Markets Must Become Competitive

In my last newsletter, I argued that we should think of prices as emerging from the interactions and bargaining of individuals. The slogan that I stole from Joe Ostroy is that maximization precedes prices. This slogan stands in contrast to the standard, price-taking approach, where prices must exist before people act. With price-taking, prices precede maximization.

Word games are fun, but who cares? The two visions of markets lead to different understandings of how markets work and, ultimately, different policy recommendations.

In the standard approach, a market is competitive (or not) by assumption. In jargon, it is exogenous to the model whether people are price-takers or not. As IO economists have long realized, it is problematic to think of the level of competition—or more easily measurable characteristics like concentration—as exogenous. They are instead equilibrium outcomes. One benefit of the price-taking model is that it’s easy to use. Draw supply, draw demand, and point and the intersection. Every textbook starts there.

To get beyond price-taking, we must recognize that markets become competitive. It’s an equilibrium outcome that plays out through time. As the Austrians say, the market is a process.

Entrepreneurs and How Prices Emerge

There actually is one textbook that explicitly teaches markets the way I recommend. The answer will surprise you. Or not, if you’ve read this newsletter.

Armen Alchian and William Allen’s Universal Economics starts with a simple bargaining situation and shows how prices emerge. (Thanks to Bryan Cutsinger, a great teacher of price theory, for pointing me to their exposition of this.)

Let’s go through Alchian and Allen’s example.

We are visiting a camp where hurricane refugees are living. Monthly, each refugee receives Red Cross parcels with 20 bottles of water and 20 granola bars. (The old editions had cigarettes and candy, which sounds much more fun, but we'll stick with water and granola bars.) To start with, people consume their rations. There are no markets or trades, competitive or not.

Someone soon arrives on the scene and asks, “what are the chances that everyone in this camp places the same value on water and granola bars? Surely there is a better outcome.” Or in language from Israel Kirzner, an entrepreneur discovers a possible profit-making opportunity. In other work, Alchian calls this person a middleman.

The entrepreneur researches and learns that Sam dumps some of his water on the ground. Sam must not care that much for water. That is, Sam places a relatively low value of substitution on water. Joe, in contrast, doesn't eat all of his granola bars, so Joe places a relatively high value of substitution on water.

The entrepreneur realizes that there are gains from trade out there. Buy low; sell high. He goes to Sam and offers ten granola bars for ten waters. Sam accepts. He goes Joe and offers eight waters for ten granola bars. Both accept the trade since it makes them better off, and the entrepreneur can take home two bottles of water for himself. Pure profit!

Each person (Sam, Joe, and the entrepreneur) pursuing their goals generates markets and prices. Maximization precedes prices.

This market isn’t instantaneously competitive in the textbook sense. People aren’t facing perfectly elastic demand and supply curves. People can influence the going rate for water by adjusting the amount they trade. The entrepreneur is even charging a markup. Tsk, tsk, tsk.

We could end the story here and call on regulators to break up this monopoly. Price doesn’t equal marginal cost after all. The initial entrepreneur may even be hiding his actions, so others don’t learn how he is making a profit. That wasteful rent-seeker! He certainly isn't going to introduce Sam to Joe. But should he? He did the investigation to discover that gains from trade exist. He’s earning a return on his knowledge.

Alchian and Allen remind us that there is a process playing out. Yes, this process doesn’t work instantaneously. There are setbacks. But this isn't the end of the story. Over time, we can expect his profits will be eaten away. Again, we are going toward a competitive market.

Eventually, another person discovers what is going on and offers both Sam and Joe a better deal. The new prices make Sam and Joe better off, leading to smaller profits for the entrepreneurs as a group and much smaller for the original entrepreneur. Or maybe before entrepreneur number two comes on the scene but fearing a potential entrant, the original entrepreneur decides not to bargain too hard and give Sam and Joe “fair” prices.

Regardless of the exact timing, since the entrepreneur's arbitrage opportunity can be replicated whenever someone learns about it and money-making information has a way of spreading, other entrepreneurs will enter. Those competitors will drive the market to the competitive outcome, where the entrepreneurs are just covering their costs on transporting the goods.

Is this a competitive market? In the textbook sense, this isn’t competitive right away. It is competitive after the second entrepreneur enters since they compete on prices, and Bertrand competition is competitive. Instead of “competitive,” Alchian and Allen call this an “open market.” 

“Open markets” mean that access to markets is open to all people without arbitrary, contrived barriers— not that there are no costs involved in providing exchange-facilitating services.

Is it guaranteed to lead to competitive prices? No. Of course not. But we can ask, what would stop this process? We could imagine a few easy reasons. The group in charge of the camp could pass a rule that says people can’t freely trade. More realistically, they limit who can participate in trade. One may worry about the “exploitation” of Sam and Joe by this outsider, so he may not be allowed in. No foreigners allowed! That would stop the process or slow it down, at least. Now we can talk about barriers to entry.

If this all seems squishy, it can be made formal. Alchian and Allen provided a crystal clear example of this mechanism in 1964. A mere 55 years later Rafael Guthmann and I translated this basic idea into mathematics in a working paper that I've mentioned a bunch of times. Other work on market-makers does the same thing.

Math or not, I think this is the most important parable in economics. Everything else about markets can be augmented onto this simple setup. We can see why advertising is used. We can see why middlemen or money emerge. When I draw my supply and demand graphs that I love, I need to remember that in the background is always an entrepreneurial process. I hope others can do the same.