Competition and Economic Efficiency

The association between competition and economic efficiency goes back as far as Adam Smith’s ‘invisible hand’ metaphor. In the dominant paradigm of neoclassic economics, economic efficiency is coherent with economic development. As a mechanism of virtue selection, competition encourages efficiency by allowing the most efficient firms to survive and grow at the expense of their inefficient counterparts. The exit of these efficient firms frees up resources, which can then be used by more efficient firms. Focusing on the basic condition of competition, Stigler (1987) argued that the central element of market competition is the freedom of traders to use their resources where they choose and to exchange them at a price they choose.

In terms of firm behaviour, competition is multidimensional and can have desirable effects not only on Ricardian short-term allocative efficiency, but also on Schumpeterian long-term dynamic efficiency. Dynamic efficiency refers to technological improvement that leads to increase in the efficiency and welfare of the economy. The effects of competition on growth and development are not only in the short run but also in the long run. In the short run, competition is necessary to ensure that allocative efficiency is achieved and consumer welfare is maximised. These basic functions of competition are static and they are complemented by some dynamic functions: competition is the driving force behind the technological progress and long-term economic growth. Thus well-functioning competition is crucial to long-term economic development. The dynamic efficiency is effectively promoted by a combination of cooperation and competition among firms. Dynamic efficiency has been related to the intensity of competition by two influential views. The first, generally referred to as the Schumpeterian hypothesis, argued that firms must make high level of profits and enjoy some monopoly power in order to invest the funds necessary for successful innovation (Kamien and Schwartz, 1971). The second view argued that competition leads to increased incentive for firm to gain a competitive advantage (see later subsections for a detailed discussion) – one way of doing this is to invest in research and development projects (Nickell, 1996). On the other hand, it is argued that Schumpeterian dynamic efficiency ‘cannot be obtained by totally ignoring Ricardian competitive advantages’ (Yoshitomi, 1991). Thus the existence of cooperation

between firms should not hamper competition – as the basic mechanism of market, competition is the precondition of short-term allocative efficiency as well as long-term economic growth.

A distinction between monopoly and competitive market structure has long been recognised, stretching back as far as Aristotle. As the basic instrument of static, partial equilibrium analysis, the model of perfect competition highlights the ability of competition to achieve an equilibrium allocation of resource that is Pareto optimal under an extremely decentralised market structure – a ‘perfectly competitive’ market. The competitive equilibrium has desirable efficiency properties – perfect competition will lead to economic efficient in the traditional Pareto sense in which resources are so allocated that no one can be made better off without someone else being made worse off.¹⁹ The desirable properties are in part due to free entry and exit of firms. The role of entry and exit in assuring the equalisation of returns across markets is not logically limited to the case of extremely decentralised market structure, the case in which it is technological feasible for a market to host a very large number of firms. The theory of contestable markets developed by Baumol et al. (1982a) extends the neoclassical partial equilibrium theory of a long-run competitive equilibrium to the case of increasing returns to scale. This theory suggests that an industry consisting of one or a few firms may be efficient by emphasising the role played by potential entry. When firm are in a protected market, incentives to achieve minimum cost may be blunted and a considerable amount of slack may exist at all levels of the organisation. The term ‘X-inefficiency’ is used to describe this kind of internal disorganisation.²⁰ If competitive pressures can be intensified, X-inefficiency will tend to disappear.

To the neoclassical economists, a monopoly, which can be simply defined as ‘absence of competition’²¹, is the polar opposite to perfect competition. Monopolies have been under fierce attack since the classical economists. The neoclassical approach to monopoly involves the comparison of monopoly with perfect competition. The most influential study has been that of Harberger (1954) who provided the core of the economists’ case against monopoly – the price-cost divergence, as well as the resource misallocation and the resulting deadweight welfare loss.²² In the view of neoclassical economists, a monopolist in economic theory is the sole producer of a good or service for which there are no close substitutes. Some entry barriers also exist which prevents other firms from entering the market and competing with the incumbent. Under these circumstances the firm can choose the output and price that maximises profit. The monopolist’s pricing behaviour leads to allocative inefficiency.²³ A simple diagram in Figure 3-1 depicts the costs of monopoly.

We assume that costs remain constant over the entire output range. Given the market

19 For the general equilibrium analysis, competition is also a basic assumption for the efficient allocation of resources. The First Fundamental Theorem of welfare economics claims that: 1) if there are enough markets, 2) if all consumers and producers behave competitively, and 3) if equilibrium exists, then the allocation of resources in that equilibrium will be Pareto optimal (Arrow, 1951; Debreu, 1959).

20 Leibenstein (1966) first introduced the term ‘X-efficiency’.

21 Irving Fisher (1923) defined monopoly as ‘absence of competition’.

22 In the same study, however, Harberger estimated that the welfare loss from the existence of monopoly in the United States was virtually non-existent – a merely 0.07 percent. Some economists have challenged Harberger’s estimates. Scherer, for instance, estimated that monopoly has imposed social costs equivalent to about 6 percent of the gross national product.

23 However, the monopolist may be technologically efficient and in the long-run equilibrium the industry will also be efficient in this sense (Utton, 2003).

demand, then under competitive conditions the price is OPc and the output is OQc. Consumer surplus, PcBD, is maximised. In case that a monopolist controls the industry, price will be increased to OPm and output will be decreased to OQm as the firm equalises marginal cost with marginal revenue. It is clear that at output level OQm there is a difference CA between price and marginal cost. Under the monopolistic condition the area PcACPm becomes the monopoly profit and the consumer surplus shrinks to PmCD. In principle consumers would like to pay the monopolist a sum equal to the area PcACPm in exchange for an increase in output to OQc. The net welfare loss is the triangle ABC, the so-called ‘deadweight’ welfare loss. The diagram simply illustrates how output restriction leads to the price-cost divergence and the consequential resource misallocation. The redistribution of value PcACPm in favour of the monopolist is fundamentally caused by the monopolist’s ability to hold price above long-run average costs – the market dominance.

Figure 3-1 Welfare losses from monopoly (market dominance)

In addition, the protection of the monopoly may lead to ‘X-inefficiency’.²⁴ The stronger the protection for a monopoly, the weaker are its incentives for X-efficiency. The reduction of monopoly by removing entry barriers can have the effects of improving both allocative and X-efficiency (Utton, 2003). Furthermore, as argued by Stiglitz (1996), the welfare loss from reduced competition can be much larger than that Harberger (1954) suggested due to the rent-seeking behaviour by monopolists. The analysis of monopoly has provided the initial economic underpinning of competition policy. The putative need to address actions that reduce competition and result in monopoly is reflected in the first two sections of the pillar of US antitrust policy – the 1890 Sherman Act. Section 1 prohibits the

‘restraints of trade’ (cartel agreements) and Section 2 proscribes ‘monopolisation’, a term describing actions by which a firm becomes a monopoly through ‘unfair’ competitive

24 In response, Leibenstein pointed out that Harberger based his estimates on aggregate measures, so that could not capture a great deal of inefficiency which he termed as ‘X-inefficiency’.

O Q_m Q_c ^Quantity

Pm

A C

B

Demand Marginal revenue

Price, cost D

P_c

Deadweight welfare loss

practices.

The dichotomy between monopoly and competitive market structure is far too simple.

There is a much wider spectrum of market structure in between. Against the theoretical standard of perfect competition, Edward Chamberlin and Joan Robinson renewed economists’ interest in imperfectly or monopolistically competitive process in the 1930s (Chamberlin, 1933; Robinson, 1933). The analysis of Cournot oligopoly has provided additional economic underpinning of competition policy. The Cournot oligopoly theory supports another pillar of US antitrust policy – the 1994 Clayton Act. Section 7 of this act prohibits mergers that ‘may tend to inhibit competition’. Historically, the models of imperfect competition emerged after the rise of the modern industrial enterprises around the turn of the 19th and the 20th Century (cf. Chandler, 1977). In the circumstance in which large firms dominate industries, the positive and normative implications of models of imperfect competition are of interest, as are the design of government policies such as competition and regulatory policies aimed at improving efficiency of markets. In contrast to the model of perfect competition, the models of imperfect competition are uncertain about whether the force of competition is entirely beneficial. The notion that competition can be wasteful was popularised by Edward Chamberlin. Under the condition of imperfect competition, firms face down-sloping demand curves or upward-sloping supply curves for some products. This is different from the perfect competition, in which firms face perfectly elastic demand and supply curves for all products. Chamberlin’s ‘excess capacity theorem’

has provided theoretical support for the ‘wasteful competition’. The theoretical argument of ‘excessive competition’ has presented additional challenge for the widespread belief that the more competition there is, the better the economy will function. Also known as destructive or cut-throat competition, excessive competition refers to situations when competition results in prices that cannot cover the costs of production, particularly fixed costs. Although insufficient competition is harmful to an economy, excessive competition may be ruinous. The literature on excessive entry has provided an additional dimension for the excessive competition argument. Recent studies in theoretical industrial organisation has demonstrated that there are cases where social welfare will be increased by strengthening, rather than weakening, the protection of incumbent firms from the threat of potential entry.²⁵

A number of studies have found a positive relationship between competition and productivity as well as between competition and the rate of productivity growth (Geroski, 1990a; Porter, 1990; Baily and Gersbach, 1995; Nickell, 1996, 1997). Productivity growth, in turn, accounts for most of the income and growth differences across countries (Easterly and Levine, 2000). In developed countries, productivity growth is generally the result of technological advances. In developing countries, productivity growth has mostly been attained through technology spillovers from trade, Foreign Direct Investment (FDI) and licensing. Market competition increases productive efficiency by providing incentives for managers to cut costs, reduce slack, innovate, and improve institutional arrangements in production (Vickers, 1995; Nickell, 1996). In the presence of competition, firms adjust their operations to raise efficiency and less efficient firms exit the industry. The mechanism of entry and exit has been argued to be an important source of industry wide productivity growth (World Bank, 2002). In a study of South Korea between 1990 and 1998, plant exit and entry accounted for as much as 45 percent of manufacturing productivity growth during cyclical upturns and 65 percent during downturns (Hahn, 2000). Porter (1990) has

25 See Stiglitz (1981), Mankiw and Whinston (1986), Suzumura and Kiyono (1987) and Suzumura (1995).

observed that the sectors with strong domestic – even local – competition have produced the most successful companies in worldwide markets. None of these studies make a difference between foreign and domestic companies, which according to Dunning presents a vital flaw in their reasoning. We will come back to this issue in Chapter 4.