Competition and Market Power Why a "Well-Regulated" Market is an Impossible Ideal

Standard accounts of basic economics usually begin by outlining the features of “perfect competition.” For example, Mankiw’s popular Principles of Economics defines a perfectly competitive market as one that satisfies the following properties

  1. The goods offered for sale are all exactly the same
  2. the buyers and sellers are so numerous that no single buyer or seller has any influence over the market price.

    The implication of these two properties is that all firms in a perfectly competitive market are “price takers.” If any firm tried to set a price higher than the current market price, their sales would immediately drop to nothing as consumers shift to other firms offering the exact same good for a cheaper price. As long as firms can enter and exit a market freely, perfect competition also implies zero profits. Any market experiencing positive profits would quickly see entry as firms try to take advantage of the new opportunity. The entry of new firms increases the supply of the good, which reduces the price and therefore pushes profits down.

After defining the perfectly competitive market, the standard account begins to extol its virtues. In particular, a formal result called the First Welfare Theorem shows that in a perfectly competitive equilibrium, the allocation of goods is Pareto efficient (which just means that no other allocation could make somebody better off without making somebody else worse off). So markets are great. Without any planner or government oversight of any kind, they arrive at an efficient outcome on their own.

But soon after developing the idea, we begin to poke holes in perfect competition. How many markets can really be said to have a completely homogeneous good? How many markets have completely free entry and no room for firms to set their own price? It’s pretty hard to answer anything other than zero. Other issues also arise when we begin to think about the way markets work in reality. The presence of externalities (costs to society that are not entirely paid by the individuals making a decision – pollution is the classic example), causes the first welfare theorem to break down. And so we open the door for government intervention. If the perfectly competitive market is so good, and reality differs from this ideal, doesn’t it make sense for governments to correct these market failures, to break up monopolies, to deal with externalities?

Maybe, but it’s not that simple. The perfect competition model, despite being a cool mathematical tool that is sometimes useful in deriving economic results, is also an unrealistic benchmark. As Hayek points out in his essay, “The Meaning of Competition,” the concept of “perfect competition” necessarily requires that “not only will each producer by his experience learn the same facts as every other but also he will thus come to know what his fellows know and in consequence the elasticity of the demand for his own product.” When held to this standard, nobody can deny that markets constantly fail.

The power of the free market, however, has little to do with its ability to achieve the conditions of perfect competition. In fact, that model leaves out many of the factors that would be considered essential to a competitive market. Harold Demsetz points out this problem in an analysis of antitrust legislation.

[The perfect competition model] is not very useful in a debate about the efficacy of antitrust precedent. It ignores technological competition by taking technology as given. It neglects competition by size of firm by assuming that the atomistically sized firm is the efficiently sized firm. It offers no productive role for reputational competition because it assumes full knowledge of prices and goods, and it ignores competition to change demands by taking tastes as given and fully known. Its informational and homogeneity assumptions leave no room for firms to compete by being different from other firms. Within its narrow confines, the model examines the consequences of only one type of competition, price competition between known, identical goods produced with full awareness of all technologies. This is an important conceptual form of competition, and when focusing on it alone we may speak sensibly about maximizing the intensity of competition. Yet, this narrowness makes the model a poor source of standards for antitrust policy.
Demsetz (1992) – How Many Cheers For Antitrust’s 100 Years?

Although the types of competition outlined by Demsetz are a sign of market power by firms, they are not necessarily a sign that the market has failed or that governments can improve the situation. Let me tell a simple story to illustrate this point. Assume a firm develops a new technology that they are able to prevent other firms from immediately replicating (either because of a patent, secrecy, a high fixed cost of entry, etc.). This firm is now a monopoly producer of that product and can therefore set a price much higher than its cost and make a large profit. The government sees this development and orders the firm to release its plans so that others can replicate the technology and produce their own version. Prices fall as new firms enter and profits go to zero. Consumers are better off since prices are lower and they have a larger choice of products. (A similar story could also be told if the government simply mandated a lower price by monopoly firms).

But the story isn’t over. If I’m another entrepreneur (or even an existing firm) watching this sequence of events, I’m a bit worried. That new idea I was thinking about is going to cost a lot. If I had the possibility to make a large profit, maybe I would be willing to take the risk and go for it anyway. If, on the other hand, I knew for sure that even when I achieve success the government immediately reduces my profits to zero, am I still going to undertake that project? Not a chance. The potential for future profits is an incredibly important incentive for innovation.

Here’s another example from the real world that illustrates the opposite case. In the late 1990s, Microsoft tried to bundle Internet Explorer with their Windows operating system (essentially giving away Explorer for free). This move made it difficult for independent internet browsers to compete (Netscape was the market leader at the time). An antitrust lawsuit was brought against Microsoft and they were initially ordered to break up (which never actually occurred in the end as far as I know, but that doesn’t matter for the story). In the EU, they were required to provide a browser choice page when installing Windows.

In each of the two examples above, there is a clear tradeoff. In the first, consumers are better off in the short run (lower prices), but potentially worse off in the long run (less innovation). The second case is exactly the opposite. Consumers are worse off in the short run (they don’t get a browser for free) but potentially better off in the long run (more browser competition). Can we say for sure whether regulation helps or hurts in either case? Can we even say whether the regulation would push the market to be more competitive or less? I don’t see how (but which browser you are using right now despite the relatively lenient restrictions on Microsoft might give some indication).

I’m not saying regulation is never a good idea in theory. But in practice, it turns out to be really hard. Even in the cases above where it is obvious that a firm is trying to take advantage of monopoly power, it remains unclear whether a move closer to “perfect competition” will result in an increase in actual competition. You can of course pick apart the stories above and come up with some regulatory scheme that balances present and future costs and benefits. But doing so in general would require governments to have even more information than the already ridiculous knowledge assumptions implicit in the perfect competition model. It’s easy to point out imperfections in markets. It’s much harder to figure out what to do about them.

Notice that I haven’t necessarily made an argument against regulation. The takeaway from this post should not be that markets always work or that regulation always fails (I’ll leave that for future posts!). My point is simply that pointing out a flaw in the free market does not automatically imply an opportunity for a regulatory solution. The question is much more complicated than that.

But having said that let me leave you with one final thought. Markets are incredibly dynamic. Whenever the market “fails,” all it takes is one clever entrepreneur to come up with a better method and correct the failure. When government fails? Well, maybe we can come back to that in ten years when they get around to discussing it.