Some Confusions of Language in Economic Thought

Fifty years ago, in 1968, Austrian (and Austrian school) economist Friedrich A. Hayek published a monograph called The Confusion of Language in Political Thought [4]. Hayek argued that the words we use and the meanings we give to them greatly influence how we think about the political system and the wider social order in which we live. This is no less so, I would suggest, in the language and the meanings of words used in economics.

Hayek’s focus was on the misunderstanding created by the false notion that society is the product of design. He emphasized that many, if not most, of the institutions of the social order are not the result of human design, but are the cumulative results of multitudes of people interacting over many generations.

Social Order Without Political Design

This is a theme in social analysis that has been a part of Austrian economics since the founding of the Austrian school by Carl Menger. He explained that markets and money, language and much of the legal system, social customs and cultural traditions, and polite manners are all the evolved outcomes of a vast number of individuals, each pursing their own personal self-interest for the most part. Their interactions and associations with each other slowly form into behavioral patterns, informal rules, and interactive procedures by which and through which human beings come to arrange and adapt their conduct with one another in a wide variety of social settings.

It is not that human beings do not consciously guide their actions according to a plan. Indeed, all meaningful human action is pursuit of a chosen set of ends with selected means the use of which is believed most likely to bring about the desired ends. And it is not that individuals do not agree on plans through which they hope to improve their circumstances through collaborative activities. They most certainly do.

But out of these interactions emerge many outcomes that none or few of the participants could have fully anticipated as their actions set in motion various social or economic processes. These are part of the unintended consequences of human action. As one of Carl Menger’s famous protégés, Friedrich von Wieser, pointed out:

The economy is full of social institutions which serve the entire economy and are so harmonious in structure as to suggest that they are the creation of an organized social will. Actually they can only have originated in the cooperation of … independent persons.…

How could any general contractual agreement be reached as to institutions whose being is still hidden in the mists of the future, and is only conceived in an incomplete manner by a few far-seeing persons, while the great mass can never clearly appreciate the nature of such an institution until it has actually attained its full form and is generally operative.…

Much more satisfactory is the explanation based on gradual historical evolution, which takes into account the powerful factor of time.… [Menger] uses the phenomenon of money as a paradigm by which he assumes to show that all social institutions of the economy are nothing more than the unintended social results of individual [human interactions].

Or as Austrian economist Ludwig von Mises concisely expressed it:

The historical process is not designed by individuals. It is the composite outcome of the intentional actions of all individuals. No man can plan history. All he can plan and try to put into effect are his own actions that jointly with the actions of other men constitute the historical process. The Pilgrim Fathers did not plan to found the United States.

Hayek reasoned that the language used in political theorizing and discussion conjured up the impression that society is a planned organization with those with political power and responsibility able to redesign the rules of human association as they want.

In terms he later used, all such beliefs are examples of a “fatal conceit” of an arrogant and misplaced “pretense of knowledge.” Matching the division of labor, Hayek long emphasized, is an inescapable division of knowledge that leaves all of us with limited abilities to understand enough of all the complexity and continual changes in the social order to presume to restructure the institutions of society to fit some preferred notions of distributive social justice or other ethical deserts.

Perfect Competition: A Misdirection of Economic Thought

The same misuses of language can be seen at work also, I suggest, in economic theorizing and policy making. The first example of this is the idea of competition. In everyday language, we usually use the word “competition” to represent an activity the purpose of which is to do better than we have done ourselves in the past or better than the related activities of others.

Yet this is not the meaning given to competition in the standard economics textbooks in which young students are introduced to the core concepts and implications of economic thinking. The economists’ model of perfect competition imagines a market in which there are so many sellers that each one is too small to influence the market price by its own production and supplying decisions.

Thus each seller takes the market price as given and passively adjusts its individual supplies to minimize its production costs and maximize its (net) revenues. The model also presumes that somehow each selling price and all the input prices have so fully adjusted to the objective supply and demand conditions in a market that each seller is earning zero profit, with total costs equal to total revenues.

The model also presumes that each seller in a market sells a product exactly like the one being offered by its rivals in that same market. That is, there is no attempt to offer a product different from that of all the numerous other “perfect competitors” in that market.

The model also often assumes that each and every market participant possesses perfect or sufficient knowledge of all relevant market conditions such that both as buyers and sellers people never make mistakes. Thus, no buyer pays more for any good than it could have been purchased for from someone else, and no seller ever accepts a price lower than it could have received from some other interested buyer.

Price and Quality Competition as a Discovery Procedure

It should be relatively clear that by defining competition in this manner one drains the very meaning of “to compete” of all of its common sense, everyday meaning. This definition is not how, for instance, the classical economists of the 19th century understood the concept. The noted British economist and historian of economic ideas Lionel Robbins once pointed out that

I cannot help suspecting that if they [the classical economists] had been confronted with the systems of this sort [“perfect competition”] … they would have had some hesitation in acknowledging a near family relationship. Their conception of the System of Economic Freedom was surely a conception of something more rough and ready, something more dynamic and real than these exquisite laboratory models.

In his 1946 lecture “The Meaning of Competition” and his 1969 essay “Competition as a Discovery Procedure,” Friedrich Hayek highlighted that to reduce the idea of competition to the textbook assumptions is to assume away all the essential and real characteristics of any actual competitive process.

The essence of real, dynamic market competition is the attempt to devise the most efficient ways of producing products or offering services to sell them at lower prices than one’s rivals in the quest for more sales, larger market share, and greater profits. It is through the price changes initiated by market participants for consumer goods and the factors of production that competition tends to bring supplies and demands into balance.

This is no less the case, Hayek insisted, in the attempts to offer better and different versions of an existing product, or, indeed, the marketing of an entirely new product. These attempts, too, are a primary means of winning the business of potential customers and not losing one’s current clientele.

Competition as a Source of Human Betterment

Price competition and quality rivalry are the means through which the standard of living for the buying public as a whole (which means ultimately all of us) is improved over time. Our dollars go further as price competition lowers buying prices, and product improvements enhance the variety and features of what we are buying to better our lives.

Think about the rotary-dialing desk telephone of a few decades ago versus the modern smartphone, which is a means for many forms of telecommunication and entertainment and certainly far more than simply a device for audio conversation. Think of the old manual typewriter and business offices with “typing pools” of secretaries to prepare hard copies of everything versus the modern laptop computers or tablets, which have changed the way written communications are composed and shared in every corner of our lives.

Think of black-and-white television with rabbit-ear antennas that you’d have to sometimes hold in your hand with one foot in the air to get a decent broadcasting signal versus flat-screen TVs with high-definition color pictures transmitted through wifi and high-speed fiber optics.

A mere hundred years ago, it was still very common for many to get about by foot or on horseback. By the 1950s, train travel was becoming passé in America with the growth in popularity of commercial airplanes and with automobiles in almost everyone’s driveway. Today, self-driving cars seem to be only a few years in the future, and entrepreneurs are planning private exploration of Mars and entertainment flights to outer space for joyriding consumers.

All these contrasts represent dramatic changes in the quality of everyday goods in some people’s own lifetime, at significantly lower (inflation-adjusted) prices compared to those earlier versions.

A central thesis in Hayek’s argument was to draw attention to the fact that all such changes have only been possible because of the incentives and motives of competitive profit seeking through which market participants discover what they can do, how well they can do it, what they can do differently, and where their best fit may be in the social system of division of labor. No one knows what could be done better, differently, or less expensively until he or she tries. But to be able to try requires the institutional setting of open, free competition through which a person can peacefully and honestly improve his or her own circumstances by serving the interests of others through exchange.

In other words, it is only through market competition that we discover what may be possible: from riding a horse to work in 1900 to someday in the near future traveling to Mars to settle a new human colony; from speaking loudly a century ago so those in the back of a large room might hear what you’re saying, to whispering today on your smartphone to a person on the other side of the planet.  (See my article “Capitalism and Competition.” [5])

Perfect Competition Defines Real Competition as Market Failure

Yet this is the very notion of competition that the perfect-competition model denounces as anticompetitive behavior. To offer a lower price than one’s rivals, to market a product with qualities different than theirs implies some essential market failure needing correction.

With the perfect-competition model lurking in the background, many mainstream economists over the years have concluded that some type of government regulation or price intervention may be called for, precisely to try to make market sellers conform to what the model says the real world should be like.

The fact is, no one possesses perfect knowledge of anything. Real competition serves as a method to discover knowledge, utilize that knowledge, share that knowledge, and replace existing knowledge with new knowledge, and it works most effectively through a market-based price system to guide people in their actions and responses to changing circumstances and things learned.

As Hayek expressed it, “Modern civilization has given man undreamt of power largely because, without understanding it, he has developed methods of utilizing more knowledge and resources than any one mind is aware of” — that is, the market institutions of rivalrous competition and the price system.

Misunderstanding Monopoly as Market Failure

Matching this misconception of the real meaning and relevance of market competition is a myopic notion of monopoly. In the mainstream economics textbooks, monopoly is defined as a situation in which a single seller has control over the price of its product by modifying the quantity of the product.

The textbooks provide a diagram showing a monopolist’s demand curve and marginal-revenue curve (that is, the extra revenue to be earned from selling one more unit of the good), and an average-total-cost curve (the average total cost per unit of producing at any given level of output) and a marginal-cost curve (the extra monetary expenditure from producing one more unit of the good).

The diagram draws attention to the fact that the monopolist’s optimal level of output (at which marginal revenue equals marginal cost) may easily come at a combination of higher price and lower output than if the monopolist was acting as if it was a perfect competitor.  Thus, the monopolist’s privately optimal price-quantity combination is declared suboptimal compared to the socially optimal price-quantity combination under perfect competition. Hence, monopoly conditions create market failures.

A starting problem with that textbook diagram is that it is analogous to a single, frozen frame taken out of a motion picture that tells nothing about what went before or what may follow.

Why There Are Monopolies: New Products, Small Markets

How did this monopoly arise? Is it because an innovative entrepreneur came up with a new product, and thus is initially the only seller of the product? If so, and if it turns out to be a profitable one, the seller’s very success will attract other sellers into its market in attempts to capture some of its business by devising ways to produce their versions of its new product at a lower price or with better qualities.

Looked at as a rivalrous process through time, the single seller’s profit will, in an open market, draw in competitors who will undermine its monopoly. When Apple first marketed its tablet, the iPad, in 2010, it quickly gained an 83 percent market share because of its initially unique qualities and attractiveness. As of the first quarter of 2018, Apple’s tablet market share was less than 29 percent. Rivals have encroached on Apple’s domination of that market over the last eight years, thus ending its earlier near-monopoly position.

Another reason for a monopoly over a period of time may be that a particular market is too small to sustain more than one seller, given the limited number of buyers and their constrained financial abilities to pay for various goods. Carl Menger argued that looked at historically, “monopoly, interpreted as an actual condition and not a social [i.e., a political] restriction on free competition, is … as a rule the earlier and more primitive phenomenon, and competition the phenomenon coming later in time.”

Indeed, Menger stated that “the manner in which competition develops from monopoly is closely connected with the economic progress of civilization.” In small towns, a single carpenter, lawyer, physician, blacksmith, or owner of a general store might be sufficient to satisfy the limited wants and exchange potential of the residents and surrounding countryside folks.

But as the town grows into a city — a more central trading and manufacturing area — the increasing demands for the various monopolists’ services become greater than the monopolists’ individual labor services or resources can accommodate. The prices for their services and wares rise, and some consumers are unable to have their demands fully satisfied. Over time, Menger explains, these factors will create the natural market incentives and opportunities for rivals to enter these expanding markets, and each of the monopolists becomes, over time, simply one of the competitors servicing consumer demands in that community.

The textbook expositions of monopoly usually miss all this because their fixation is on the geometry of the given curves in a diagram and on comparing what is presumed to be a perfectly competitive price and quantity of a good versus a single-seller combination of higher price and smaller quantity. As a result, for more than a century those caught in this textbook-diagram mindset have concluded the need for government interventions and regulations to break up a single large firm into smaller enterprises or to attempt to set the price of the monopolist’s good according to what the government “experts” determine should and would be the price if perfect competition prevailed.

All these interventionist attempts presume that those experts in the government bureaucratic agencies can look into the misty crystal ball of empirical economics and discern the right price. But if Hayek’s argument about the meaning and nature of competition is correct, there is no answer to the question of what is or could be a competitive price in a market other than to allow competition to work unrestricted by government regulation, control, or selective privileges. Free, or at least relatively free, markets everyday discover what the prices of goods and services could and should be, based on the changing patterns of supply and demand with the market participants attempting to do things in better and less expensive ways.

Understanding Competition as a Dynamic Process in Time

Another Austrian-born economist, Joseph Schumpeter, offered a complementary analysis to that of the Austrian school’s economists. The real nature and importance of the competitive process can only be appreciated, Schumpeter said, when looked at from a longer historical perspective than the frozen frame of the textbook diagram:

In dealing with capitalism we are dealing with an evolutionary process … that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.

This process of Creative Destruction is the essential fact about capitalism. The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers’ goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates.

It is hardly necessary to point out that competition of the kind we now have in mind acts not only when in being but also when it is merely an ever-present threat. It disciplines before it attacks. The businessman feels himself to be in a competitive situation even if he is alone in his field.

But all of this is misunderstood, leading to misguided thinking about the nature and working of markets and government policies because of the confusions of language in economic thought. (See my article “Capitalism and the Misunderstanding of Monopoly.” [6])

Market competition is transformed from a force of rivalrous improvement in the service of consumer demand into a static situation in which any entrepreneur who tries to lower price or improve quality is a creator of market failure. Any market innovator who has devised a way to offer something new or better than its rivals, resulting in its capturing all or a large portion of the consumer base, is claimed to be demonstrating antisocial monopoly behavior by being the trendsetter.

This creates a linguistic confusion in understanding the actual competitive market economy, and also easily serves as the misplaced rationale for government interventions and regulations that prevent those markets from freely and effectively functioning for the long-run betterment of all in society by interfering with or suppressing real competition in the name of perfect competition.

Source: https://www.aier.org/print/9063