Saturday, August 9, 2014

The Myth of Perfect Competition

I have written extensively about the standard textbook claim that under perfect competition you'll get higher quantities at lower prices compared to a monopoly situation, and the strange fact that this proposition somehow cannot be reproduced in a computer simulation. Instead, the simulation consistently shows the same quantities at the same prices for perfect competition as for a monopoly. I am particularly interested in this result because in Switzerland later this year a referendum is being held on whether to abolish "competition" in the so-called health insurance market and install a government-run single payer monopoly instead. Of course, the claim that competition keeps quality up and prices down is heard everywhere. But apparently it cannot be scientifically shown to be true.

I've come across two explanations as to why the situation called perfect competition is unstable, and why therefore prices and quantities might converge to monopoly levels. Both of these start by asking what would happen if a firm chooses to demand a higher price than the equilibrium price at perfect competition. The theory claims that consumers would simply abandon such a supplier and fulfill their purchases elsewhere which in turn would discourage such a deviation. However, beyond mere assertions to that end the theory fails to show that this is indeed so.

Joseph Stiglitz, for example, says that the process of switching to a new supplier involves a certain cost (looking for a new supplier, driving farther, etc), and as long as the price increase is lower than the cost of switching, the consumer is better off if he remains with the supplier, despite the higher price.

This may be so, but there's a more serious problem with the theory (cf The Economics Anti-Textbook by Hill and Myatt): It is not certain at all, that the other suppliers are able or indeed willing to absorb these defecting customers. Economists, of course, will claim that because the firms are small, the number of defectors is small enough and thus easily absorbed by the remaining firms. But if the firms are small, it also implies that one or a few additional customers are being felt by those firms that receive them. The fact that firms are small cuts both ways. In any case, however, the firms are unable to absorb additional customers for a simple reason: they are already operating at the sweet spot where the production capacity is maximized and marginal cost equals marginal revenue. One additional unit produced and — because of the rising cost curve (remember?) — the firm incurs a loss. The firm has thus two options: refuse to serve the customer or raise the price, which, according to the theory, will drive away customers and hence inflate the number of defectors even further.

But consider what happens if only a single customer is willing to accept the higher price, e.g. because there is no place else to go: the firm serving this one customer will make a positive profit because it can successfully charge a price above marginal cost (remember that because MC = MR, all other firms make no profit at all). The theory implies that this cannot possibly happen as no customer would pay a higher price, given all the fabulous competition among firms. But at the same time it fails to show that the customer has any other place to turn to, and Stiglitz suggests that the customer may actually benefit from staying.

But this is not all: because all participants in perfect competition, firms included, have total knowledge, they all know that any small raise in price has the potential to lead to a positive profit because no other firm is able to absorb any possibly defecting customers. Therefore a few might stay. Remember that one single loyal customer is enough. Knowing all this, all firms — who are profit maximizing after all — will exhibit a tendency to increase prices just a little in order to exploit this non-negligible potential for profit. This tendency acts like an electromagnetic force between equally charged particles that will eventually drive prices away from the so-called equilibrium point towards the only real stable equilibrium price point: at monopoly level.

There you have it. The whole myth of perfect competition that rests on a completely fabricated assumption (of rising marginal costs) cannot be verified in a computer simulation. Instead, prices appear to converge at monopoly levels even for hundreds of thousands of profit-maximizing and non-colluding firms that compete in a market. Furthermore, a plausible story exists that explains why this is indeed a possible or even likely outcome given all assumptions presented. Will any of this change any debate anywhere on this planet about markets vs state-run monopolies?

Take a guess.