
Mike Munger recently wrote about an elementary misunderstanding of economic competition many legislators and regulators seem to harbor – the idea that improving competition means ensuring there are more firms rather than less. This misunderstanding springs from what Munger calls a confusion between the textbook definition of “perfect competition” (which Munger calls an “idiotic concept”) and real competition, as it occurs in the world outside of the classroom blackboard. Munger cites this example:
That got me thinking about other cases where “more firms = more competition = better” fails to hold true. Two big examples struck my mind – banking, and mobile operating systems.
Let’s start with the first. Prior to the Great Depression, Canada had a largely unregulated banking system. From that system, what emerged was a relatively small number of very large banks that operated across the country. In the United States, there was a highly regulated banking system that (among other things) heavily skewed towards a “unit banking” system rather than a branch banking system. That is, banks were geographically limited in how far they could expand (operating across state lines was often a no-go) and were thus limited in size. From this system, what emerged was a system of tens of thousands of fairly small banks across the country.
From a “more firms = more competition = better” perspective, it might seem like the United States, with its vast number of banks, would be in a better situation than Canada, which was “dominated” by just a few very large banks. But in practice, the opposite was true. Because banks were so numerous and small, it also meant each individual bank was highly undiversified in the assets it held and was all but chained to local economic conditions. Large, highly diversified banks can better absorb economic shocks than small, undiversified banks. This is part of the reason why in the Great Depression the highly regulated United States banking system had over 10,000 bank failures and the lightly regulated Canadian banking system had none at all.
The second example that came to mind was mobile operating systems. Right now, it’s not at all uncommon to see a certain amount of handwringing over the fact that mobile operating systems is effectively a duopoly between Android and iOS. Wouldn’t it be better if there were more mobile operating systems on the market, because of increased competition? Well, no, not necessarily. If you’re wondering why, then as Munger himself would say, the answer is transaction costs.
Let’s consider a pretty extreme example. Imagine a genie snapped its fingers and tomorrow there was 10,000 different mobile operating systems on the market. Why wouldn’t that be good for competition? Well, one of the annoying features of the real world that’s left out of the introductory blackboard models is transaction costs. If you want to produce and sell an app that simulates a coin flip to help improve the lives of indecisive people, there’s simply no way you’re going program and format that app for 10,000 different OS’s. The transaction costs are simply too high. The same is true for every programmer and app developer out there. The more operating systems are out there on the market, the more complicated and expensive it is to make your application or program available to everyone on the market. Over the last couple of decades, there have been a wider variety of operating systems. Symbian was one. BlackBerry had their own, called (rather unimaginatively) BlackBerryOS. WebOS was another. Windows Mobile had a good run, too. These have all fallen away, leaving Android and iOS locked against each other. Would it be better if all these defunct mobile operating systems were still out there, providing more and better competition? Maybe so in the imaginary world of perfect competition. But in the real world, a world where transaction costs exist, it’s not at all clear that this would be the case. More operating systems means increasing transaction costs associated with producing everything we use those operating systems for – which could very well make the mobile OS market less rather than more productive.
What is the “optimal” number of operating systems? I don’t know. Neither do you. The answer can’t be derived from the blackboard, the armchair, or from tea leaves. But the best chance we have to discover the answer is when markets are free enough for actors to engage in real world market competition.
READER COMMENTS
Dylan
Jun 10 2024 at 12:58pm
While I agree with you that you can’t deduce the level of competition just from the number of firms in the market, but I’m not sure the examples you give indicate that the market is more competitive than less.
Yes, the Canadian banking industry has been more stable and less prone to failures, but it is also conservative, takes far longer to adopt new innovation than U.S. banks, and doesn’t specialize making it harder for small businesses in certain sectors to access capital. The consolidated banking sector is arguably one of the factors leading to Canada’s underdeveloped venture capital market, meaning most Canadian startups end up coming to the U.S. for capital once they are past the seed stage.
Mobile is more personal to me, since I haven’t had a phone I’ve liked in over 15 years. Yes, transaction costs are part of the reason the market developed the way it has, and a world with 1000 mobile OSes and few apps for any of them would be worse for almost everyone. But, in such a world, it seems far more likely that universal standards and webapps would have developed more fully than they have, and that would be a better world (for me at least)
David Seltzer
Jun 10 2024 at 3:33pm
Kevin: Per fewer firms, like Visa, Mastercard or American Express, given their larger share of the market, there is a potential for economies of scale. (lowest point on the average cost curve). Economies of scale lead to lower production costs and lower prices for consumers. If there is no regulatory capture, or illegal barriers to entry, innovators compete in those markets and drive prices lower. I was Yale Brozen’s research assistant at The University of Chicago, GSB. I worked on his concentrated industries study. Yale’s work and later, Sam Peltzman’s research, found that profits are higher in concentrated industries not because prices are higher but because they do not decline as much as costs when economy scales increase. In effect, long term average costs decline as innovation introduces, for example self-checkouts lanes. Larger firms have a cost advantage over smaller firms. Think Costco or Walmart.
Monte
Jun 10 2024 at 4:54pm
The “more firms=more competition=better’ is an unrealistic assumption that actually breaks down as the limit approaches infinity (Fama/Laffer, 1972). This post is a good reminder that, under certain conditions, a market can be perfectly competitive even where a duopoly exists. Perfect competition isn’t always best for the consumer and can, in fact, find itself at cross-purposes with individual liberty.
David Henderson
Jun 10 2024 at 5:22pm
Good post.
One correction: “the idea that improving competition means ensuring there are more firms rather than less” should be “the idea that improving competition means ensuring there are more firms rather than fewer.”
steve
Jun 11 2024 at 10:55am
I dont think the idea that you might be able to have good competition with just 2 companies has not been accepted, but rather that when you only have 2 or 3 its less likely that you have meaningful competition.
Steve
David Seltzer
Jun 11 2024 at 3:22pm
Steve: You might look at Ruben Kessel’s, A Study of the Effects of Competition in the Tax-exempt Bond Market in the Political Journal of Economy. Competition in underwriting new issues of tax-exempt bonds has the expected effect on underwriters’ spreads. Spreads decrease as competition increases. What the study found, it only took a second underwriter coming into the market to narrow the spreads.
David Henderson
Jun 11 2024 at 4:27pm
David, George Stigler gave Kessel’s data in his article “Monopoly” in my Concise Encyclopedia of Economics.
It’s here.
Kessel’s first name was Reuben.
David Seltzer
Jun 11 2024 at 5:51pm
David, sorry about the misspelling. Thanks for catching my error
steve
Jun 11 2024 at 4:29pm
Thanks, but I think you are mostly reaffirming my observation. In some markets it works. In other markets when there are only 2 or 3 competitors prices have risen. There are a number of markers that I think are worrisome if you look at what has happened while we have generally seen a lot fo consolidation in most of our industries.
Among those we find that mark-ups have greatly increased and while profits as measured by a share of GDP have doubled in the last couple of decades business investments only grew by 13%.
https://hbr.org/2018/03/is-lack-of-competition-strangling-the-u-s-economy
Steve
Jon Murphy
Jun 11 2024 at 4:42pm
Steve-
There are some subtlties to your argument you need to be aware of:
The first is the difference between economic profit and accounting profit. You’re referencing accounting profit here, but that’s not the relevant metric for “meaningful competition.” Economic profit is. Mark-ups and accounting profits increasing tells us nothing about how competitive a market is or is not (this is something economists have discussed for decades now. See, for example, Harold Demsetz excellent paper “Barriers to Entry” or GF Thirlby’s paper “The Ruler”).
Second, Profits can increase for no other reason than inflation. So, you’d need to adjust for that.
Third, tech companies are evidence against your point, not for it: they act as if they are perfectly competitive (price is equal to marginal cost).
Fourth, if your point is simply ” In some markets it works,” then yes, but that’s not the point here. What are the conditions that allow monopolists to arise and increase prices? If you dig in, you’ll see it’s heavily regulated markets where competition is now allowed to happen (eg health care).
Overall, one does not need many firms to get competitive markets. 2-3 get you there.
David Seltzer
Jun 11 2024 at 5:55pm
Jon: Much better answer than mine. I should have included the difference between economic profits and accounting profits. Thanks!
Henri Hein
Jun 12 2024 at 1:16pm
I think this should be “markets where competition is not allowed to happen.”
Monte
Jun 12 2024 at 1:18pm
Peter Thiel argues that competition is for losers. He was heavily influenced by Rene Gerard, who surmised that, while competition can be productive, it stifles progress once it becomes an end in itself. Schumpeter reinforces this argument by pointing out that monopolies provide large (though temporary) rewards to successful innovators, while competition does not:
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