Barriers to Competition

The Evolution of the Debate

Ana Rosado Cubero

• Publisher: Routledge
• Year: 2015
• ISBN:
  9781317315964
• Edition: 1
• Topic: Volkswirtschaftslehre
• Subtopic: Wirtschaftstheorie

Focuses on the different methods that economic science has employed in order to detect and measure barriers to entry. This book presents a chronological analysis of competing Harvard and Chicago Schools' interpretations of this phenomenon.

1 IMPERFECT COMPETITION IN ECONOMIC THEORY BEFORE 1956

DOI: 10.4324/9781315653402-2

The Sherman Law has been in force in United States since 1890, and President Wilson signed the Federal Trade Commission into law in 1914.¹ Both are the origin of controversy over the intervention of the government in the traditional laissez faire prevailing in America’s industrial development. This chapter intends to achieve a big goal: to illustrate the debate between the academics who believe in the benevolence of the free market against academics who believe in the market power exercised by a big company. As they fight to survive nowadays, we are faced with one of the most important debates in the field of economic theory. Most of this book is about how academia has been able to develop worthwhile economic tools for the courts since 1956; the Guidelines should be considered as the legal framework within the courts’ decisions can be taken based on economic theory. In this chapter we intend to discuss only the origins of the issue, marked from 1890, the date of the Sherman Law, until 1956 – the date when what could be considered the first economic book full of economic tools – Barriers to Competition emerged. Bain’s book is a deliberate attempt to control trusts in the United States, through economic framework and empirically-supported arguments. Academics who believed in the exercise of market power by trust found in Bain’s book the scientific support they needed. The bad behaviour of a firm within an industry, mainly against rivals within a market it considers its own, began to be taken into account in economic theory as a result of the book’s publication. The main consequence was the publication of the 1968 Guidelines, which limited the capacity of trust’s performance, followed by the 1984, 1992 and 2000 Guidelines. Economic science must wait until the 1980s when game theory became a tool to demonstrate the behaviour of companies.

We begin this chapter with a survey about the main topics in theory of the firm during the 1940s, both in England and in United States. The first objective should be to get approximation of the predominant economic thought at this time, we can then include the American economic thought in the theory of imperfect competition and its main economic tools to support these imperfections: the barriers to entry. The main reason for the present analysis could be detected is that the majority of the arguments find their origins in the 1930s and 40s; when the limit price framework was developed as well as the barriers to entry theory.

This section includes a revision of the behaviorism school and its promoters, Herbert Simon, Richard Cyert and James March. The inclusion of behaviour premises in the theory of the firm as well in Industrial Organization analysis could consider Joe Bain´s as its main contributor and followed by the Structure-Conduct-Performance paradigm, in the field of economics theory.

The second section of this chapter refers to the lines developed by academics to demonstrate the non-workable competition in the main American markets. The starting point could be John Bates Clark’s report of 1902, where he mentioned the convenience of some kind of market control. The second book of John Bates and John Maurice Clark published in 1912 is another example of the raised interest in reducing the market power of the big companies in order to maintain customer welfare. The controversy between Joe Bain and George Stigler about workable competition is included in this section, yet it is only the starting point of the Harvard School and the Chicago School debate. At that stage they exchanged ideas, which were published in the most relevant scientific magazines. It was an intellectual debate between them; no one else was included at this time, despite the lasting battle lines developed several years later. The main argument about how markets work, making Chicago and Harvard confront each other, still survives nowadays. It is dealt with in Chapter 4 of this book, this long fight centred around the convenience of state market intervention, which aren’t exactly regulation issues but yet still is about pursuing non-workable competition or unfair business.

The third section tries to achieve the earlier theoretical support of the main barriers to entry as excess of capacity and advertising. We keep in mind the possibility of finding earlier references about barriers to entry at some point in the future.

1.1 Perfect Competition and Imperfect Competition: Including the firm in Marginalism Analysis.

In Cournot’s² model, and according to his theory of oligopoly, when the excess of price over marginal cost approached zero as the number of like producers became large.

Let the revenue of the firm be: qi·p and MC: marginal cost

The equation for maximum profits for one firm would be

$p\cdot qi\cdot \left(dp/dq\right)=MC$

The sum of such n equations would be

$n\cdot p+q\cdot \left(dp/dq\right)=n\cdot MC$

For n.qi = q the least equation may be written:

$p=MC-p/n\cdot \text{E}$

Where Е is the elasticity of market demand.

Cournot paid no attention to conditions of entry and so his definition of competition also held for industries with numerous firms even though no more firms could enter. Then the three necessary conditions of perfect competition are:

1. Large numbers of participants on both sides of the market,
2. Complete absence of limitations upon self-seeking behaviour and
3. Complete divisibility of the commodities traded.

Under these assumptions competition should be restricted to meaning the absence of monopoly power in a market, and a perfect market is one in which the traders have full knowledge of all offer and bid prices. Perfect competition is defined by the condition that the rate of return of each resource be equal in all uses, Stigler established that: ‘Industrial competition requires 1.- that there be market within each industry, 2.- the owners of resources be informed of the returns obtainable in each industry and 3.- there be free to enter or leave any industry’.³

In the Cournot model, firms simultaneously choose quantities, and the price is set at the market-clearing level by a fictitious auctioneer. In the Bertrand⁴ model, firms simultaneously choose prices, and then must produce to meet demand after the price choices become known. In each model, firms choose their best responses to the anticipated play of their opponents. In the Stackelberg’⁵ model, one firm behaves as leader while the other is the follower; the leader moves first, and chooses an output which is observed by the follower before the follower makes its own choice. Technically, ‘The Stackelberg equilibrium is not an alternative equilibrium for the Cournot game, but rather a shorthand way of describing equilibrium of an alternative extensive form’.⁶ The Cournot and Bertrand models are all static games, in which firms make their choices once and for all. The economic theory indebted to Nash his theorem, in game theory Nash-theorem is: every finite n-player normal form game has mixed strategy equilibrium.

From the beginning of the twentieth century, it became increasingly obvious that a new model of imperfect competition was needed which would include the firm as an endogenous variable. The old model built by Cournot and developed by Leon Walras and Alfred Marshall was under siege from a variety of new proposals. Each new proposal included important modifications of the original model, until, finally, a new analytical framework emerged known as the imperfect competition model. Economists both British and American published new approaches to the traditional supply and demand equations: Edward Chamberlin from Harvard University, Arthur Pigou, Joan Robinson, John Hicks and Kenneth Boulding from different British Universities; Frank Knight, George Stigler and Ronald Coase from Chicago University; Fritz Machlup from Johns Hopkins University in Baltimore. Edith Penrose discussed the industrial theory developed by Marshall because she built a theoretical model to demonstrate that while a firm is growing the market structure on its industry changes simultaneously.

Making a tight summary of the vision of Marshall defended in his Principles of Economics, 1890, about the company we saw the thinking that led him to design a model in a certain way. Marshall develops the idea that a company follows the normal cycle of life is born, grows and when managers are unable to make it grow, dies. Therefore, in this industry will be new generations of managers who will continue the cycle. This reasoning leads him to believe that the history of an industry is more than just the history of the companies that compose it and that therefore it is interesting to study the total industrial output. The behaviour of each particular company will depend, consequently, on the industry group that it belongs to and its age within the industry. The resulting theoretical model is a model of a theory of industry, where equilibrium is characterized by a more or less constant number of aggregate outputs and a fixed number of firms. The advantage of such models is that it is possible to prove the theory with empirical data. The framework is restrictive but it allows to economic science began to explain the real world.

The behaviour of firms within the market in which they operate is a subject which has often been dealt with in economic theory. There is a sense in which imperfect competition can be seen as part of the different strategies undertaken by firms to exclude a competitor from a market. We assume that when a new producer takes the decision not to enter a given market, those firms already set up within the market see their profits decrease since they have to relinquish part of their market share to the newcomer. Then, when firms already operating within a market set up barriers to entry, for example, they agree to share out the market amongst themselves or obtain sets of regulations which prevent new competitors entering the market, what they are really doing is guaranteeing rents not profits. Rents are inefficient from the point of view of production theory, apart from for appropriating consumer surpluses: the consumer is obliged to pay more for a product, which he would have been able to buy more cheaply if the market works in perfect competition: because perfect competition means, among others requirements, free entry. Price theory deals with this problem.

In chronological order, then, we will begin with Frank Knight’s major book, Risk, Uncertainty and Profit, published in 1921; here Knight expressed his support for Marshall’s partial equilibrium analysis, based on equations taken from mechanics in Physics, and his model is essentially Marshallian. Despite his view of John Bates Clark as master, he doesn’t hide his admiration to Marshall, mainly when Marshall became theoretically flexible, he said: ‘But Marshall himself has adopted a cautions, almost anti-theoretical attitude toward fundamentals, he refuses to lay down and follow rigidly defined hypothesis, but he insists on sticking as closely as possible to concrete reality and discussing representative conditions as opposed to limiting tendencies’.⁷

The method of economics is simple, Knight pointed out that we have quite a few possibilities to discuss, and describing effects or results under given conditions, he wrote: ‘Every movement in the world is and can be clearly seen to be a progress toward an equilibrium’.⁸ From inside of predominant economic theory in the twenties, he expresses his nonconformity with Marshallian price theory with the next words:

But in actual society, cost and value only “tend” to equality; it is only by an occasional accident that they are precisely equal in fact; they are usually separated by a margin of “profit” positive or negative. Hence the problem of profit is one way to looking at the problem of the contrast between perfect competition and actual competition.⁹

The first steps to transforming the theory of Marshall in a modern theory of the firm were given by two economists at the School of Cambridge, funded by Alfred Marshall himself. In 1920, Arthur Pigou,¹⁰ in his book entitled Economics of Welfare, he analysed the effect of industrial profits rising, falling and remaining steady. While Piero Sraffa¹¹ in 1926, in his article entitled ‘The Laws of Returns under Competitive Conditions’, noted that most firms operate under such conditions that demand does not allow them to exhaust their capacity, in other words, have to face fixed costs and unused capacity. This item comes into serious conflict with the static model of industry that Marshall had designed, as any company that faces a market price and yield subject to increasing profits are at their incentives to increase production without limit.

The third step was proposed by Chamberlin from Harvard University. It assumed that firms in an industry characterized by the same cost curves, where each business also faces the same demand, when the number of firms is sufficiently small, Chamberlin said: ‘Especially since the demand curve is known only in a vague and uncertain way’.¹² Technically each company in the industry will face a decreasing demand curve, therefore, to a monopoly in the direction of Marshall. Since a decreasing demand curve means that consumers are indifferent to the supplies of others companies in the same industry. Using a framework without any type of agreement (not tacit included) the interdependence among competitors must be neglected, as the influence to each other should be; it make sense to consider an infinite number of sellers with movements instantaneous in this case: ‘The prices of all move together, and from this it follows at once that the equilibrium price will be the monopoly one’.¹³ By ...