The Difference Between Healthy Competition and Monopoly

I’m currently doing some work on evolutionary economics without really having gotten far beyond the basics. I am certain this stuff is great and important, but all the books always kind of loose me at the point where too many “statistical moments” come in, I am asked to solve non-linear differential equations and I find myself spending most of my time reviewing how the rules of integration work. I’m terrible at math, is what I’m saying. But the book by Stanley Metcalfe on my desk at the moment still seems a really terrific introduction into the topic. What really fascinated me, however, is something only marginally related to the models themselves. Something so blatantly obvious when you think about it yet so cleverly hidden that I had never noticed it with this clarity. One of economists’ favorite words is actually nothing but a farce in most standard economic models: we speak of competition where there really is none!

Let’s start with the classics, where Adam Smith still had the deal down pretty well. In his view, and obviously paraphrasing and simplifying, competition was responsible for achieving two very different yet equally important goals. The first one is coordination, bringing a wide range of seemingly unconnected individuals together in a way that allocates a given set of resources as efficiently as possible. All hail the invisible hand of the market! Yet the second role of competitions is just as important: to apply constant pressure on individuals and firms to promote economic progress, in his world mainly through the division of labor. Yet at some point in history, during the transition from classical to neo-classical economics, we seem to have simply thrown out this second characteristic of competition. Marshall was the one to provide the ultimate refinement of a framework that views competition no longer as a constant, never-ending process, but as a basically stationary state. To be fair, Marshall himself was reluctant to actually use the term “competition” to describe his equilibrium states, but some of those who followed in his footsteps apparently were not.

The equilibrium state of neo-classical economics is generally one that is defined by what has come to be labeled as “perfect competition”. It includes perfect markets, which simply means that identical goods and services are bought and sold for the same price throughout the economy, leaving no room for arbitrage, atomistic competition (which essentially rules out anything but decreasing returns to scale) and free entry into and exit from the market. Yet what is most interesting is an accurate description of what actually happens in such an equilibrium state, which is supposedly reached basically instantaneously: not much! We have a great number of firms producing exactly the same thing at exactly the same price with consumers doing the same on the other side of the equation. In the words of the Rumanian economist Georgescu-Roegen: „the condition commonly labeled as a ‘perfectly competitive industry’ actually involves no competition at all”.

I was surprised to find out that Frank Knight, one of the founding fathers of the Chicago School of Economics, was the one who came up with the concept of “competition as a contest”. One of the main pillars of such a system is that the different players actually behave differently, in part on purpose, in part due to a lack of information. The economy is essentially populated with a potentially large amount of “players” that live in the same world yet have different views of this world (and how to succeed in it). I see no reason why competition should be anything else. Clearly an arrangement where every single firm does exactly the same is not an arrangement where anyone competes. Yet the question as to why firms behave differently also leads us to a seeming paradox. What creates competition in the first place is the prospect of gaining monopoly power. Instead of being opposites, the terms competition and monopoly actually become requirements of one another – which essentially brings us to the title of this post.

It is a key property of any well-functioning competitive system that it allows for (even if only short-lived) monopoly profits. It is these profits that make the system go and keep it going. Without these profits there would be no funds to innovate with and evolve in the first place. At the same time, at geneticist Richard Lewontin noted, “evolution consumes its own fuel”. While every firm is in a constant struggle to achieve extra profits, every other firm is in a constant struggle to destroy these extra profits. The vital advantage of an evolutionary economics take on the issue, however, is the ability to differentiate between “good” and “bad” extra profits; between monopoly power that results from superior innovational success and monopoly power that simply exploits. A static analysis fails miserably in this regard. It is also worth noting that trying to measure the “level of competition” in an industry by simply counting the amount of firms involved in that industry is a totally misguided way to go about the problem. And the whole issue also actually has real-world implications: IBM, for instance, ended up winning the anti-trust case brought against it in the ‘80s and ‘90s, and a big deal of it was due to the difference described above. The damage done to IBMs image, however, was disastrous despite winning in court. Instead of bringing down a genuine monopoly the case arguably ended up doing considerable damage to one of the most innovative firms in history. So while there is little doubt in my mind that there are plenty of monopolies to be broken up around the world, every monopoly is not alike. Indeed, some of them might even be monopolies for good reasons.


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