Competition in Free Markets

Production

The primary purpose of production is consumption. Economic activity is by definition the production and consumption of goods and services. Except for the special case of the so-called “Robinson Crusoe” economy (an economy in which there is only one person who has to necessarily be self-sufficient) every real economy involves exchange or trade. The ability to trade what one has produced for things that one wants to consume generates wealth and increases welfare.

You can of course restrict your consumption to only those things you produce, but you will have a Hobbesian existence: “solitary, poor, nasty, brutish, and short.”

Exchange

Exchange makes possible the creation of wealth through division of labor and specialization, two intimately connected concepts. Surgeons operate, bakers bake, brewers brew, carpenters build, architects design, programmers code, … ad infinitum. The ability to exchange decouples production and consumption. Crusoe’s production and consumption are rigidly linked. In our case, we don’t produce any of the things we consume, and don’t consume what we produce.

Specialization is not optional in any even moderately advanced society; it is mandatory. People have to specialize. To become a specialist in any field, you have to forego learning other fields. The opportunity to exchange and trade allows the division of knowledge because trade makes possible the division of labor.

Markets

The importance of exchange or trade in human society cannot be overestimated. Exchanges happen in what we call “markets.” If you own something that others value and are willing to trade for something you value, you can do the exchange in the appropriate market. In nearly all cases, one side of the trade involves money. We don’t trade stuff directly; we trade money for goods and services.

Money is anything that is universally accepted in trade. You can exchange money for whatever you want from the store because the store can exchange money for whatever it wants from others.

Free Markets

Markets are where buyers and sellers do their trade. Markets that do not have barriers to entry or exit are called “free markets.” In a free market, you are free to offer to sell your stuff, and are also free to refuse to sell your stuff. No one prevents you from being a buyer or a seller in a free market. So also no one forces you to be a buyer or a seller in a free market. The freedom that buyers and sellers have to enter or exit the market is what makes the market free.

Consider the labor market. If I am willing to work for you for $10 an hour, and you offer to pay me $10 an hour, then we have a voluntary trade in a free market. But if the law puts the minimum wage at $15 an hour, it prevents that $10 trade. The market for labor with a minimum wage is not a free market.

Competition

In free markets, because there are no barriers to entry or exit, for every good or service there will normally be numerous sellers and sellers. This leads to competition. Note that the competition is not between buyers and sellers, but instead is between sellers on the one hand, and between buyers on the other hand. Sellers compete with other sellers, and buyers compete with other buyers. Thus the sellers of potatoes, say, will compete with other sellers of potatoes for buyers of potatoes, who would be competing with other buyers of potatoes.

This is called “competition in the market.” Everyone likes competition in the market, except for the market participants. The sellers of potatoes don’t like having other sellers of potatoes in the market because it lowers the price of potatoes; and the buyers of potatoes don’t like having other buyers of potatoes in the market because that raises the price of potatoes.

Markets Discipline

Competition in free markets lowers prices. Because buyers will not buy at a higher price if another seller is offering a lower price. A seller does not get to charge an arbitrarily chosen high price; he is prevented from doing so because there other sellers can enter the market at a lower price. Free markets impose discipline on market participants because of competition. Competition is a given state of affairs in a free market.

But what if there is something that has only one supplier? In that case, even in a free market, because the supplier does not have competitors, would not that supplier be able to charge an arbitrarily high price to maximize his profits? Yes. That is the case when the supplier is a monopolist. As the monopolist, you are the only supplier and buyers don’t have a choice of suppliers.

Monopolies

Even in free markets, monopolists can make big profits. But only for a while; monopolies eventually end. The high profits that monopolists make in the market attracts other suppliers to provide whatever the monopolist sells, or produce substitutes to it. Not immediately but eventually, other suppliers remove the monopoly from dominating the market if there are no barriers to entry.

In the natural course of events, monopolies don’t last forever (nothing lasts forever, anyway.) But that natural course can be prevented by force, and monopolies can be imposed. The agency that has the ability to that is the government.

Remember that monopolies don’t last because other suppliers eventually enter the free market. But the government can restrict entry, and thus favor the monopolist. Why would the government do so? Because the government itself can profit from the monopoly.

Market for Widgets

Let’s concoct an example. Suppose there is a market for widgets (which are things that exist only in the imagination of economists, and which they imagine people want to buy.) Suppose further it is a free market for widgets: anyone who wishes to can buy or sell widgets. Because of competition among widget sellers, and the competition among widget buyers, the price of widgets will be determined by the usual forces of demand and supply.

If the supply of widgets increases without a corresponding increase in demand for widgets, the price of widgets will fall; if the demand increases without a corresponding increase in supply, the price will rise. The price will reflect the relative changes in the demand and supply of widgets.

Prices Emerge

The market price is not determined by any particular buyer or seller. The market price emerges out of the myriad interactions of all the buyers and sellers. Nobody has a privileged position in a free market to determine prices. Nobody gets to dictate prices. Every participant wants to increase his own position as best as he can, and the resulting price is not anyone’s choosing. The market is a process and out of this process, prices emerge.

An analogy would be helpful. In game of football, each team tries to score as many goals as it can. Each team “maximizes” the goals they score. The result of the game (say Team A scores 4 goals, Team B scores 3 goals) emerges from the process which is the playing of the game. In no way are the two teams jointly trying to maximize the total number of goals. The two teams participate in the process but cannot directly determine the result that emerges. In markets, prices emerge out of the process of competition. The important words are process and emergence.

Super-normal Profits

In the market for widgets, the suppliers make normal profits, not super-normal profits because of competitive free entry. As noted before, the suppliers would rather not face competition. Suppose the typical widget supplier makes only $10 in profits, or normal profit. Suppose a monopoly supplier of widgets to the market could make $100 in profits, or super-normal profit. It could then work out a deal with the government. It could get the government to restrict entry into the market, and in exchange pay the government anywhere up to $90 for the privilege (the difference between the normal and super-normal profit.)

The government would then use any of the many options. It could grant outright monopoly rights to one of the many widget suppliers. But to which one? The supplier that bids the highest amount for the monopoly rights. Thus you have another kind of competition. Where there used to be a competition in the market, you now have a competition for the market.

Limiting Competition in the Market

In the competition in the market, the consumers win because of price and quality competition. By shifting the competition from within the market to competition outside the market, the winning supplier gains and the government gains, but the consumers lose. The consumers lose because the supplier can choose the quantity/price combination that maximizes his profits (out of which he pays the government.)

So that’s the end of this little bit of simple economic reasoning. Free markets are good for the economy because of competition. Competition is good for the economy but bad for suppliers. To limit competition in the market, suppliers have an incentive to bribe the government.

The government uses various mechanisms such as license, quotas, and permits. By getting into the economic game, the government becomes a participant in the game, instead of being an impartial referee. By limiting competition in the market, the government hurts the economy and enriches itself and its cronies at the expense of the consumers.

Crony Capitalism

This is what is called “crony capitalism” — the government and its friends extract wealth from the people. That is why those in government are so fond of interfering in markets. And when that is allowed to happen, the economy cannot prosper. That is why countries like India are poor. The government prevents the creation of wealth that markets are so good at.

At the top of this piece, I quote Adam Smith from one of his lectures from 1775 (before the publication of his book An Inquiry into the Nature and Causes of the Wealth of Nations in 1776). Read it carefully.

Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice; all the rest being brought about by the natural course of things. All governments which thwart this natural course, which force things into another channel, or which endeavour to arrest the progress of society at a particular point, are unnatural, and to support themselves are obliged to be oppressive and tyrannical.

It is the highest folly to disregard Adam Smith’s insights.

{This post was motivated in part in response to a reader’s comment where he wrote:

Almost every policy the 0.1% lobby for essentially boils down to this: limit output of food/energy/housing/education/health-care/transport so that income from their owned assets used to produce these outputs remains as high as possible.

Only in markets that the government restricts entry into is it profitable for suppliers to exploit consumers. Firms will naturally want to limit competition but they cannot do anything other than bribe the government to do the dirty work of screwing the consumers. It’s not the “0.1% lobby” but rather the “0.0001% lobby” that constitute the politicians and bureaucrats in any economy. Putting the blame on lobbyists is misplaced; the fault lies in the government. That is why the constitution should prohibit the government from interfering and distorting free markets.}