INSTITUTIONAL ECONOMICS: DYNAMICS OF COMPETITION

Until recently, economic theory had focused upon the individual decision and that state of equilibrium in which individual decisions are perfectly coordinated. Decision-making is increasingly seen as a process. We shall discuss the nature of competition and competitive pressures. Then we shall compare three main types of market process: the neoclassical, the Austrians and the radical subjective.

Given the significant nature of the knowledge problem (see Lecture 1 and 2), how can ignorance be reduced? how can knowledge be dispersed? how can knowledge be corrected without destabilising the system? The competitive use of property rights.

The market is a social institution in which people exchange property rights. Economic competition is an evolutionary process of social interaction in the market, in which people discover and test new knowledge: the discovery process - unlike the neoclassical model, which emphasises scarcity and economising.

New information and new knowledge do not come cost-free. The preparedness to incur information costs will depend not only curiosity, creativity, acquisitive urge and rivalry between competitors, but also on the institutions (e.g. trade associations, community trust, and government regulation) within which they operate.

What matters is the capacity and preparedness to make surprising discoveries. The knowledge search by alert and interested buyers is essential to the supply of innovative products. When there is no competition and rivalry in the market, people will have no incentives to incur information costs, and the knowledge search declines.

We can identify three key functions of competition that deals with the questions raised earlier.

• Reduction of ignorance: A system of private property rights motivates people to search for rewarding use of their assets. Competition is a process involving costly and risky information search, from which they hope to further their self-interest.
• Dispersal of knowledge: In a competitive economy, successes and failures become known. Also, the price signal spreads coded information about the market wants and rivals offers. For example, the oil prices increases of 1974-5 and early 80s.
• Control of errors: In a private property competitive system, people are held responsible for their loss, and learn from their mistakes. Also, actors exploit their competitors’ errors so that they gain from their corrections e.g. buying cheap stocks.

Sellers often adjust the institutions of the markets so as to reduce the effective transaction costs to the buyers, including their information costs. We can distinguish between search goods (quality of the product (say, a jacket) can be evaluated readily by inspection prior to a purchase), and experience goods (quality of the product (say, tourist holiday) can only be established by the experience of using or consuming it).

• For search goods, market conventions leave much information search costs to the buyers, though the sellers still provide price listings of the goods.
• For experience goods, suppliers bear the costs, giving buyers credible commitments of quality. For example, advertised brand names, standardised products, free samples, trial experiences (music-listening, wine tasting).

The cost of transacting business shift between sellers and buyers in response to competitive conditions.

Information problems can also be reduced by trading through middle-agents or intermediaries, who use their personalised economic ties (e.g. family networks), or financial networks (e.g. credit agencies) to bring buyers and sellers together.

There are two ways in which competition can be inhibited.

• Private restrictions: restrictive business practices avoid and mitigate competitive pressures through the formation of cartels, pricing and marketing agreements, mergers, and so on.
• Political restrictions: suppliers and organisations obtain political intervention (e.g. regulating market entry, quality standards, safety and hygiene directives) that softens the competitive pressures on them and secures their market niches.

Market interventions create an industrialised politicised ‘rentier class’. Parliamentarians, bureaucrats and other political agents have strong incentives to supply favours that protect client producer groups.

Another form of political intervention in the free private trade of property rights is judicial activism – judges interpret the commercial and property laws to support organised interest groups.

While restrictions and interventions can be justified to enhance knowledge-creating capacity of competition (e.g. standardised weights), most regulations exclude or hinder potential rivals. This eases the competitive pressures for innovation, so that protected industries become high costing and unenterprising.

We shall discuss the different assumptions of the models relating to how decision makers perceive the world, how these perceptions change over time, how additional information may be sought and how the decision maker can limit its exposure to uncertainty. Then we consider some implications of three different approaches for various business practices and institutions.

• Neo- Classical (NC) Approach: In this model, each agent characterises future prices by means of a probability distribution and continually updates this in light of new information. The crucial feature of the NC approach is that the form that future can take is known in advance.
• Austrian (A) Approach: The problem is not uncertainty (or risk) but ignorance. Over time, however, the agent discovers things of which it was previously unaware. Some aspects of the future are known to the agent, but not others.
• Radical Subjectivist (RS) Approach: It emphasises that imagination is needed to create the alternatives between decisions. The future is not so much unknown as it is non-existent or indeterminate at the time of the decision. The agent’s task is not to estimate (NC) or discover (A), but to create.

In all three types of process, the agent is uncertain about the environment in which it operates, and in all cases its perceptions change over time. Yet the nature of this learning process is quite different.

• The NC approach is characterised by risk and revision of probability estimates.
• The A approach by ignorance and alertness to hitherto unperceived opportunities.
• The RS approach by indeterminacy and imagination.

Advertising: For NC models, it conveys information, though it can also be misleading. There is no mechanism in the NC model for changing tastes. For A models, it can alert consumers to the existence of unsuspected opportunities. It reveals tastes to the hitherto unsuspecting consumer. Agents may make mistakes as a result of advertising, so that advertising cannot be said to be always co-ordinating on purely theoretical grounds. For RS models, it can help to form tastes, by stimulating the agent’s own imagination. The possibility of changing preferences by advertising does exist.

This raises different issues of public policy. For NC models, the issues are whether advertising is an economical means of conveying information, how far it may be deceptive and what costs it imposes, and whether truth-in-advertising policies are cost-effective. For the A models, there is little to criticise in advertising if attention is not focused on mistakes. For RS models, the issues for public policy concern the kind of influences that should be brought to bear on the consumer as it exercises on imagination. Issues of efficiency becomes into issues of morality, as advertising influences consumers’ tastes.

Property rights and Industrial organisation: Consider the question of whether the worker or its employer will own worker’s tool. An important consideration is how far the tools are liable to be damaged by careless actions on the part of the worker, and how costly it is to monitor the worker’s behaviour. Here, there is no certainty as to the kinds of action that might be taken; but the pattern of ownership will determine the total cost of owning and operating the tools. It is predicted that ownership will be such as to minimise the total cost (i.e. property rights change to make organisation of work efficient).

For NC models, the expected returns of the different patterns of ownership will be calculated, but the possibility of unexpected developments (e.g. the discovery of new use for the work tools, or the discovery of cheaper substitutes) render the work tools less valuable. It is now relevant to consider which party is best able to ‘predict’ and respond to such unexpected change, and which party is most optimistic about the possibility of such development. A and RS models can consider these issues. For A and RS models, ownership of a resource reduces exposure to unexpected events. Property rights are a means of reducing uncertainty without needing to know precisely what the source or nature of the future concern will be.

Consider another example of the size and scope of the firm. It is suggested that mergers are a means of reducing exposure to uncertainty. But insofar as the firms wish to guard against quite unexpected events, NC models fail to adequately analyse mergers.

There is no distinction between A and RS models with respect to property rights if the unexpected developments are assumed to be purely exogenous. But insofar as the parties themselves may have an incentive to design and bring about the outcomes that had not previously been anticipated, and insofar as there is element of conflict in which surprises play a significant role, then RS models embodying imagination would seem more appropriate than A models embodying discovery. According to RS approach, the business strategy of merger is not a calculation of probabilities (as in NC models), but reflect an entrepreneurial vision and a creative guess, but it is unclear and tentative so that it cannot be described as discovering or exploiting an unseen opportunity (as in A models).

Regulation and privatisation: What will be the effects of regulation and privatisation upon an industry’s performance? NC models direct our attention to the effects of ownership on the choice among available alternatives, with calculated returns on capital.

A models draw attention to the regulation on the discovery of new opportunities. Greater competitive pressures will increase the likelihood that opportunities will be noticed, so that innovation will be greater.

RS models suggest attention to the process by which alternatives are drawn up for decision and to the techniques that might be adopted to ensure the successful implementation of the chosen plan. Any proposed course of action involves an imagined future.

Three types of market process have been discussed. The NC type takes as given the set of products or actions that can exist and assumes that market participants continually revise their expectations concerning prices. The A type assumes that data are known or unknown, with market participants discovering and reacting to new opportunities over the course of time. The RS approach points out that all action is taken in the light of imaged future conditions, and hence emphasises creativity and uncertainty. The element of radical (structural) uncertainty is missing from the NC model, and is downplayed in A model. The RS perspective seems necessary to obtain a full understanding of the many real-world institutions such as advertising, property rights, firms and government regulations.