Competitiveness in Markets

My last post ended with no real conclusion and only one interesting result, as has been pointed out by multiple people. This post is going to rectify that, as I will begin a discussion as to when competitive markets are desired and when alternatives are actually more useful.

I'm sure some of you are already thinking something involving the idea that a market is always in the best possible condition when it is competitive. However, there are a number of reasons why competitive markets do not always maximize social utility.

The theory of capitalism is ultimately based around a simple principle - voluntary exchange. A voluntary exchange is one in which both parties agree to the exchange. This agreement is made only if both parties believe they benefit from the exchange. As all exchanges in a truly free market are voluntary, every exchange within a truly free market should, ideally, increase the utility of both parties involved.

This, of course, glosses over a trio of important points. First of all, the fact that both parties may not have equivalent knowledge about the exchange. In an instance where knowledge is not distributed equally, it is possible for a voluntary exchange to be one that is not beneficial to both parties.

Secondly, there exist a class of market failure called externalities, as described back towards my first few posts. An externality is a cost or benefit of an exchange that falls upon individuals not directly  involved in the exchange.

Pollution is the class example of a negative externality, as the cost of pollution is shared by many individuals not involved in the process of creating pollution or buying the goods manufactured by said process. For positive externalities, higher education is generally used as an example, as many people benefit positively from a more educated populace but have nothing to do with the education process or the positions that are filled because of it.

Third, common property goods and public goods are not allocated properly in a free market. Public goods are non-exclusive and non-rival; that is, someone else's use of a public good does not reduce the amount of it available nor prevent someone else from using it. Common property goods are only non-rival; that is, you cannot prevent someone from using them but the use of the good reduces the amount of it that is available. Lighthouses are an excellent example of public goods, while publicly available. grazing land is the class example of a common property good.

We'll come back to some of these problems later, as my final point in this series of posts will be to determine when markets are performing optimally and how to get them to that point.

For now, let us assume that we are examining a market in which everyone has access to all information and there are no externalities. Moreover, this market is in no way related to a common property or public good.This market obviously does not exist, but these assumptions allow us to ignore some general problems and focus specifically on the competitiveness of the market.

As such, in this market any voluntary exchange will always result in a net benefit for the parties involved. This means that, generally speaking, a market holding to these conditions would provide the greatest benefit to society when the most transactions occur.

In addition, a truly competitive market would offer indistinguishable goods at the same price to all buyers, with the number of firms and buyers being to the point that no single transaction causes a change in price, no matter how large. The more competitive the market, the closer it resembles this model.

Our third and final consideration is that of economies of scale. In a market that possesses economies of scale, it is cheaper to produce goods when you produce a large number then when you produce a small number.

Now, let us examine a market for good N. Let us say that efficient production of N for a single firm falls between A and B. Let us say that there exist M different significant differentiations of good N, and that the demand for each is N1, N2, N3, ... , NM. Finally, let the total demand for N be D.

A voluntary transaction will occur if and only if both parties believe they benefit from the transaction; simply breaking even is not enough, as there is then no motivation to perform the transaction.

Let us say that there exist no significant differentiations for good N. N1 then equals D. If D < A, then either no N is produced or there is significant scarcity rent that drives up the prices for N. If A<D<B, the socially optimal number of firms producing N is one, and will be X if X*A<D<X*B.

In simple terms, the optimal number of firms in this market is the number that produce as close to the total demand for good N while staying mostly within the bounds of efficient production.

This can be extended to markets with differentiation simply by treating each differentiation of N as its own market.This is justified because each significant differentiation of N is more or less attractive to a subset of the individuals who have a desire for N and, as such, the existence of each distinct differentiation increases the possibility for voluntary exchanges.

Treating each as its own market leads us to the same conclusion as when we have no differentiation for each one, so we can simply treat a market with differentiation as a composite of markets without differentiation, with one difference - all goods within a differentiable(This analysis leaves out the idea of rent-seeking behavior, which we will examine at a later point. This behavior sets in through the use of monopoly power to create barriers to entry and other such cases, and significantly changes the solutions given here.)e market provide the same service, and therefore we can substitute between them.

This means that slack from one company can be taken up by another to reduce scarcity rents and still providing opportunities for voluntary exchange.

Still, the same overall conclusion holds, even if the exact numbers are not the same. We will not go through the math here, as it is very long and does not add anything useful in addition to the short mathematical section above.

From here, we can then say that the optimal number of firms and production of firms in the market for N is almost never the same as in the model for a competitive market.

We then conclude that competitive market structures are not always socially optimal.

This is contrary to the beliefs of many people, I'm sure, but I welcome the discussion, controversy or what-have-you.

(This analysis leaves out the idea of rent-seeking behavior, which we will examine at a later point. This behavior sets in through the use of monopoly power to create barriers to entry and other such cases, and significantly changes the solutions given here.)

As I move on from here, I'll be taking time to examine other peculiarities of markets, i.e. several of the things that are assumed to not be present in this examination of competitiveness. I will, hopefully, reach a conclusion as to what can be done to move a market closer to its socially optimal form by the end of the next few posts.

Anyways. Questions, comments, suggestions, complaints, and whatnot are all welcome. Especially suggestions, so I don't run out of things to talk about. Should be able to dump them below fairly easily.