Cost, Uncertainty and Welfare

Frank Knight's Theory of Imperfect Competition

Stephan John Nash

• Publisher: Routledge
• Year: 2018
• Print ISBN: 9781138611177
• eBook ISBN: 9780429873188
• Topic: Social Sciences
• Subtopic: Sociology
• Index: Social Sciences

First published in 1998. This work contributes to the discussion of Knight by showing that uncertainty broadens the conception of economic welfare, and that a new cost analysis holds the key to unlocking the Knightian corpus. It develops Knight's suggestion that uncertainty-control costs can be reduced - arguing that the large firm enjoys economic rent from utilizing its dominant vantage point in the market. The author demonstrates that while Knight provides the intellectual stimulus which propelled Chamberlin's thesis of monopolistic competition, Chamberlin uses a very abstract form of uncertainty in his analysis.

1 Introduction

Economists recognise the theoretical significance of the risk-uncertainty distinction, which Knight delivers in his seminal work Risk, Uncertainty, and Profit (1921a). While this distinction is important, we argue that it cannot be properly understood unless we grasp Knight’s major contribution to economic theory: the establishment of an alternative theory of welfare economics (Myint 1948, 10). This contribution remains obscure because a broad range of commentators classify it as ‘social philosophy’, rather than economic theory. For example, non-economists, such as Allan Bloom (1990), support that classification. As Bloom (1990) says, “Philosophy came first, I think, for Frank Knight” (Bloom 1990, 198). Similarly, economists such as Breit and Ransom (1982) portray Knight as a social philosopher, resembling David Hume, rather than as an economic theorist (Breit and Ransom 1982, 197-9). We disagree. In contrast, we argue that the methodology which is used to evaluate Knight, rather than the content of Knight’s work, leads to such a conclusion. This methodology has three basic assumptions. First, it assumes that a valid distinction can be drawn between Knight’s contribution to economic theory and his contribution to ‘social philosophy’. Second, it assumes that Knight’s risk-uncertainty distinction is his only major contribution to economic theory. Third, it assumes that the overwhelming majority of Knight’s other published work is ‘social philosophy’, being largely irrelevant to economic theory. We disagree with all three assumptions.

In addressing the first assumption, we argue that the dissection of Knight’s work into economic theory and ‘social philosophy’ is difficult, if not impossible. Indeed, the precise nature of the distinction still represents a source of discordance between eminent economists. For example, Buchanan (1968) argues that Knight’s collection of essays, The Ethics of Competition (EOC) (1921-1935) is relevant to economic theory (Buchanan 1968, 426). In contrast, Stigler (1987) argues that the EOC is not of particular relevance to economic theory (Stigler 1987, 58). Whereas one eminent economist includes the EOC as being relevant to economic theory, another excludes it as irrelevant. Such disagreement highlights the difficulty of attaining broad agreement on which of Knight’s works pertain to economic theory, and which pertain to ‘social philosophy’; we argue that a more comprehensive form of assessment is required. Other economists indicate that Knight’s work requires such an assessment. For example, Myint (1948) observes that Knight is responsible for, “… a broader welfare economics, …” (Myint 1948, 10). Myint (1948) argues that this broader welfare economics is not based on a narrow examination of uncertainty. Rather, Knight concentrates on the axiomatic premises of orthodox economic theory, with “… a more self-conscious examination of the methodological difficulties …” which pertain to these premises (Myint 1948, 10). We concur; it is only by addressing such methodological difficulties, that we can begin to clarify Knight’s argument for a broader type of welfare economics.

Recently, some evidence of a more wide-ranging assessment of Knight is emerging in the literature, which supports our questioning of the existing methodology. For example, Le Roy and Singell (1987) argue that previous economists interpret Knight’s risk-uncertainty distinction much too narrowly, resulting in a misunderstanding of the distinction (Le Roy and Singell 1987, 394). We agree. By broadening the scope of our analysis we effectively reconstruct the context in which Knight draws the distinction between risk and uncertainty. Similarly, Raines and Jung (1988) extend the scope of their analysis. These authors draw on some of Knight’s ‘philosophical’ writings as a means of grasping his economic theory of monopoly. However, the authors still insist on the separation of Knight’s philosophical discourse from his economic argument; they stop short of abandoning the existing methodology which is used to evaluate Knight (Raines and Jung 1988, 139-43). In contrast, we extend this more encompassing approach to Knight by abandoning the existing methodology.

In our examination of the second assumption, we argue that Knight’s conception of the social welfare function, which we define as, “… an aggregate measure of national, or social, well being”, constitutes a major contribution to economic theory (Mansfield, 1979, 450). Moreover, we cannot properly understand Knight’s view on the regulation of imperfect competition unless we see his ‘philosophic’ discourse as the narration of his concept of the ‘social welfare function’.¹ Knight’s supposed ‘philosophical’ discourse includes the definition of economic freedom, economic power and economic efficiency. Each of these comprise a component part of Knight’s ‘social welfare function’; economic efficiency does not subordinate all other considerations. Orthodox theory, however, considers the achievement of economic efficiency as the most important means of delivering economic welfare.

In our analysis of the third assumption, we argue that it is necessary to accept Knight’s ‘philosophical discourse’ as providing an economic analysis of imperfect competition. Knight’s academic career exhibits his primary focus on economic, rather than philosophical, issues. For example, Knight provides a detailed account of economic freedom in 1943, which outlines the difference between economic freedom and political freedom (Knight 1943a). At all times Knight focuses on the economic definition of freedom; he contrasts the notion of political freedom with the notion of economic freedom. To Knight, the two are completely different. Whereas writers of political philosophy, such as John Locke, discuss the right of all to the, “… fundamental political principles of freedom and equality (Tarcov 1984, 1) Knight points out that economic actors do not enjoy the right to equality of economic freedom. Knight argues that orthodox economic theory posits that, under conditions of perfect knowledge, all economic actors enjoy the right of equal economic freedom. While Knight accepts that this right may exist under perfect knowledge, he disagrees in the case of uncertainty. For Knight, uncertainty seriously undermines - even destroys - this right; a large inequality of economic freedom exists in the case of uncertainty. In this way uncertainty creates a host of opportunities for utility maximisation, yet only those economic actors with economic freedom have access to all of these opportunities, according to Knight. Economic freedom, therefore, shapes an economic actor’s access to the economic opportunities which uncertainty creates. Knight develops this novel conception of economic freedom in later works, such as Free Society, its Basic Nature and Problem (1956a). Here, Knight (1956a) proposes that investment in human capital can help to redress the problems which result from the unequal distribution of economic freedom. Later, Knight (1960a) integrates this more refined notion of economic freedom into his discussion of economic welfare in, Intelligence and Democratic Action (1960a). Here, Knight concludes that the recognition of a broader policy objective, which embraces a consideration of both economic freedom and economic power, is vitally needed. Throughout his academic career, therefore, Knight’s analytical focus is firmly on economic, rather than philosophical, issues.

Before we can be convinced that Knight presents an economic, rather than philosophical, argument we must question previous evaluations of Knight. We argue that such evaluations confuse, rather than clarify, the appreciation of Knight. An example of such an evaluation is the American Economics Association’s valediction to Knight (1973). Here, the American Economics Association presumes that from the beginning of 1930 Knight’s, “… main interests began to shift from economic theory to social philosophy” (American Economics Association 1973, 1048; Stigler 1987). We disagree for two principal reasons. First, we demonstrate that all Knight’s major published works display his continued involvement in economic theory, rather than ‘social philosophy’. Second, Knight’s Presidency of the American Economics Association, in 1950, almost one quarter of a century after his supposed departure from economic theory, highlights his continuing involvement in the profession (American Economics Association 1973, 1048). Moreover, even if we disregard these two reasons we argue that neither the American Economics Association nor any other economist, provides a detailed rationale for why one part of Knight’s work relates to economic theory while another relates to ‘social philosophy’.

Our strong disagreement with the standard assessment of Knight’s scholarship leads us to challenge the existing assessment of Knight’s policy stance. For example, on the subject of monopoly regulation Raines and Jung (1988) argue that Knight accepts monopoly as, “… a mechanical defect …” in the free-market system (Raines and Jung 1988, 141-3). Here, the authors argue that Knight perceives monopoly as being responsible for some short-run costs; these costs are outweighed by the long-run efficiency benefits which flow from monopoly (Raines and Jung 1988, 143). Monopoly, therefore, delivers a net efficiency benefit to the free market system, over the long-run. In other words, the authors construe Knight as placing his support behind monopoly because of the efficiency gains which monopoly delivers. However, we argue that Knight’s conception of economic welfare forces him to replace the single-minded pursuit of economic efficiency with a broader policy agenda; economic efficiency is only one of several equally important policy goals. Consequently, Knight’s policy approach to monopoly is significantly different to that which Raines and Jung (1988) suggest.

Such differences in the assessment of Knight’s policy stance are, however, merely indicative of a much more significant contribution: Knight argues that the orthodox notion of profitless equilibrium and the existence of uncertainty are inconsistent. According to orthodox theory, the separate activities of economic actors lead to a situation of stable equilibrium, in the long-run. Such equilibrium is primarily characterised by the absence of abnormal profit. In contrast, Knight, argues that uncertainty creates abnormal (or super-normal) profit in the long-run. Firms compete for this abnormal profit by continually seeking ways to reduce the costs of production, particularly the costs which flow from uncertainty.² Knight maintains that firms can alter the level of such costs by changing the scale of production, in turn, uncertainty forces firms to operate in a way which promotes a continuous variation in the level of economic activity, over the long-run. This absence of any long-run equilibrium, combined with the presence of abnormal profit, characterises Knight’s perception of the competitive outcome which exists under uncertainty. This leads Knight to conceive of a specific perspective on imperfect competition which focuses on the supply, rather than the demand, side. Knight does not ignore product differentiation. Instead, Knight argues that the competitive differentiation of cost is of more importance to the explanation of the variation in profit margins under conditions of uncertainty. However, this conclusion requires that we grasp Knight’s work as an integrated whole.

We commence our examination of Knight by looking at the axiomatic premises which comprise Knight’s conception of welfare economics. We then follow with a survey of the main influences on Knight. This survey serves a dual purpose; it supports our examination of Knight’s welfare economics while also narrowing the focus of our analysis to Knight’s theory of imperfect competition. By comparing and contrasting Knight’s analysis of imperfect competition with the work of other eminent economists, we are able to extract the unique characteristics of Knight’s analysis. These characteristics, combined with our assessment of Knight’s welfare economics, form the basis of the discussion on Knight’s policy response to imperfect competition. Given this broad structure of argument, let us now explain each Chapter of this thesis in greater detail.

To best understand Knight’s concept of welfare economics, we argue that it is necessary to visualise economic freedom, the balance of economic power, and economic efficiency as representing the three extreme points of an equilateral triangle; every extreme point in the triangle represents an objective of economic policy. In Chapter Two, we argue that economic welfare depends on achieving a balance between each objective, according to Knight. However, the omnipresence of uncertainty makes the accurate identification of such a balance particularly problematic. Despite this difficulty, we argue that as long as these three objectives are kept in a rough balance, economic welfare can be enhanced by progressing in all three fronts pari passu. Any attempt to pursue large gains in one direction, at the expense of one of the remaining two, will not only be futile, but will be detrimental to overall welfare. In summary, judicious economic policy must pursue a balanced progress in all three directions; single-minded concentration on any one objective is deleterious to economic welfare.

Knight’s conception of welfare economics draws on some of the most influential economic theorists of his time. Indeed, we argue that an understanding of these influences is crucial to our analysis of Knight’s linkage of uncertainty with profit (Knight 1921a). Our first task in Chapter Three is, therefore, to define how Knight’s influences shape the creation of this linkage. For example, Knight argues that Marshall obscures the analysis of uncertainty by burying the premises of his analysis under a plethora of, “qualification and detail” (Knight 1921a, 15). By explaining profit as the result of intra-firm cost differentiation Knight indicates that profit is yet another example of utility (or profit) maximising behaviour. In addition, Chapter Three seeks a rationale for why Knight develops the linkage between uncertainty and profit. We argue that Knight seeks to develop ‘fair’ standards of competition; something which J.B. Clark attempts, yet fails, to define. Clark argues that such standards are necessary to prevent the competitive economy from becoming self-destructive. According to Clark, examples of cut-throat competition tend to overshadow the meritorious aspects of free-market; Knight continues to seek ways of preserving the free-market system. In other words, Knight creates the linkage between uncertainty and profit so as to ensure the long-run survival of the free-market system.

Given that Knight provides a new perspective on the economics of imperfect competition, we argue that it is essential to juxtapose this contribution to the acknowledged founders of imperfect (and monopolistic) competition, J. Robinson and E.H. Chamberlin. Chapter Four provides such a juxtaposition. By comparing and contrasting these authors we discern the essential difference in Knight’s approach. Both Chamberlin and Robinson disagree with orthodox theory because it fails to incorporate product differentiation into the analysis of competition. However, in expressing their disagreement with orthodox theory they both describe an analysis of monopolistic (and imperfect) competition which centres on the slope of the demand curve. In contrast, Knight argues that orthodox theory fails to incorporate cost differentiation into the analysis of competition. Thus, one view of imperfect competition focuses on the demand side, while Knight focuses on the supply side. Knight argues that larger market share creates better access to market knowledge, when compared to the marginal (small) firm. This, in turn, means that the large firm reduces the impact of uncertainty on the cost of production. As long as the marginal (small) firm exists, product prices are set at a level which allows them to earn a normal level of profit. The large firm, in contrast, earns economic rent because industry price is higher than the average cost of production. In other words, a differentiation of profit exists in the imperfectly competitive market, because uncertainty inflicts higher costs on the marginal (small) firm. Knight argues that this analysis of imperfect competition leads to a distribution problem, along with an efficiency problem.

In Chapter Five, we briefly outline a policy which goes some way to alleviate the distribution problem which exists in Knight’s analysis of imperfect competition. We suggest that a lump-sum tax can capture the economic rents which the large firm earns without reducing economic efficiency. Orthodox economic theory is indifferent to such a policy suggestion, because the policy does not change (narrowly defined) economic efficiency. In contrast, the spirit of Knight’s discourse is sympathetic to the imposition of such a tax mainly because of his conception of the ‘social welfare function’.

Notes

1   We use the term ‘social welfare function’ to describe Knight’s integration of the ‘social’ aspects of existence with the ‘economic’. As we will show in this work, Knight perceives both as being intimately linked.

2   In contrast, John Kay (1993) argues that firms derive economic rent from the creation of a unique set of relationships or contracts, which he describes as “architecture” (Kay 1993, 66-87). Instead of extracting economic rent from the knowledge set of the industry, Kay (1993) argues that each firm creates economic rent from its own knowledge set. Proprietary knowledge, therefore, creates economic rent (Kay 1993). Knight (1921a) argues that a latent pool of potential proprietary knowledge exists in every industry. If firms employ this latent knowledge to reduce the costs which emanate from uncertainty, then this latent knowledge becomes the proprietary knowledge of the firm. As we illustrate in Chapters Four and Five of this work, Knight discovers the way firms extract abnormal profit by transforming latent proprietary knowledge into actual proprietary knowledge (Kay 1993).

2 The Knightian Pyramid

Introduction

There appears to be a deep-seated conflict between liberty [economic freedom] and equality [economic power balance] on the one hand and efficiency on the other [brackets added] (Knight 1935c, 61).

Frank Knight’s economic thought is centred on the integration of three economic objectives. Reduction of the significant tensions between each of these objectives is the goal of Knight’s economic thought. Optimal levels of economic freedom, imbalance of economic power and economic efficiency are interrelated into a unified whole by Knight. The aim of this Chapter is to present, with the assistance of an explanatory device which we term the ‘Knightian Pyramid’, the essence of this significant system of thought.

Knight’s interrelation of economic objectives has been identified by other economists. For example, Kern (1987) argues that Knight follows a process of maximising the marginal contributions of each independent objective, so as to maximise the overall w...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Dedication Page
• Table of Contents
• List of Figures
• Preface
• Acknowledgements
• 1 Introduction
• 2 The Knightian Pyramid
• 3 Intellectual Influences
• 4 Comparison of Knight with Chamberlin and Robinson
• 5 Some Policy Implications
• 6 Conclusion
• Bibliography
• Index