Friday, May 20, 2016

F. A. Hayek and the Meaning of Competition

 Friedrich A. Hayek

Richard Ebeling emails:

Seventy years ago, today, on May 20, 1946, Austrian economist, Friedrich A. Hayek, delivered at Princeton University one of his most important and insightful lectures on, “The Meaning of Competition.” It was published in 1948 in a collection of his essays, “Individualism and Economic Order.”

The central argument of Hayek’s lecture was to challenge the logic and relevance of the “perfect competition” model in mainstream Microeconomic theory. He said that the assumptions of the perfect competition model – that all market participants on the demand- and supply sides, respectively, are too small relative to the overall market in which they interact to influence the market price, i.e., each takes the market price as “given’; every seller in each market produces and sells a product that is exactly like that marketed by their immediate rivals in the same market, i.e., no product differentiation; and each market participant possesses perfect or sufficient knowledge about relevant market conditions to never make a buying or selling mistake in terms of the price they pay as demanders or accept as sellers – are such that they logically eliminate any meaning to the normal and everyday use and understanding of the idea “to compete.”

The perfect competition model assumes away all those “problems” that competition is, in reality, meant to solve. As Hayek had explained in his earlier article, “The Use of Knowledge in Society” (September 1945), knowledge is never perfect or the same for all individuals because inescapably matching the division of labor is a division of knowledge.

And given that the future is inherently unpredictable in a world of change, the task and role of competition is precisely to provide an institutional setting in which individuals have both the incentives and opportunities to try to discover, in peaceful rivalry with each other, who may be able to make that new, better or less expensive product that consumers might be willing to purchase, Hayek now elaborated and explained in “The Meaning of Competition.”

Through the assumptions of the perfect competition model, microeconomic theory assumed away the need for a theory of the market process the very purpose of which could and should be to explain how individuals in the market would ever establish through their interactions the hypothetical conditions that, if ever achieved, would reflect and define a state of perfect economic equilibrium within and across markets.

Economists may draw their supply and demand curves, and their marginal revenue and marginal and other cost curves on the classroom chalkboard, and show the “optimal” equilibrium relationships; but in the real world none of these curves are known and even if ranges of them could be empirically identified “today,” market conditions will inevitably be different “tomorrow.”

One of the dangers to which mainstream economists were susceptible, Hayek warned, was the belief that because they could abstractly and hypothetically trace out what such equilibrium conditions and relationships logically should look like, they too easily fell into the illusionary trap that this enabled them to practically or empirically identify any existing market situation as “perfectly” or “imperfectly” competitive. The implication being that if the observed market situation was declared to be “suboptimal,” the duty of economic policy should be to regulate and direct markets into the “perfectly competitive” pattern.

Hayek’s policy perspective and prescription was to accept the fact that such imaginary perfectly competitive equilibrium states can never be determined and calculated in the real world. This is partly due to the fact that we don’t know what the market “facts” and relationships can be and will be independent of and before the competitive process has been allowed to play itself out.

The benchmark of comparison, Hayek said, was not any existing market set of outcomes relative to the imaginary conception of a state of “perfect competition.” Instead it should be a comparison between situations in which competition did not operate, primarily due to various forms of government interventions, restrictions, and prohibitions, and the positive results when any degree of free, unrestricted and open competition is a work, when the market is left alone.

As Hayek concluded, and came in later years to especially emphasize, the necessity was for economists was to accept and show greater humility, that there are inevitable limits on what the economist can know and “correct” as a matter of policy. And that the best that may be possible in any given situation is only discovered through the competitive process, which requires allowing the market to work with little or no interference from governments and their economic policy advisors who often suffer from (as he entitled his 1974 Nobel lecture) a “pretense of knowledge.”

The full text of Hayek’s lecture, “The Meaning of Competition,” is available online here.


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