Competition and Free Trade

Pascal Salin

• Publisher: Routledge
• Year: 2017
• Print ISBN: 9781138103436
• eBook ISBN: 9781351592932
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Competition and free trade are both concepts which are absolutely central for the understanding of human societies but are also often the subjects of fears and criticisms. It is argued that it is not possible to understand what competition really is without referring to the concept of freedom, and that free trade must be understood as the way to expand the scope of competition.

This book uniquely analyses the two concepts as closely interlinked, by approaching them in two parts. The first, 'Competition', introduces the reader to the traditional competition model, and explores the dynamics and range of the term in an authoritative way. The second part, 'Free Trade' examines the different types of trade, and analyses them in a wealth of contexts, from customs duties to import quotas. With discussions surrounding protectionist arguments, politics, liberalization and history, the author presents an overview of how competition and free trade operate in the real world.

This book dispels the fears and misunderstandings which have developed around these central pillars of the modern economy and is essential reading for those studying international economics, international trade, political economy or corporate finance.

Part I

Competition

Introduction

The concept of competition is frequently used in daily life. One speaks of competing sportsmen as well as pupils in a school, or firms that are competing in a market, or politicians who compete for a position in an election. The analysis of competition also plays a central role in economic theory. In fact the working of markets is not the same whether there is competition or not. But still one needs to know how it is defined. There is from this point of view a traditional theory of competition, the so-called theory of pure and perfect competition, which one can also call the theory of atomistic competition (because producers are analyzed as simple ‘atoms’ of something much broader than them). This same theory analyzes a monopoly or a cartel by reference to the situation assumed to be optimal, namely pure and perfect competition. This traditional theory is dominant in textbooks and in a great part of economic literature. It also inspires what is called, for instance, competition policy (or antitrust policy). It is questionable, however, as we show in the present book. Oddly enough, it is rather the concept of competition used in everyday life that gives a correct vision of what it is, whereas the traditional theory is based on a purely formal approach that is not really able to explain reality. Another approach to competition must therefore be developed in economic theory: that of free competition, i.e. the one that corresponds to the possibility to freely enter into a market. The result is a totally different appreciation of monopolies or cartels, which may, depending on their specific characteristics, have a harmful role or, on the contrary, be useful in meeting some specific needs of markets and in being key factors of innovation and economic progress.

1 The traditional competition model

Given the importance of the traditional theory of competition as a central model of economic theory and as a reference for policy decisions, it is necessary to identify which are the critical assumptions and the essential implications of this theory. It goes further than the simple analysis of a situation of competition: it turns into a normative theory by demonstrating that competition leads to an economic optimum.

The characteristics of ‘atomistic’ competition

In an exchange economy, each good corresponds to a market: an abstract place in which the supply and the demand for a good are confronting. From the confrontation of supply and demand a price is determined, which one calls an ‘equilibrium price’ as far as it corresponds to the wishes of buyers and sellers of this good.

If there is competition on a market, the price of the corresponding good is exactly the same all over its market: the price of one pound of wheat is the same on the entire wheat market. This is the ‘law of one price’, which results from simple assumptions concerning the behaviour of economic agents. It is just assumed that, generally speaking, individuals, be they suppliers or buyers, are able to compare prices. A buyer will look for the lowest possible price, a supplier will wish to obtain the highest possible price. If a producer offers a good at a higher price than the one proposed by all other suppliers, he will obviously not sell his commodity and, if he wants to stay on the market, he must align his prices on those of his competitors. Symmetrically, if his price is lower than the one offered by his competitors, he will be encouraged to increase it (and possibly to increase the amount of supplied goods) in order to increase his profits. Thus, as soon as one has done the simple assumption according to which individuals who act on a market are able to compare prices and to assess their own interests, it follows that there is a single price for one given good.

The implementation of a single price depends on the existence of several producers placed in a situation of competition, which means that their products are likely to be the subject of comparisons and that these products are perceived by buyers as exactly identical one to each other. But to what extent can we say that there is competition? This is the problem we have to solve.

There is from this point of view what can be called a traditional theory of competition which one finds, for instance, with a number of variants, in virtually all the textbooks of microeconomics. But let us first accept a convention of language. We will see later that this traditional definition, still widely used, is extremely questionable. We must therefore distinguish between the traditional concept of competition and the concept that we will suggest later, which we will call ‘free competition’. Now, the traditional approach is characterised by the fact that it implies the existence of a large number of producers and buyers, so that each of them can be considered as an ‘atom’ of this great set of individuals who are acting in markets. We will therefore use the term atomistic competition to refer to the traditional concept of competition.¹

To clarify the traditional concept of competition let us take, for instance, the definition given by George Stigler²: ‘A competitive market can be defined easily only as a perfect market; it is a market on which the price will be influenced neither by the purchases nor by the sales of a single person. In other words, with regard of any buyer, the elasticity of supply is infinite; with regard to any seller, the elasticity of demand is infinite.’

Let us just recall that the price elasticity is defined as the ratio of the variation in quantity (demanded or supplied) in comparison to the variation of price.³ Thus saying that the elasticity of supply is infinite is saying that no price change is possible (an infinitesimal variation in the price would result in an infinite variation of available quantities). In Stigler’s definition, then, there is competition whenever no producer can be considered as different from others: Competition is thus of the atomistic kind.

If one adopts this approach to competition, a market can be competitive only so far as it is ‘perfect’. Let us imagine an area in which there are many bakers, each producing only one perfectly well-defined good, namely a one-pound loaf that has exactly the same characteristics (say, its taste, its appearance, and the length of its preserving period). One can therefore consider that these different loaves are perfectly substitutable one to the other from the point of view of their physical characteristics or even from a subjective point of view, namely their ability to meet the needs of potential consumers of bread. But let us imagine that it is very difficult to move inside this region and that the inhabitants live in communities that are very isolated from each other. Information about the price of bread will be extremely limited, without even mentioning the possibility of carrying a loaf from one place to another. From an economic point of view, one can therefore consider that the different loaves are not perfectly substitutable: The bread produced in A is specific, and the baker who produces it may ask a price different from the one that is demanded by the baker B. The ‘atomistic’ definition of competition leads therefore to considering that there is no competition, as far as there is a differentiation of goods. We will have the opportunity later on to revisit the relationship that may exist between differentiation of goods and competition. But we will retain, in any case, this idea that it is not only the physical characteristics of the goods which matter, but rather their subjective and economic characteristics. Two goods are different from an economic point of view, if they are perceived as different by one or more individuals, taking into account the uses they intend to give to these goods.

Atomistic competition cannot therefore be conceived other than concerning a ‘perfect market’: a market where information is perfect, ensuring a single price for each of the goods that are perfectly substitutable. For this traditional theory of competition, any competitive market is necessarily perfect, but any perfect market is not competitive. For a market to be competitive – that it is, according to the usual terminology, in a situation of ‘pure and perfect competition’ – some other specific features must be added.

The traditional theory naturally cares about the conditions that are necessary for competition to exist, those that allow the existence of a single price on the market and which prevent a producer from proposing a price different from that of ‘competitors’ for the same good. The list of these conditions differs slightly according to different authors, but there are in general the following elements⁴:

• · Perfect information, of course
• · The existence of a large number of buyers and sellers, each having a small economic dimension in relation to others
• · An homogeneous product
• · A divisible product

This list of conditions – common to most authors – seems obvious if one relates it to the essential concern of the traditional theory. In fact, competition is defined by its ‘atomistic’ nature: Each seller or each buyer is of negligible importance in relation to the whole market of a given good. The existence of a large number of buyers and sellers plays a particularly important role in the traditional theory of competition. This implies that each market participant is interchangeable and that none has sufficient weight for any individual decision to have an influence on the market. If a seller or a buyer withdraws from the market for a good, the price of this good is absolutely not modified. If each produced good could be differentiated from others, it would not be true that each seller or buyer is of negligible importance compared to the whole market for a good. Therefore, for pure and perfect competition to prevail, it is necessary not only that there be a large number of sellers and buyers, but also that the goods that they exchange be undifferentiated (which excludes the case of an indivisible good with a great economic size) and that the information about them be perfect. The list of conditions that must be met so that there is atomistic competition is therefore nothing more than a consequence of this idea that no consumer and no producer can affect the market price of a good. If the goods are not perfectly identical, the behaviour of a producer or a buyer of a good slightly different from others will influence the price of this specific good. Consider, for instance, the case of one pound of pleasantly packed arabica coffee. There may be a large number of buyers, but only one producer, and he thus enjoys a certain margin of freedom to determine his prices. In other words one should perhaps not mention in this case the market for coffee in general, but the ‘market for a nicely packed arabica coffee’. The fact remains, however, that there is a very strong substitutability between these neighbouring products, so that the price of a good slightly different from the others cannot evolve in a perfectly independent way. If it increased too much, buyers would leave it to buy a close substitute. Whatever it is, the divisible character of a good makes more likely the existence of a large number of producers and buyers: atomistic competition is more likely to exist in the market for wheat than in the market for nuclear power plants.

The traditional theory implies that there is no pure and perfect competition, for instance, in markets such as the market for nuclear power plants or the market for big planes. But it has an implication which is more subtle and probably more threatening for the theory in question, as we will see: the definition of the characteristics of a good is necessarily arbitrary, all the more so since one should distinguish its purely physical characteristics and its subjectively perceived characteristics. Thus, if the inhabitants of an area are sensitive to the personality of the bakers who sell bread to them, loaves with identical physical characteristics but sold by different bakers will be considered by them as different. Should we then mention a bread market – in which there would be a large number of sellers – or a bread market A, a bread market B, and so on? The precise delimitation of an economic good, and therefore of the limits of what constitutes a ‘market’, by an outside observer being necessarily arbitrary, it becomes also arbitrary to decide whether there is a large number of sellers. We will come back later to this problem.

Another condition of competition is often but not always stated: the freedom of entry into a market. For the advocates of the theory of pure and perfect competition – unlike what we shall see later – this condition is important only insofar as it can be connected to what is almost the only criterion of competition: the existence of many producers and sellers. One can indeed consider that this criterion is more likely to be satisfied whenever it is possible to enter freely into a market. And it is precisely because the freedom of entry into a market is only a derived condition (considered traditionally) that it is sometimes omitted from the list of the conditions that are necessary for competition to exist.

Generally speaking, we can say that the traditional theory of competition is based on a single criterion: the great number of buyers and sellers for one given good. But for each author the list of conditions that must be met for competition to exist is shorter or longer, more or less comparable to the lists of other authors. One may consider the nature of the goods (homogeneity, indivisibility) as well as the behaviour of participants in the market (freedom of entry) or the characteristics of the processes (quality of information). And if the criterion of the great number of participants in the market is thus put forward, it is because it admits the particular case of the general theory of prices – an infinite elasticity of the supply curve, or of the demand curve, that an individual must face. For the supplier as well as for the buyer, the price is given by ‘the market’ and no one is able to influence it.

The implications of the traditional theory

One can draw important consequences from the traditional theory of competition; some of these inspire many laws and regulations. First we will see how the relationship between the working of the market and an individual producer is analyzed within this theory, and second, how this theory becomes normative.

Competition and market equilibrium

To understand the scope of the traditional theory of competition, it is convenient to use the usual instruments of microeconomic analysis. Let us imagine, then, a world where there are, for the sake of simplicity, two goods, wheat and tomatoes, but where there are many producers of both these goods. Let us also assume for the time being that there is no money, so that we are in a barter economy. It is usual in microeconomic theory to speak of the ‘wheat market’ and of the ‘price of wheat’, or, of course, to speak of the ‘tomato market’ and of the ‘price of tomatoes’. In fact, in a market, one always trades a good against another. In other words, under the simplified assumption we have chosen, the wheat market is actually the set of all transactions by which some people supply wheat and demand tomatoes (they are called ‘wheat suppliers’), while others demand wheat and supply tomatoes (they are called ‘wheat demanders’). The wheat market is therefore actually a market of ‘wheat against tomatoes’. Similarly, what is called the ‘price’ of one pound of wheat represents the quantity of tomatoes that can be obtained on the market in exchange for one pound of wheat, tomatoes being thus used as a standard of value: one says, for instance, that 1 pound of wheat ‘costs’ 2 pounds of tomatoes; that is, it is traded against 2 pounds of tomatoes.⁵

Let us thus represent this ‘wheat market’. In Figure 1.1 we have depicted the quantity of wheat demanded or supplied – on the abscissa axis – in relation to the price of wheat (expressed in terms of pounds of tomatoes or in terms of currency units). The general forms of the supply and demand curves correspond to simple assumptions concerning the rational nature of human behaviour. All human activity is indeed the outcome of arbitrations betwe...

Table of contents

• Cover
• Title
• Copyright
• Dedication
• Contents
• Foreword
• Part I Competition
• Part II Free trade
• Bibliography
• Index