Notes on the Meaning of 'Competition' in Economic Thought

These notes draw heavily on lectures on Perfect Competition Theory given by Louis Makowski at Cambridge University in Spring 1983.

1. The Classical Economists

The concern of classical political economy was to enunciate the 'natural laws' of the economy. The classical economists sought, in particular, to identify the determinants of prices and hence of the distribution of the 'social product' among different members of society.

For Adam Smith (1723-90), the natural laws were conceived of in terms of market forces establishing prices through the operation of competition. As for competition itself, Smith used the term "in the sense of rivalry in a race--a race to get limited supplies or a race to be rid of excess supplies" (Stigler, 1957, pp. 1-2). In taking this view, Smith was building on what other writers of his time, including Cantillon, Turgot, and Hume, had said about competition.

It was, however, first and foremost Smith's labor theory of value, rather than his treatment of competition, that Ricardo (1772-1823) and Marx (1818-83) developed further in their own writings. Smith had argued (as in his famous deer-beaver example) that, at least in a pre-capitalist economy, the relative prices of goods were determined by their relative labor contents. Ricardo asserted that the same principle held even in advanced, capitalist, economies. For Marx too, labor was the basis of all value.

2. The Marginal Revolution

The so-called Marginal Revolution of the 1870s, generally associated with Walras (1834-1910), Jevons (1835-82), and Menger (1840-1921), marked a shift in emphasis in economics away from production towards the demand side. From here on, (marginal) utility was given equal--or, sometimes, greater than equal--billing with cost as a determinant of price. But this common starting point aside, the different schools of thought that subsequently formed around Walras, Jevons, and Menger diverged from one another in important ways.

2.1 Walras

The central concern of Walras and his successors was with the role of prices in equilibrating supply and demand. Participants in the economy were envisaged as arranging their production and consumption activities in the face of given market prices. And the main question was: Do there exist prices at which supply and demand balance? Walras himself is credited with the first formulation of this question in an economy-wide ('general equilibrium') setting.

Similar in spirit to the general equilibrium analysis of Walras was the partial equilibrium approach of Marshall (1842-1924). The operation of a (single) market was conceived of in terms of supply and demand schedules, with market participants again treating prices parametrically. The price of the good in question was then said to be determined by the point of intersection of the two curves--that is, by the cut of the so-called Marshallian scissors.

The treatment of the firm given by Cournot (1801-77), and later taken up by Marshall and others, was in the same vein. For Cournot, the decision facing the firm was that of how much output to bring to the market. He derived the resulting optimality condition--that marginal revenue equal marginal cost--for the case of monopoly, and proceeded through duopoly and oligopoly to the case of "unlimited competition." Here, each of a large number of firms perceived that price would be affected hardly at all by its own output decision, and hence chose a level of output that equated marginal cost to the given market price.

The formulations of Cournot, Walras, and Marshall laid the basis for the development of the modern mathematical economics of Samuelson, Arrow, Debreu, and others. Indeed, the conventional wisdom today is that Walras' version of marginalism was successful while Jevons' and Menger's (see below) were not. But as this stream of ideas took hold, the fundamental idea of competition itself underwent a curious metamorphosis. Competition in the sense of active rivalry (as in Smith) became instead competition in the sense of passive price-taking behavior.

2.2 Jevons

For Wicksteed (1844-1927) and Clark (1847-1938), following in the footsteps of Jevons, marginalism was a tool not so much for analyzing the question of the determination of price, but rather for directly attacking the more fundamental question of the distribution of the social product. Under Wicksteed's and Clark's marginal productivity theory of distribution, participants in the economy were rewarded according to their respective marginal products:

It is the purpose of this work to show that the distribution of the income to society is controlled by a natural law, and that this law, if it worked without friction, would give to every agent of production the wealth which that agent creates. However wages may be adjusted by bargains freely made between individual men, the results of pay that result from such transactions tend, it is here claimed to equal that part of the product of industry which is traceable to the labor itself; and however interest may be adjusted by similarly free bargaining, it naturally tends to equal the fractional product that is separately traceable to capital. At the point in the economic system where titles to property originate,--where labor and capital come into possession of the amounts that the state afterwards treats as their own,--the social procedure is true to the principle on which the right of property rests. So far as it is not obstructed, it assigns to every one what he has specifically produced.
(J. B. Clark: The Distribution of Wealth: A Theory of Wages, Interest and Profits. Macmillan: 1899, preface. As quoted in Makowski and Ostroy 1992, pp. 371-2.)

Edgeworth (1845-1926) also took marginalist thinking in a direction that de emphasized price. His theory of contracting and recontracting placed bargaining between individuals at the center-stage of economic activity:

Here it is attempted to proceed without postulating the phenomenon of uniformity of price {Footnote: The term will sometimes be used here for rate of exchange in general, as used by M. Walras} by the longer route of contract-curve.
(F. Y. Edgeworth: Mathematical Psychics. Kegan Paul: 1881, p. 40. As quoted in Makowski and Ostroy 1992, p. 402.)

According to Edgeworth then, price was to be understood as an epiphenomenon of the bargaining process, rather than as an a priori construct as in the Walrasian-Marshallian theory.

The ideas of Wicksteed, Clark, and Edgeworth appear to have had relatively little impact on the development of mainstream economic thinking in this century. But it turns out that game theory--more specifically, cooperative game theory as formulated by von Neumann and Morgenstern and succeeding workers--addresses very similar issues to those that concerned Jevons' immediate followers.

2.3 Menger

The third leg of the marginalist stool was the so-called Austrian School, founded by Menger. Subsequent members of the school included von Böhm Bawerk (1851-1914), von Wieser (1851-1926), who emphasized the importance of measuring costs in opportunity cost terms, von Mises (1881-1973), Schumpeter (1883-1950), and von Hayek (1899-1992).

The Austrian School thought of competition as an active process centering at least as much around innovation as around price, and believed that the entrepreneurial quest for profits lay at the heart of the economy.

The Austrian view of competition was carried further by Knight (1885-1962), who argued that entrepreneurial profit was possible only in the presence of uncertainty. Knight also noted how limited was the notion of competition as commonly employed in economics:

The "perfect" market, of theory at its highest level of generality, is conventionally described as perfectly or purely "competitive." But use of this word is one of our worst misfortunes of terminology. There is no presumption of psychological competition, emulation, or rivalry, and this is rather contrary to the definition of economic behavior. Market relations are impersonal, between persons and goods; and persuasion or "bargaining" is also excluded.
(F. H. Knight: "Immutable Law in Economics: Its Reality and Limitations," American Economic Review, 1946, 36, pp. 93-111.)

Modern economists who have, to greater or lesser extent, followed the Austrian tradition include Buchanan, Coase, and Kirzner.

References

Buchanan, J., Cost and Choice: An Inquiry in Economic Theory. Chicago: The University of Chicago Press, 1969.

Kirzner, I., Competition & Entrepreneurship. Chicago: The University of Chicago Press, 1973.

Makowski, L. and J. Ostroy, "The Existence of Perfectly Competitive Equilibrium à la Wicksteed," in P. Dasgupta, D. Gale, O. Hart, and E. Maskin, eds., Economic Analysis of Markets and Games: Essays in Honor of Frank Hahn. Cambridge: The MIT Press, 1992, pp. 370-403.

McNulty, P., "A Note on the History of Perfect Competition," Journal of Political Economy, 1967, 75, pp. 395-399.

Stigler, J., "Perfect Competition, Historically Contemplated," Journal of Political Economy, 1957, 65, pp. 1-17.