Lesson 3 of 8
A process, not a state
Hayek's objection to perfect competition: if it existed, every activity the verb describes would be impossible. Competing is the finding out.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Perfect competition is a description of a state of affairs, and Hayek argues it already assumes the outcome that competing is supposed to produce.
- If everybody knew everything, none of the activities a business person calls competing would have anything to do. The model rules out its own subject.
- The differences between one firm's product and another's are not deviations from an ideal. On this account they are the facts that create the problem competition solves.
Ask a business person what competition is and you get activities: undercutting, improving, advertising, finding a customer nobody served. Ask an economist and you may get a set of conditions. Hayek's 1946 lecture, published as an essay in Individualism and Economic Order in 1948, is about that gap.
Two things called competition
Perfect competition, as a state
- Many sellers of an identical product.
- All parties know the relevant facts.
- No single seller can affect the price.
- The outcome is already reached.
Competing, as an activity
- Cutting a price to win a customer.
- Making the product different from the next one.
- Telling people the product exists.
- Finding out what will work by trying it.
If the conditions on the left held, nothing on the right would have any work to do.
The objection, stated exactly
Hayek's argument in section one is that the theory of perfect competition assumes a state of affairs to exist which, on the older view, the process of competition is what tends to bring about. If the state described by the model actually obtained, he says, the activities the verb describes would not merely be unnecessary. They would be impossible.
He is careful that this is more than a complaint about a word. His concern is that by using the term for a set of conditions, economists persuaded themselves they were saying something about the process that produces those conditions, when that process is left almost entirely undiscussed.
Why identical products are not the normal case
The model needs a single homogeneous good. Hayek's reply is that no two producers ever make exactly the same thing, if only because the goods leave different places, and that these differences are not noise around an ideal. They are among the facts that create the economic problem in the first place.
He goes further, and this is the sharpest part: the case for perfect competition sometimes leads people to argue that variety should be reduced by standardisation to make a market work better. He treats building every house alike in order to have a perfect market in houses as an obvious reduction to absurdity.
How this connects to the two previous lessons
The knowledge problem said the relevant facts are scattered. Prices said a signal travels without its cause. This lesson says the same thing about competition: it is a procedure for finding out things nobody knew, including who can supply a thing most cheaply and what people will actually buy.
A model that starts by assuming the answers is not wrong about arithmetic. It is answering a question that comes after the one this tradition is asking.
Check yourself
What is Hayek's central objection to the theory of perfect competition?
- Its assumptions are hard to measure
- It assumes the state of affairs that competing is supposed to bring about
- It ignores the role of government
Show the answer
Answer: B.
Section one of the essay makes exactly this argument, and adds that under those conditions the activities the verb describes would be impossible rather than merely unnecessary.How does he treat differences between one producer's product and another's?
- As frictions that reduce welfare
- As part of the facts that create the economic problem
- As irrelevant to competition
Show the answer
Answer: B.
He argues no two producers ever make exactly the same thing and that assuming the differences away answers the question by removing it.What does he say about reducing variety by standardisation to improve a market?
- He supports it where products are close substitutes
- He rejects it, using the example of building all houses alike to create a perfect market in houses
- He treats it as a question for engineers
Show the answer
Answer: B.
He separates useful voluntary standards from the argument that variety should be suppressed to obtain the conditions of the model, and rejects the second.Sources
- Hayek, 'The Meaning of Competition', in Individualism and Economic Order, 1948, reproducing a lecture given at Princeton in 1946: section I on perfect competition assuming the state that competition tends to produce, and section II on product differences and on standardisation.
- Hayek, 'The Use of Knowledge in Society', American Economic Review, 1945, for the dispersed knowledge this account of competition rests on.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- The component example is invented to show what a model assumes. It describes no industry.
- Hayek's objection is to using perfect competition as a standard for judging real markets. It is not a claim that the model is useless for every purpose, and economists who use it would not accept the characterisation without reply.