition.
According to Hayek, perfect competition represents a
situation where actual competition has ended. To Hayek,
competition is a procedure in which competitors search for
opportunities for profit. Competitors begin this procedure
with relatively little knowledge of the situations that they
face in the markets in which they sell. Competition between
sellers then amounts to a discovery procedure as sellers learn
how to increase their profits and buyers discover new opportunities
for consumption. This analysis directly contradicts
the assumptions of perfect competition, which are predicated
on the presence of perfect information. Hayek stressed that
competition is important precisely because it drives individuals
to improve on the limited knowledge that they possess.
Consequently, attempts to condemn the market system
because sellers lack perfect information make no sense.
Because competition involves the discovery of new
opportunities for trade, the assumption of perfect information
means that “perfect competition” would exist only
in situations where all competition is over. Israel Kirzner
extended Hayek’s arguments in noting the crucial importance
of alertness on the part of entrepreneurs in discovering
new opportunities for profit.
Hayek and Kirzner emphasized that competition is an
open-ended process and doubted the realism of perfectly
competitive models. Under perfect competition, competition
is an end state where all individuals know who their best
potential trading partners are. By focusing on continuous discovery,
Hayek and Kirzner demonstrated the importance of
competition as a means of collecting the information that the
perfect competition concept takes for granted.
The importance of advertising to competition was discussed
by George Stigler and Lester Telser, who demonstrated
that advertising acted as a means of reducing the
costs of gathering information. To Stigler and Telser, advertising
fosters competition by informing individuals about
the opportunities that await them in markets.
Some economists have noted that in some markets natural
barriers to entry and exit limit competition and may
even result in the formation of private monopolies.
Although this concern is legitimate, there are two important
points to keep in mind. First, as economist William Baumol
has argued, potential competition can work just as well as
actual competition. In some cases, monopolies may form,
although it is possible for other sellers to enter the market.
In such instances, monopolists (in the sense of single sellers
in the market) will price their products as if they in fact
had competitors. In other words, monopolists who fear
potential competition will charge competitive prices to prevent
entry by competitors. Because the primary complaint
about monopolies is that they charge prices above competitive
levels, it makes little sense for anyone to worry about
monopolies that use low prices as a barrier to entry.
Second, even if a monopolist secures another type of
barrier to entry and sets prices above competitive levels,
this fact does not imply that there is no competition.
Instead, these situations generally imply that competition
has moved to a different level. Barriers to market entry are
seldom free and generally require maintenance. Demsetz
points out that if some companies have higher profits than
others, it may be because they have some uncapitalized
asset, such as a trademark or goodwill. Some entrepreneurs
create a barrier to entry through innovation. If an entrepreneur
creates a new product or develops a new technology
that reduces costs, then that entrepreneur is able to charge