What follows is a speculative discourse on the economic analysis of competition. It’s a discourse that I believe I made in an earlier post – but, if I did make it, I cannot now find it. So, for the record I make it again. It’s wonky, it might be incorrect in its details, and it’s below the fold.
Imagining an Alternative Model of Perfect Competition
Economic competition, from the standpoint of each supplier, is an economic reality with which he or she must deal in order to achieve the ultimate goal of each supplier qua supplier – namely, to increase as much as possible his or her firm’s net present value. Absent special privileges, each supplier in a competitive market attempts to achieve this goal by adjusting its operations on several margins. Cutting prices to attract more buyers is only one such competitive move. Improving product quality is another. Lowering per-unit costs of production and distribution is yet another.
In neoclassical mainstream economics, however, price competition is treated as if it is the only, or, certainly, the paramount form of competition. This obsession with price competition is unwarranted. While I stand second to no one in my appreciation of the indisputably central and vital role that market-determined prices play in a market economy, it is an error to suppose that price competition is the only, the paramount, or exclusively the best form of competition.
Of course it’s true that consumers want to pay as low a price as possible for a unit of any given good or service. For the very same reason, consumers want to get as much quality as possible in that good or service for any given price at which that good or service is available for sale.
When consumers act to “maximize their utility” or to “get good bargains” – call it what you will – prices are not all that matter to them. If prices were all that matter, then even billionaires would eat only ramen-noodle dishes, wear only cheap second-hand clothing, and don only Timexes and never Rolexes.
So suppose that economists had formulated the theory of perfect competition differently. Suppose that, instead of assuming exogenously given and fixed goods and services (of given qualities) in order to see how competition affects the prices of goods and services, economists had assumed that the prices of different types of goods and services are exogenously given and fixed in order to see how competition affects the types and quality of goods and services made available on market.
In this Alternative Model of Perfect Competition, economists would explain that, in a ‘perfectly competitive’ industry, each firm is a “product-quality taker.” At each moment in time, each firm could sell as many units per period as it wished without improving its product’s quality, and would lose all sales if it lowered its product quality by even the tiniest amount. As in the actual, familiar model of perfect competition, each firm’s only “choice” in the Alternative Model is the quantity to produce. Each firm would produce that quantity of output at which marginal cost equals price.
Remember, in this Alternative Model of Perfect Competition, price never changes. As with product quality in the actual, standard model of perfect competition, in this Alternative Model, price throughout remains exogenously given and fixed.
Yet while each firm, in the Alternative Model, is a product-quality taker, for the industry of which each firm is a part, product quality is variable. Product quality is what the model is meant to explain. In a way analogous to how in the actual, standard model of perfect competition increased consumer demand for a good causes price and industry output to rise, increased consumer demand in the Alternative Model causes product quality to fall and the quantity of output to rise – again, with price remaining unchanged. Likewise, a decrease in consumer demand for the product would cause product quality to rise and the quantity of output to fall.
Importantly, from the perspective of the Alternative Model, an industry in which a firm could lower both its price and its product quality while still attracting enough buyers to stay in business would be labeled a “monopolistically competitive” industry. This industry would be regarded as suboptimal compared to a perfectly competitive industry. The price cut would be treated by economists as a suspect tactic used by the firm to enable it to reduce product quality below the ‘perfectly competitive level’ without losing all of its customers. The economist would explain that this lowered price is called “price differentiation”; without it, the firm would have been compelled by competitive forces to continue to supply the optimal, higher level of product quality. But now, because it lowered its price, this firm can reduce the quality of its product without losing all of its customers.
In a world in which this Alternative Model of Perfect Competition reigned, among the standard fare in economics textbooks would be demonstrations that firms’ use of “price differentiation” as a means of freeing themselves from being “product-quality takers” is a source of monopoly power that leads to suboptimal allocation of resources.