This post was prompted by some things I have seen on the internet lately (especially Twitter) about economic models. Specifically, I am referring to suggestions that economists shouldn’t teach the model of perfect competition, or should de-emphasize it, because markets in the real world are not competitive.
These suggestions reminded me of one of my favorite papers Margaret Levenstein’s presidential address to the Business History Conference "Escape from equilibrium: thinking historically about firm responses to competition." Enterprise & Society (2012): 710-728. Levenstein understands what models are for. The point of economic models is not to copy reality or to create jars that we can sort different markets into: This market goes in perfect competition; that market goes in monopoly. The point of the models is to help us understand what matters.
The model of perfect competition assumes:
1. Firms maximize profits
2. There are many buyers and sellers
3. All the firms sell an identical product
4. There are no barriers to entry or exit.
From these four assumptions we can derive at least two conclusions (if you are not familiar with the model there is brief explanation at the bottom of this post):
1. The price will be equal to the marginal cost, which is the additional cost of the last unit produced.
2. In the long run, firms will earn zero economic profit.
Maggie Levenstein pointed out these conclusions are not really what business students want to hear in their microeconomics course:
“The punch line of this course is that, in long run competitive equilibrium, free markets produce an efficient outcome in which firms earn zero profits. The answer to the final exam question, "What will an efficient economy look like?" is answered by finding where profits are equal to zero. This is often puzzling to students, especially the MBA students I teach most of the time. At some point I realized that it was important to clarify to them that equilibrium is not a goal, but a result, and that their job as managers and leaders was to escape from equilibrium. Long-run equilibrium is not the goal but the result of competition. It is what competitive pressure pushes firms toward, but from the point of view of the firm, it is to be avoided. Competition is not a state; it is a force, and it is a force that, left unchecked, will leave you earning zero profit.”
But this is precisely why the model is what business students (and business historians) need to hear. MBAs want economic profits. But how do you get them. The model tells you how. First, you have to convince people that your good is not exactly the same as everyone else’s. If you do that you can increase your price without having your customers run off to your competitors. If you can do that you can hang on to those higher prices. Second, you have to prevent people from copying you.
There are multiple ways to accomplish these goals. You might use marketing to convince people that other goods are not a substitute for yours and get a patent or trademark to keep people from copying you. You can also earn economic profits through innovation. When you introduce a new product, you are the only one selling it. You can charge a higher price without having to worry about people running off to your competitors. What if your competitors start to copy you? Then you have to do it again. One short little monopoly after another.
The point is that the model tells you what matters. In the example I have been using it provides some useful direction for thinking about strategy. Unless I want to compete purely on price, I need to differentiate my product from others. How am I going to do that? If I want to earn more than an ordinary accounting profit, I need to keep other firms from entering my market.
Levenstein also explains in her paper why the model is important for business historians when thinking about entry and exit and firm behavior. She also notes that these actions to escape from competitive equilibrium can be ones that benefits consumers (new, better, cheaper products) or negative (collusion or combination to reduce competition).
The model of competitive markets also provides a useful starting point for thinking about why prices are what they are. People often complain about prices being too high. The model suggests that if there are no barriers to entry prices will be driven down to the point that they just cover the costs, including a reasonable accounting profit. So, a useful place to begin thinking about high prices is to ask if there are barriers to entry. If you can’t identify any substantial barriers to entry you might want to consider the possibility that prices are high because the good is costly to produce.
The talk about whether to emphasize the competitive or the monopolistic models is misguided because it encourages people to think of the models as jars that they should sort real world markets into so that they can see which jar has the most in it and then emphasize it. Instead, models should be thought of as tools to understand the influence of important market features, such as number of sellers, product differentiation, and barriers to entry on the behavior and performance of firms. Models of monopolistic competition and monopoly don’t tell a different story than the model of perfect competition, they are all part of the same story. A lot of firms selling exactly the same thing implies that the firm is a price taker. Introduce product differentiation and the firm can increase its price without losing all of its customers. Barriers to entry imply zero economic profit. Allow one firm to keep competitors out of its market and you get not only the ability to raise price above marginal cost but the possibility (though certainly not the inevitability) of economic profits. In a model we can say products are differentiated or not. In reality, there are degrees of substitutability between goods. In a model we can say there are barriers to entry or there are not. In reality, there are no barriers there are no absolute barriers. The model of perfect competition is not useful because it perfectly mirrors reality but because it doesn’t.
Many models matter precisely because they do not provide a mirror of reality. For instance, Janet Yellen’s husband, who is also an economist, developed a model of the market for goods, like used cars, in which there is asymmetric information. George A. Akerlof "The Market for Lemons: Quality Uncertainty and the Market Mechanism." The Quarterly Journal of Economics 84, no. 3 (1970): 488-500. In the model the market collapses. Are there in fact markets for used cars in the real world? Yes. Does that make the model stupid? No. The point of the model is to encourage people to think about the problem of asymmetric information. Akerlof provides several examples of ways that people have dealt with asymmetric information. The fact that there ways of solving the problem does not mean that the problem does not exist or that it is not important.
The prisoners’ dilemma illustrates the problem of maintaining cooperation when people can benefit individually by departing from cooperation. The point of the model isn’t to suggest that people never cooperate. Obviously, they do. The point of the model is that we need to think about how people are able to overcome the problem: repeated interaction, legal enforcement, social norms, etc.
The bottom line is that models can be very useful if you use them to think about what matters. You will find them less useful useful if you think of them as providing jars that you can sort the world into.
If you are not an economist and are wondering how the conclusions can be derived from the four assumptions, here is what I hope is a relatively easy to understand explanation
First conclusion: the price of the good is equal to the marginal cost of production.
Together assumptions 2 and 3 imply that the firm is a price taker; it has no influence over the price of the good. No matter how much or how little they produce it has no effect on the market price because there are a lot of other people selling at exactly the same thing as them. Because they are price takers, the additional revenue from selling another unit of the good will just be equal to the market price. If it is selling for $5, every time they sell another unit of the good, they get another $5. Economists call the additional revenue from selling an additional unit of the good marginal revenue. So we have concluded that because firms are price takers marginal revenue will be equal to the price (MR = P).
The first assumption, profit maximization, implies that the firm’s marginal revenue will be equal to its marginal cost. Profit is revenue minus costs. Every time I sell something that adds more to my revenue than it adds to my costs my profits will increase. If producing another unit of a good adds $10 to my revenue and $5 to my costs, my profits have to go up by $5. If I want to maximize my profits I keep producing as long as another unit adds more to my revenue than it adds to my price. If I were to produce another unit when it added more to my costs than it added to my revenue my profits would go down. Consequently, if I am maximizing profits I keep going right up to the point where the additional revenue of the last unit is just equal to the additional cost and I stop there. Therefore, the assumption of profit maximization implies that marginal revenue equals, (MR=MC).
Putting it all together, if P=MR because there are a lot of firms producing the same good and MR=MC because of profit maximization, it must be the case that P=MR=MC. Consequently, the price of the good will be equal to the marginal cost, P=MC
Second conclusion: In the long run, firms in a perfectly competitive market will earn zero economic profit.
The term zero economic profit is usually confusing to non-economists and possibly not the best choice of terminology. Most people think of profit as the money a businessperson has left over after they have paid their employees, their suppliers, their insurance, etc. Economists call that the accounting profit, but that there is another cost that it does not include: The businessperson must get something or they won’t be willing to stay in the business. Imagine you are running a busines and have to tell me the minimum accounting profit that would make you willing to stay in business. Imagine you tell me $60,000. That $60,000 is also a cost. Economists call it an implicit cost. If it is not paid the resources that you bring to the business will not continue to be directed to that business. If the accounting profit is greater than your implicit cost, we say you are making economic profits. If the accounting profit is less than your implicit cost, you are making economic losses. If the accounting profit is exactly equal to the minimum amount that would keep you in the business, you are making zero economic profit.
But what will if you are making economic profits? Will other people like you just ignore that or will they want to try to get some of those economic profits as well. In the model of perfect competition there is nothing to stop them from entering that market too. if you are making more than the minimum that would draw you into the business other people with similar skills and abilities to you will want to get in on that. As they enter the market, they increase the supply of the good and drive down the price. The opposite happens if the accounting profit is not large enough to make you want to stay in the business. As people leave the business the supply decreases pushing the price back up. Free entry and exit mean that the price of the good tends toward the price that will just provide a reasonable accounting profit, as much as people with similar skills and abilities are earning.