April 30, 2013

Competition in Context: National Economies

In last week's post I outlined five points about competition that tend to go overlooked in economic discourse:
  • The amount of things we are competing for changes over time.
  • The future amounts of things we are competing for are uncertain.
  • The things we are competing for may be created by the competitors themselves.
  • The amount of things we are competing for may be artificially constrained (this is basically a roundabout way of describing the way we often create markets using public or non-rivalrous goods).
  • The current allocation of things we are competing for may have important effects on the ability of competitors to compete for more of them (this is basically a roundabout way of describing things like economies of scale, network effects, path dependency, and first-mover advantage).
I want to take these ideas and look at what they can mean for competition situated in various contexts. What does it mean for a country to be competitive as compared with a competitive business or a competitive worker? I don't want to give a full account of how competition in these areas works, rather to think about why the points I've made above are important.

In all three of these competitive arenas, competitiveness comes from offering more value than competitors are offering. Typically 'offering value' means selling similar (aka substitutable) products or services more cheaply than a rival worker, firm, or country. Although these three realms of competition are similar in the abstract, they compete to provide that value in different ways. Today I'll write about competition in national economies.

National Economies

National economies compete with each other in a number of ways, most prominently in trying to attract international investment or run a positive balances of trade (by exporting more final and intermediate goods than they import from other countries). They also compete in other ways, by attracting immigrants or more overtly through war, but I will just consider trade and investment here.

Both investment and trade flows fluctuate significantly over time, and they do so in both net as well as gross terms. This fluctuation--the resizing of the pie the economies are competing for--can have important macroeconomic consequences for countries. These kind of changes in trade and investment are well-enough understood by economists, but they can be missing from popular rhetoric in important ways. For example, protectionist policies during the great depression are thought to have exacerbated the economic downturn, but were still pursued because lawmakers (evidently) failed to see how decreasing US imports could also eventually decrease US exports.

It is worth noting that since the 1970s competition between nations has had a sort of "equalizing" mechanism that should serve to dampen competition: free-floating exchange rates. In theory this means that nations are unable to trade their way into a larger stock of value--they are only able to trade for the value of what they are producing (or can convince other countries they will produce in the future). In basic neoclassical economic theory, therefore, countries are not "in competition" in the way that firms or workers are. In practice, however, trade flows can be heavily dependent on skewed terms of value exchange if exchange rates do not adjust flawlessly (or exist, in the case of Europe).

National economies also reflect the uncertainty of competition (e.g. nations may embark on ambitious industrial planning that fails to come to fruition in the long term) and the "self-determining pie" nature of the value being competed for (e.g. nations may fail to create enough domestic demand to grow internally without relying on trade export surpluses, like China). These misconceptions about competition can have important consequences, like wasted public investment or beggar-thy-neighbor pursuit of competitiveness that ignores the importance of domestic demand. Attempts to promote competitiveness need to reflect the complexities of the real world.

Finally, competition between national economies is also powerfully affected by network effects, path dependency, institutional strength, and other forces acting on markets outside of normal supply/demand issues. This has been recognized by economics but it has been a struggle to put it into practice for many countries: some countries have been successful, such as the "asian tigers" and more recently the BRICs, but others have been unable to harness these positive externalities for their competitive gain. Economics has incorporated some of these ideas into standard trade models but overall they fail to capture many ideas useful for policy.

April 22, 2013

Production as Privilege: Thoughts on Competition

I started writing a post about mercantilism, but I realized I needed to do a bit more thinking about competition first. The last post on this blog was talking specifically about the effect of competition on how people consume, but this is looking more generally at the nature of competition within market. This post is part of a series called Production as Privilege, looking at the way that production relates to the distribution of wealth.

Conceptual Tool #11: Understanding Competition

Competition is a fundamental concept of economics but it is usually restricted to a simplistic market framework of buyers and sellers, or game theoretical choices and payoffs. Let's think a bit harder about what competition is: what we are competing for, who is doing the competing, what are we competing with, etc...

To start with, here are two basics we should be able to agree on:

Competition requires at least two entities. Usually these are firms or individuals, but we can also think about competition between other aggregations: classes, industries, cities or countries.

Competition must be for something that is limited in some way. In economics these are somewhat unhelpfully known as "rivalrous" goods. The point is that they can run out, and each competitor can't have as much as it wants. We don't have to compete for air unless we are underwater.

There are several ways in which we think about competition that are misleading.

First of all, we tend to think about it in static terms, with competitors gunning for a set quantity of stuff. This is rarely true: competitors are often chasing after expanding or contracting amounts of stuff--where "stuff" can be anything from wind-generating capacity to customers who want to purchase typewriters. People have recognized this dynamic element of competition and it gets reflected in business strategies like "blue ocean" strategy.

Once we recognize the dynamic nature of competition, it becomes clear that competition has a probabilistic component as well. We often compete to optimize our returns in the future, and such returns necessarily involve uncertainty. We compete for uncertain outcomes when we buy raffle tickets that might win us a new TV, or when we create export-processing zones that we hope will attract foreign investment.

The third thing we often fail to recognize, and this is perhaps the most interesting point I'm making, is the way that competitors' own actions can shape the availability of what they are competing for. That is, competitors may be competing for pieces of the pie, but the pie may expand or contract based on the actions of the competitors. This is because the fungibility of money converts many different types of competition into competition for value, and we produce value in order to exchange it for other value. This is not a trivial point: it is the crux of Adam Smith's (and all modern free trade supporters') argument against mercantilism (see here) and for the productive power of self-interest.

Fourth, we also forget that much of competition is for things that are artificially scarce. Certainly most newer digital products are kept artificially scarce through copyrights and other legal protections. What's less commonly understood is that compound interest on loans creates scarcity as well, by asking people to pay back more than their original amount. Some bankruptcies are thus actually required because not everyone can win. (Although it's also true that new loans can be created; so I'm not sure I fully understand the implications here.)

Finally, while economics is well acquainted with problematic economies of scale and network effects, the extent to which there is free entry into markets and truly open competition is often overstated. Mass retail markets are dominated, perhaps by definition, by massive economies of scale. Many primary and non-consumer markets are basically oligopolistic--one rationale for deregulated trade is that national-level oligopolies will be replaced by more efficient international competition. And digital markets have entirely different economies of scale than the world has ever seen, where the tools of production and maintaining scarcity take almost any form we can imagine. Here is a fun TEDx talk highlighting network effects and describing the way we misunderstand them when thinking about economics.

When we put all these ideas together we get a picture of competition that doesn't look much like the basic perfect competition/monopolistic competition/oligopoly/monopoly models. Instead there is a dynamic ecosystem of not only firms and workers, but also financers and consumer preferences, and an infinite variety of markets that defy easy classification. Economists know this, of course--they just don't know a precise, mathematical way to think about it.

April 8, 2013

Competitive Consumption

Economics loves competition. It's what makes the economy go 'round. Without it, markets would fall flat on their faces and buyers and sellers would have their arms twisted into horrendous deals. We'd have to pay even more for our mobile phone service than Canadians do.

Most of the attention paid to competition, though, is about competition among firms. The basic types of market competition in econ101 are types of supplier competition. We worry about monopoly often enough, but who ever lost sleep about monopsony in a consumer market? (the standard monopsony example is a single employer in a labor market)

On the consumer side, it's just assumed that there will be many consumers and they will all want to pay as little as possible. These assumptions are generally true, of course, but they oversimplify things because they gloss over why we consume.

Economics 101 starts with the idea that we have unlimited wants, and then adds on some qualifying assumptions about how we prefer variety and get diminishing marginal utility from any single type of good. The idea of unlimited wants justifies not only what happens in the economy, but how we understand the whole enterprise of economic theorizing. They rationalize endless growth and the focus on consumption and tell us what economic policy is supposed to do: meet our unlimited desires with scarce resources.

This is handy logic, but it only takes you so far. You end up with a lot of consumers who want more of certain things because... well, because they want more of them. Metaphorically, we can think of this model as the "sky's the limit" model of consumption: more is always better. (And if something does start giving you decreasing marginal utility, it just means you want more of something else.) This is the common logic used by economists, but there is less explanatory power here than there might first appear. It does not explain, for example, why happiness does not increase beyond a certain income threshold.

How else are we to understand the motive behind our desires, then? The idea I'll call competitive consumption has some interesting explanatory power, and it also has some far-reaching implications for economic theory.

Competitive consumption is socially-motivated consumption, in a somewhat simplistic want-to-have-more-than-the-other-guy manner. We can also think of it as relative or comparative consumption, or consumption motivated by inequality. Inequality is a powerful motivator, as the right likes to argue. It doesn't have to be somebody getting paid 483 times more than I do, though--just a dollar an hour is enough to drive me into paroxysms of jealousy.

Standard economic theory has developed tools to represent competitive consumption, through ideas like positional goods and prestige markets. But these ideas are seen as exceptions to the norm, when in fact they can be fundamental forces in wide range of markets.

Positional goods are things that we buy because they are scarce--often artificially scarce--and their being scarce confers social status on us. Some goods, like loaves of bread perhaps, are not really positional goods, but most things have at least a positional component. Some are literally positional: a penthouse apartment or a front-row seat. Others are positional because the required expenditure of real resources keeps them scarce, such as weekend ski-trips to Vail or sailing around in giant yachts. Still others are positional because they are kept scarce artificially, like diamonds. Or, like spots in an elite school, by means of reputation and concentration of resources and attention. ?????

Most goods have a positional aspect because that aspect is what motivates, to a large degree, our consumption. Better position is often tied to a real increase in "use value", although economics has as good as given up trying to distinguish what that means. More expensive cars might drive better or more expensive fashion might look better, but these goods are also imbued with social value and that is a powerful reason they are consumed.

Mere quantity can have a powerful impact on positionality as well. Having two or three or four cars can be handy, but it can also show status. Of course, people don't go around saying "I can't believe Rupert only has one car! What a low-class person!" But your kid might hate you if you can't take him to all his after-school activities because your spouse drove the car to work, and the other parents might think you are not a good parent. Use value has its own social implications.

Producers are quite good at exploiting consumers' competitive urges and are able to extract consumer value by providing various "qualities" of a different product that are available at different prices. Alcohol is a perfect example, with quality increasing almost imperceptibly as prices skyrocket. Countless brands also have clearly differentiated models (of cards, computers, headphones, suits, etc...) that are less a reflection of higher costs of production than of the nice infinite ladder of consumer prestige. No matter what your budget is, you can spend it all--and it will never be enough. Part of the reason is simply because we have an extremely wacky (and malleable) idea of what things are worth, but many expensive things have inherent value purely through their expensiveness.

What does it mean to take positional goods seriously and really look at the implications of competitive consumption?

First of all, competitive consumption doesn't mean that consumers are competing to buy a given good--it means that consumers consume for competitive reasons. An extreme conclusion of this idea is that demand can be infinite without increasing welfare. We can consume and consume but our utility, on the aggregate, cannot improve if utility is based on our relative position.

Second, static equilibrium analysis seems woefully inadequate. If goods are positional, then the demand for a good can (and probably does) change every time it is purchased. That is, my purchasing a new BMW might raise the overall demand for BMWs (or lower it, more likely). This is Keynes's "animal spirits" writ large across the entire consumer economy. For marketers this idea may be common sense, but economists rarely take it seriously.

But if we do try to do static analysis, what might our market even look like? A demand curve for a given good is supposed to represent the aggregation of different individuals' "willingnesses to pay", with a few people willing to pay a lot for a good and a lot willing to pay a little for it. So it slopes downward:

Competitive consumption, however, could drive consumers to create that downward slope simply for the sake of having a downward slope. That is, with no variation in preference or anything to do with willingness, demand would still sort itself along a curve reflecting little more than the ability to pay. Everybody wants to be at the top, but they can only get as far as their incomes will take them. (Note that this is looking at demand in the aggregate; assuming consumers have varied preferences, then demand with individual product markets may still be differentiated based on how much consumers want a product. But if we look at all products together we can assume people simply want "more".)

This has important implications for social welfare analysis. Economists generally just look at the area under the curve and call that the social welfare effect. (See the wikipedia article on deadweight loss for some nice graphs.) There are already powerful critiques against this type of analysis (Brad DeLong's "non socratic dialog" is one of my favorites), but if the downward slope of the demand curve is simply an artifact of consumer competitiveness, it leaves welfare analysis on even flimsier footing. If one person's utility is another person's disutility, consumption adds no value.

As mentioned above, the constructed nature of the demand curve is not a passive phenomenon. Marketers understand the competitive nature of consumption and are happy to oblige and encourage consumers' pursuit of utility in a zero-sum game.

Competitive consumption is not the only reason for consumption, but to the extent that it does reflect real motives for consumption it can have real implications for economic theory. And thus also for economic policy. Taking competitive consumption seriously requires us to rethink our ideas about equality and welfare, and the effect of consumption on happiness and aggregate utility. We have built our thinking and our policies on assumptions about human psychology and welfare that are suspect, and we will have a difficult time escaping from our current growth patterns without a better understanding of who we are and what we need. One way to do that is to take competitive consumption seriously.

April 2, 2013

The Good, The Bad, the Optimally Efficient in a Given Environment Subject to Change

This is a guest post today from our friend "Blue". Enjoy!

Economists are often accused of physics envy. This is likely valid. Often the alternative suggested is meteorology, implying a limited capacity to forecast the future. That may be a useful perspective as well, but I’d like to suggest a better, and what I consider more realistic, academic brother: genetics.

Like the economy, genetics is concerned with the survival of entities in a competitive environment. They both attempt to explain the behavior of those entities in terms of what is efficient or useful for their success. They both use lots of statistics and game theory, so at minimum you know they are fun.

Let’s back up, dear reader, and discuss the motivation for this discourse. Many economists believe that what economists are doing is describing inherent laws about the way exchanges work. The Austrians often call this “praxeology” which they roughly define as the deductive human behavior in exchanges (for “exchanges” think big markets where people are buying and selling stuff). Though they will say otherwise, the “human” part is not that all important. Rather the exchange itself gives rise to necessary actions a human must take. Thus the study of economics is, in their view, a study about the immutable characteristics of these markets, the laws that govern them and so on. We see when these exchanges/markets are functioning efficiently and say ‘this is good.’ Functioning well is good. The naturalness of it is right, it to behave as we are naturally intended to. While the Austrians are the easiest to pin down here, many, and in a way most, economists are sympathetic to this view, subconsciously if not explicitly. This is the physics envy, the aspiration of mathematical purity, the dogma.

Then there are the economists who say “whoa there buddy, ol’ pal, maybe it is not so immutable after all.” They suggest that perhaps the mathematical elegance of these endeavors should be put to the test. Let’s see how all that deduction matches up with the data, which is ultimately how physicists test their theories anyways. Of course it turns out most if not all of the theory is just awful at describing the real world. Capital flowing from poor countries to rich? Deregulation leading to more stability?

And these economists say, “well, maybe the immutable aspirations are a little too high, let’s just talk about what’s going on in the short run.” Here the models and theory are a little more useful. They seem to tell us how things work when everything is going fine, but of course they never see the crisis until it is upon us. Like meteorologists we know some immutable characteristics of what we are talking about, much as they know how high and low pressure systems will affect weather patterns, but when any specific storm will come is harder to say. This, to some extent is a legitimate aspiration for economists. Like detecting low pressure air, precipitation, temperatures, macroeconomists can say “ah, yes, look at all that accumulating debt, that hyper-inflated stock market and the exchange rate risk, a crisis is likely.” This seems to me useful. Though ultimately more art than science, it may at least have some claim to legitimacy. What is good then is nothing more than nice weather. We don’t want storms, we want pleasant skies and maybe the occasional breeze for kite flying.

But now, I’d like to turn to my proposal. Genetics. Why is this a better or more appropriate aspiration for economists? Let me first persuade you of its relevance. Both studies, economist and genetics, concern themselves with the dynamics involved in the competition of many heterogeneous entities in a given environment. Yes, genes look to replicate and businesses look to accrue profits, but exchange babies for wealth and we are starting to get there. Funny that both genes and socially constructed business strive for survival, immortality really, perhaps there is something philosophical to be said there, but I digress.

And what, then, if anything, can genetics teach economics? In genetics what is good in one environment may spell disaster in another. The march of evolution is not necessarily progress as much as it is adaptation. It’s contingent, conditional, contextual, the opposite of immutable. Indeed what evolution fosters is not necessarily good or bad; it simply creates utility at a given time and in a given environment. What is natural has no sanctity, it will save your life in the forest only to crush you on the grass lands. What is natural is neither good nor bad, it is simply happenstance, the accrual of millions of interactions between entities, their environment and randomness.

And so then the deep questions, the first principles of economics, are open once again for debate. What does a good economy look like? Just because something is good for an individual, does that necessarily mean it is good for society? What are meaningful metrics for these things (the average lifespan of a small business is 8.5 years)? Can a business live forever? What is similar or different about how humans and businesses interact with the giant, dynamic, evolving, idiosyncratic, instructionally contingent monetary environment we call the economy? Indeed.