The Costs and Benefits of Competition

by Don Boudreaux on April 20, 2014

in Competition, Complexity & Emergence, Financial Markets, Hubris and humility, Seen and Unseen

Warning: Wonky

A debate is now underway over at Steve Landsburg’s The Big Questions.  And this post here at the Cafe is the first of what will likely be two or more on this debate and the larger matter that it touches.  The debate involves the merits of high-frequency trading and private investments made by high-frequency traders to gain competitive advantages over each other.  Most of this post will be below the fold because it is, as I warn above, quite wonky.

First, though, a preface.  For the second time in as many weeks I find myself in disagreement with Steve Landsburg.  I do not exaggerate – or employ the following compliment as a disarming debate tactic – when I confess that such disagreement leaves me very uncomfortable.  Over the past 20 years, since first reading his The Armchair EconomistI’ve learned enormous amounts of economics from Steve.  And I continue to learn from him.  Steve has far more to teach me in a day than I could teach him in a lifetime.  Still, I believe that Steve’s suspicion that high-frequency share trading (“HFT”) and its associated investments are socially wasteful is unjustified.

Steve’s position, as I interpret it, is the following (I summarize in my own words): investments made by high-frequency traders to gain competitive advantages over each other are socially wasteful.  This waste is real despite the fact that the investments are all private.  While each investing high-frequency trader might in fact profit personally from his or her investments, the social costs of those investments are likely too high to make each of those investment worthwhile from society’s point of view.  Each investor (say, to build a fiber-cable tunnel) reckons only the private costs of that investment against its likely private benefits.  But if there are economically relevant costs to others that the investors ignore – and if those ignored, “external” costs are higher than the net private gain to the investor – then the investment is socially wasteful.

The logic of the above summary of Steve’s position is unassailable.  If all of those things are true in reality, then some or all investments made today by high-frequency traders are unambiguously socially wasteful.  The question, then, is this one: In reality, are the “external costs” – those costs not reckoned by high-frequency investors – likely to be real and large enough to render these private investments socially wasteful?

I believe that the only answer that we can give to this question is “no.”  Or, the answer to me is clearly “no” if we accept the practical wisdom of relying upon competition more generally to guide owners of private property to use their resources in socially productive, rather than in socially wasteful, ways.

I will object in a follow-up post to some specific points raised by Steve, but to keep this post readably compact, I here state only my general conclusion.  My conclusion is one that reflects many of the points made by some of the commenters – especially Methinks – at Steve’s post.

The discussion at Steve’s blog – his post and the many comments on it – reminds me of a debate that occurred in the 1980s over competitive market activities that were alleged to be instances of private rent-seeking – instances of private rent-seeking that were socially wasteful.

Consider producers of breakfast cereals.  Kellogg’s, General Mills, and other cereal producers each spends lots of resources developing new cereal flavors, test-marketing them, and then advertising and selling these new flavors to the public.  Each producer expects to gain from its private investment.  Yet each producers’ investment reduces the value of its competitors’ similar investments – an alleged external cost not reckoned by each firm when calculating whether or not to invest in developing and marketing a new breakfast-cereal flavor.  Would Steve (or anyone else) look upon such investments with suspicion?

My guess is that Steve would not suspect such investments as being socially wasteful.

As for “anyone else” the answer is yes.  Sadly.  There’s a long tradition of some economists, and of many non-economists dabbling in economics, declaring that private-firm’s efforts to differentiate their products and to advertise them are often socially wasteful.  Most of these declarations either revealed a misunderstanding of competition or a sophomoric fascination with mere abstract possibilities (or both).

Of course it’s possible that some instances of private competition for greater consumer patronage generate social waste.  (Indeed, I’m 100 percent certain that, in reality, such wasteful competition – when judged from the perspective of an omniscient economic observer – occurs frequently.)  Mere possibilities, though, are irrelevant.  What matters is whether or not the class of activities in question is more or less likely to promote consumer welfare.  It’s possible, for example, that the new dry-cleaner that opens up down the street from an established dry cleaner will, in the end, prove to have ‘wasted’ resources by setting up in competition.  Yet no serious economist would declare agnosticism about the merits of allowing free entry into the dry-cleaning business.

At least, I’m pretty sure that Steve Landsburg would not declare that the new dry cleaner likely results in a socially wasteful use of resources.  And yet that new dry cleaner reduces the investment value of competing dry cleaners (as well as of other firms, such as manufacturers of ironing boards for home use).  A 21st century John Kenneth Galbraith would object.  ”Come on,” asks the new Galbraith with a knowing smile, “is the extra convenience afforded to consumers from one additional dry cleaner really worth the use of thousands of square feet of retail space, hundreds of hours weekly of worker time, and new valuable machinery?  I think not.  And do note” – continues today’s Galbraith – “that that new dry-cleaning entrepreneur did not reckon the reduced value of the investments of other dry cleaners in his cost when he decided to invest in his new dry-cleaning firm.  Market failure!”

Yet how is Steve’s conclusion that the investment by high-frequency traders in the fiber-cable tunnel is socially wasteful different from the conclusion reached by my hypothetical 21st century J.K. Galbraith regarding the new dry-cleaning establishment?  I don’t see the difference.

It’s true that I do not know just what are the potential private or social benefits from shaving off a few milliseconds from the time that it takes traders in New York to learn what asset prices are in Chicago.  I know next to nothing about finance.  But I also know next to nothing about dry cleaning.  And next to nothing about breakfast-cereal production.  I do, however know something about economics and competition.  And what I know about economics and competition leads me to the conclusion that private expenditures of money to gain competitive advantages over rivals is a - the – chief source of economic growth and enhancement of consumer welfare.  I reach this conclusion no less or more confidently about competition in the finance industry than I reach it about competition in the dry-cleaning and breakfast-cereals industries.

Sometimes such investments rather obviously enhance consumer (or “social”) welfare, as when Apple invests in developing the iPhone.  But most such investments that enhance consumer welfare do not do so in such splashy or obvious ways: the new dry-cleaner down the block, the new breakfast cereal, the new flavor of dog food, the new style of socks, a new edition of The Armchair Economist that reduces the value of the investments that other economics educators put into their attempts to bring economics to life for the general public.

It would be absurd for anyone who knows economics to insist that each new retail store or each new modification in existing products (such as a new edition of an economics book) be subject to some non-actual-market cost-benefit test before we conclude that the competitive forces that led to the new store or to the newly differentiated product is not socially wasteful.  If we understand the logic of the competitive process, that logic applies across the board.  I do not understand why Steve – who certainly does understand the logic of the competitive process – does not apply that logic to finance.  I see no difference between the investment by some high-frequency traders to build the fiber-cable tunnel and the investment by some launderers to build a new dry-cleaning establishment or the investment by Steve to update (or even to write and publish in the first place) The Armchair Economist.

….

I’ve here rambled on long enough – more for my own satisfaction than for any other purpose.  I’ll say more on this matter in a follow-up post.

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