Competition & Entrepreneurshipfor Freedom University

By Paul F. Cwik, Ph. D.Mount Olive College & The Foundation for Economic Education

What do you think of when someone says, “competition”?

Competition

When we observe the world around us, we notice that there is competition and trade.

So, why do we compete? And, why do we trade? We compete because there is not enough to fulfill all

of our wants and desires. We compete in the economic arena. We compete in the political arena. And there is only one Stanley Cup.

However, when I think of competition, I like to think of a Pixar short called “One Man Band”…

One Man Band

Analysis: What do we learn? Who had the power? Who was competing with whom? In a market the consumer is sovereign. The consumers are the real bosses. They are the true “kings”

and “queens.” No one can tell the consumer what to buy or not buy. Each of

us has our own Subjective Preference Scale, which changes whenever we change our minds.

When we trade, we trade UNequal valuations. We subjectively value costs. E.g., $1 is NOT the cost of the

Mountain Dew bottle; it is the price. The relevant cost is the opportunity cost—the next best thing that could be done with the $1.

The producer has to produce something worth our while or we might just toss the coin into the fountain.

How do consumers determine what should be built? In the previous lecture, we introduced the Preference

Scale. The preference scale is not set in stone and it can

change from moment-to-moment. The producer’s job, from an economic point of view,

is to transform resources into useful things. But not just randomly useful things. The items at the top of scale need to be produced

first, and then we work our way down it.

How do consumers determine what should be built? continued Consumers are the ones who ultimately determine

what should be produced, in what quantity and in what quality, and who should own the capital and run the plants.

But how? Suppose that we want to build a bridge. We know how to build bridges. Technology is the

knowledge of how to produce goods and services, but this is not enough.

Should we build the bridge out of wood? Stone? Concrete? Steel? Titanium? Some combination? Which combination?

Maybe it’s best to use an example…

We Need Entrepreneurs To solve this problem, we need entrepreneurs.

Entrepreneurs are the “undertakers.” The entrepreneur’s purpose is to make profit. No

more, no less. There is no doubt that the entrepreneur is the captain

of the ship. He gives the orders. However, the consumers are the navigators of the

ships. They set the course. Producers do not simply produce for themselves; they

produce for the market. Thus, they must follow the directions of the

navigators or they will “hit the rocks” and sink.

Consumers Signal Entrepreneurs Here’s an obvious observation: Consumers are fickle. They do not care about past merit. Or how production is done

(within limits). Or how hard the workers work. They do not care who the entrepreneur is or who the workers

are who lose their jobs. We don’t call Walmart ahead of time and warn them we are

coming. But they had better have what we are looking for. And at the right

quality. And at the right price. Or what happens? The consumers, who buy Good A at a price that justifies the

input decisions, signal and provide the justification for using the inputs in that manner.

With the profit motive, the entrepreneurs are compelled to supply the most urgent wants and desires of the consumers.

They cannot waste resources.

Entrepreneurs who perceive the future correctly are rewarded with profits. (More on this later.)

Losses are the result of bad judgment and/or luck. With ceaseless change in the economy, there will

always be profits and losses. Capitalism is the only system that allows for an

objective appraisal of the social division of labor and allocation of resources (i.e., Economic Calculation).

That is how consumers determine what should be built.

The Role of Entrepreneurs

How does Mises see the problem?“The problem to be solved in the conduct of economic affairs is this: There are countless kinds of material factors of production, and within each class they differ from one another both with regard to their physical properties and to the places at which they are available. There are millions and millions of workers and they differ widely with regard to their ability to work. Technology provides us with information about numberless possibilities in regard to what could be achieved by using this supply of natural resources, capital goods, and manpower for the production of consumers’ goods. Which of these potential procedures and plans are the most advantageous? Which should be carried out because they are apt to contribute most to the satisfaction of the most urgent needs? Which should be postponed or discarded because their execution would divert factors of production from other projects the execution of which would contribute more to the satisfaction of urgent needs?”—Mises, in Bureaucracy, page 22.

Economic Problem of Allocation To solve the problem about building the bridge, we

need to solve the “Economic Problem of Allocation.” The problem each country faces is that it must employ

factors of production “in such a way that only those goods should be produced which are fit to satisfy the most urgent demands of the consumers. No good should remain unproduced on account of the fact that the factors required for its production were used—wasted—for the production for another good for which the demand of the public is less intense.” —Mises, in Planning for Freedom, page 111.

Allocation continued If someone says that we should produce more

of good X, should we? If we produce too much X and not enough Y,

we are wasting. It is a violation of the Economic Problem of

Allocation. In order to solve this problem, we need a

method to objectively measure relative scarcities. Luckily we do, and it is called…

Economic Calculation

Economic Calculation cannot be done without a common denominator.

In capitalism, all designing and planning is based on market prices. They are the guide.

Through calculating and comparing Marginal Costs with Marginal Benefits, we can determine if we should engage in more or less of an activity.

Who is to actually follow the signals? Entrepreneurs read the market signals (price and

quantity relationships) and thereby attempt to follow the consumers’ wishes.

Those who successfully meet the consumers’ demands are rewarded with profits.

Those who do not, suffer losses. If enough losses are accumulated, the entrepreneur loses his position of control over the means of production. He ceases to be a decision-maker. He must go to work for someone else.

Only successful entrepreneurs are able to maintain their position as entrepreneur.

Markets are “Value-Free”

The market does not judge or place any moral value on an object or activity.

Some may say, “What we should really do…” But this is NOT the task of government or the

entrepreneur. If one wants to get people to do things or

abstain from things, he can persuade others, but NOT use the law and force.

Economic Valuations The ultimate basis of the market is people’s subjective

valuations, and these valuations can be flawed. Unfortunately, there is no better way.

If all people are flawed, then who can be the ultimate arbiter of what is “right” or “good” or “just”?

Even the majority can reflect all our short-comings and weaknesses. Markets reflect our subjective valuations. Prices allow calculation of the “best” use of resources as we

define it by our economic choices. They allow entrepreneurs to solve the Economic Problem of

Allocation. Economic Calculation makes it possible for entrepreneurs to

constantly adjust to the demands of the consumers.

A Return to the Bridge Problem Should we build the bridge out of wood? Stone?

Concrete? Steel? Titanium? Some combination? Which combination?

But which combination is best? Entrepreneurs do not only use new technology

(know-how), they must use the best combination of the lowest costing technology.

Where there are no markets, there are no prices and no economic calculation to be done.

The Knowledge Problem Hayek pointed out in 1945 that there isn’t one person, one

computer, or government bureau that can contain all of the knowledge necessary to calculate the scarcity ratios of all goods and services in an economy.

The knowledge is dispersed and decentralized across all of us. How much do you value your toothbrush? How much does your neighbor value his? Imagine asking that question about every single good, service and

resource out there in the economy. And what about the value of your time? Such a calculation without a common denominator is impossible. How should we build the bridge? And do it in a manner so that

we don’t waste resources. I think that we can all agree that waste is bad.

Luckily there is a tool that helps the entrepreneur coordinate the economy.

It’s prices that guide the entrepreneur.

Prices help the entrepreneur uncover and exploit profit opportunities.

Prices and Profits Drive the Economy We live in a world of change. The source of economic profit

is economic coordination. As entrepreneurs correct the

maladjustments and coordinate the economy, they receive economic profit.

The larger the discoordination, the larger the profit.

However, once they adjust production processes, the opportunity for economic profit disappears.

Qe

Pe

SupplyPrice

Quantity

Economic profits are the reward for removing maladjustments from the economy. Or, in other words, they are the reward for coordinating the market.

They cannot come about any other way.

No. Therefore, there is no such thing as “excessive profits.”

As an aside, rewarding by serving is the only fair way to allocate resources.

Can there ever be such a thing as “excessively coordinating” the economy?

The Use of Knowledge

The entrepreneurs compete for resources. The prices signal their relative scarcities. “Am I too scarce for you?” An entrepreneur who does not calculate correctly will

suffer losses and have to close shop. Only those who are successful at meeting the

consumers wants and desires stay in business and can expand their control over the means of production.

And never get mad at a high price. Prices measure relative scarcity. Getting angry with a high price is like getting mad at a thermometer for it being a hot day.

Prices are Information

It is the Price System that allows for rational economic calculation.

Prices are packets of information that communicate, to all who wish to look, relative scarcities of all goods and resources.

The price system tells us the relative scarcities of goods, services (including labor), resources, and everything that we value.

The price system shows how to allocate resources. Hayek uses an example of a tin mine…

The Famous Tin Mine Example Suppose that you

manufacture a product that contains tin.

For some reason, the price rises.

Do you care if it is because of a natural disaster or because of strikes? Not really, not from an economic point of view.

What matters is that you cut back on your use of tin and look to use substitutes.

Q1

P1

Supply

Demand

Price

QuantityQ2

P2

S’

If the price rises 3 cents, then no big deal. However, if it jumps up 300%, then that’s a different story.

The price tells entrepreneurs not only in which direction to move, but by how much.

When each entrepreneur reacts like this in the market, we see plans coordinated and resources allocated. We move toward Economic Harmony.

Price System Summary

With a market price system, there is an economy of knowledge.

We don’t have to know how or why the price of a resource has gone up.

All that we need to know is whether we should use more or less of a resource and by how much.

Spontaneous Order No one person created the price system. No one could. It is the “result of human action but not of

human design.” The price system was not created by any

government or by civilization. It is the price system, itself, that allows the

division of labor and thus civilization to exist.

So how do we build the bridge?

We set the parameters of how strong it needs to be and then use the materials in the cheapest combination to achieve that goal.

If we use any lesser materials, it will collapse; and if we use any more, then it’s wasting and violating the Economic Problem of Allocation.

It is only through the competitive process that we discover what the true relative scarcities are.

Neo-Classical “Competition” If you look at a standard economics textbook, their

conception of “competition” is in the form of a noun.

It usually gives some lip service to entrepreneurs, but quickly moves to the model of “Perfect” Competition.

Assumptions:1. Homogeneous Goods2. There are so many Buyers and Sellers that all are Price

Takers3. No Barrier to Entry or Exit4. Perfect Knowledge

The Demand Curve of the Competitive Firm

P

QIndustry

S

D

Pe Pc

P

QFirm

d=AR=MR

Qe

Short-Run Profit Maximization by the Perfectly Competitive Firm

d = AR = MR

q1 Output (Q)

$/Unit

AFC

AVCATCMC

Economic Profit

Suppose that there is an Increase in Demand. What happens?

P

QIndustry

S

D

P1 P1

P

QFirm

d=AR=MR

Q1

AVCATCMC

q1

D’

P2

Q2q2

P2

Economic Profit

Economic Profits are a myth in this model, because we all have Perfect Knowledge.

Firms will always be at the point where MC = MR

Flaws in the model of “Perfect” Competition There are several shortcomings with this

highly stylized theory:1. The assumption of Perfect Knowledge.

This assumption says we know the shape of not just all our cost curves, but all the demand curves too.

This assumption says that no mistakes are ever made. There is no reason to advertise or market your product. However, most significantly, it assumes away the

problem that economics is supposed to solve:

The problem that faces us is “a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge which is not given to anyone in its totality.”—Hayek (1945)

2. Competition in this model is used as a noun, not as a verb. Competition is a rivalrous process. Imagine two sports teams. We play the game precisely

because we don’t know the outcome. If we didn’t have to, then the beloved Red Wings would be hoisting the Stanley Cup today.

There isn’t any competition in equilibrium. In fact, in equilibrium, there isn’t any action. How often to we reach equilibrium in the real world? Then why study a model that is always in equilibrium? Nevertheless, this is the first model that economists turn to.

“…[F]or the sellers to be ‘price takers,’ it requires each of them to hold a particular set of ideal typifications of themselves and others in the market, such that each passively adjusts his quantities offered for sale at whatever price he finds offered to him; nor does he attempt to differentiate his product relative to the ones being sold by his rivals. They each must have in their minds of the ‘typical’ consumer in their market who will immediately stop all their buying from any one of them and purchase this good from other sellers in the market if the price he charges were raised by him even by the smallest amount. He must believe that the consumers think of his commodity as being exactly no different from the ones sold by his competitors, and therefore the consumers are indifferent as to whether they buy from him or someone else. Each seller must believe that their actual and potential rivals have the ability to adjust their production methods and activities so rapidly to any change he may try to introduce to cut costs or improve the quality of his product, that any profits that he hoped to reap from such innovation would be immediately competed away by his rivals instantaneously matching whatever he does.

3. What is Actually Needed to Achieve “Perfect Competition”?“Only if the sellers in this ‘perfect’ market view themselves and their rivals in this way, will they act like price takers. Regardless, of the ‘objective’ conditions, if any of the sellers think they can influence the price by modifying the quantity they bring to the market; if they think they can make consumers view their product as being different than the ones offered by their competitors; if they believe they can reap profits for some period of time by introducing cost-saving techniques, then they will act in ways inconsistent with what the ‘objective’ conditions lead the economist to expect from them. Merely adding up the numbers of sellers in a market, merely comparing the physical characteristics of the goods sold, and merely estimating the ease with which a new cost-cutting technique could be physically introduced into all the sellers’ production facilities, tells us nothing about how sellers will act or how consumers will react to a change in any one or more sellers’ behavior.”–Ebeling (1999, pp. 130-1),

4. Any Profit is BAD Persistent profits are a sign that we are not perfectly

competitive. There must be something hindering the ability of

the market to “compete away” any lingering profits. Compare this to what Mises said about profits. How do Austrians view “profit”? Profits and losses are essential tools to coordinate

and organize the allocation of scarce resources. Finally, “persistent profits are bad” sets up the Neo-

Classicals perspective on monopoly theory. I believe that Pongracic will address this issue later

this week.

For Further Reading: Here are the ones you should start with:

Armentano, D. T. (1986). Antitrust Policy: The Case for Repeal. Ebeling, Richard M. (1999). “Human Action, Ideal Types, and the

Market Process: Alfred Schutz and the Austrian Economists,” in Schutzian Social Science, pp. 115-134. http://books.google.com/

Hayek, F. A. (1945). “The Use of Knowledge in Society,” American Economic Review. http://www.virtualschool.edu/mon/Economics/HayekUseOfKnowledge.html

Kirzner, Israel M. (1973). Chapter 2 “The Entrepreneur,” Competition and Entrepreneurship, pp. 30-87.

Kirzner, Israel M. (1976). “Equilibrium versus Market Process,” in The Foundations of Modern Austrian Economics, edited by Edwin G. Dolan, pp. 115-125. http://www.econlib.org/library/NPDBooks/Dolan/dlnFMA7.html#Part 3, Essay 1

Rothbard, Murray N. (1993). Man, Economy and State, Chapters 8 & 10. http://mises.org/books/mespm.pdf

Competition & Entrepreneurship

By Paul F. Cwik, Ph. D.PCwik@moc.edu