Markets must become competitive

Only through a process do markets become competitive

ICYMI, I was in the WSJ earlier this week on my usual shtick: economics is good.

Nearly every week, someone writing for a major news outlet argues that economics has failed. Our models are too abstract. Our predictions are always wrong. President Trump’s recent firing of Bureau of Labor Statistics Commissioner Erika McEntarfer is the latest notable example of this anti-economics sentiment.

Let me make what appears to have become a radical argument: Simple economics is surprisingly good at making real-world predictions.

I’ll share the full text here when I can.

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Below is an expanded version of a post from 2021.

Prices emerge from individuals’ interactions and bargaining. The slogan that I stole from Joe Ostroy is that maximization precedes prices. This slogan stands in contrast to the standard, price-taking approach, where prices must exist before people act. With price-taking, prices precede maximization.

Word games are fun, but who cares? The two visions of markets lead to different understandings of how markets work and, ultimately, different policy recommendations.

In the standard approach, a market is competitive (or not) by assumption. In jargon, it is exogenous whether people are price-takers or not. As IO economists have long realized, it is problematic to think of the level of competition—or more easily measurable characteristics like concentration—as exogenous. They are instead equilibrium outcomes. Something else determines them. One benefit of the price-taking model is that it’s easy to use. Draw supply, draw demand, and point and the intersection. Every textbook starts there.

To get beyond price-taking, we must recognize that markets become competitive. It’s an equilibrium outcome that plays out through time. As the Austrians say, the market is a process.

Entrepreneurs and How Prices Emerge

There is actually one textbook that explicitly teaches markets the way I recommend. The answer will surprise you—or not, if you’ve read this newsletter.

Armen Alchian and William Allen’s Universal Economics starts with a simple bargaining situation and shows how prices emerge. (Thanks to Bryan Cutsinger, a great teacher of price theory, for pointing me to their exposition of this.)

Let’s go through Alchian and Allen’s example.

We are visiting a camp where hurricane refugees are living. Monthly, each refugee receives Red Cross parcels with 20 bottles of water and 20 granola bars. (The old editions had cigarettes and candy, which sounds much more fun, but we'll stick with water and granola bars.) To start with, people consume their rations. There are no markets or trades, competitive or not.

Someone soon arrives on the scene and asks, “what are the chances that everyone in this camp places the same value on water and granola bars? Surely there is a better outcome.” Or in language from Israel Kirzner, an entrepreneur discovers a possible profit-making opportunity. In other work, Alchian calls this person a middleman.

The entrepreneur researches and learns that Sam dumps some of his water on the ground. Sam must not care that much for water. That is, Sam places a relatively low value of substitution on water. Joe, in contrast, doesn't eat all of his granola bars, so Joe places a relatively high value of substitution on water.

The entrepreneur realizes that there are gains from trade out there. Buy low; sell high. He goes to Sam and offers ten granola bars for ten waters. Sam accepts. He goes Joe and offers eight waters for ten granola bars. Both accept the trade since it makes them better off, and the entrepreneur can take home two bottles of water for himself. Pure profit!

Each person (Sam, Joe, and the entrepreneur) pursuing their goals generates markets and prices. Maximization precedes prices.

This market isn’t instantaneously competitive in the textbook sense. People aren’t facing perfectly elastic demand and supply curves. People can influence the going rate for water by adjusting the amount they trade. The entrepreneur is even charging a markup. Tsk, tsk, tsk.

We could end the story here and call on regulators to break up this monopoly. Price doesn’t equal marginal cost after all. The initial entrepreneur may even be hiding his actions, so others don’t learn how he is making a profit. That wasteful rent-seeker! He certainly isn't going to introduce Sam to Joe. But should he? He did the investigation to discover that gains from trade exist. He’s earning a return on his knowledge.

Alchian and Allen remind us that there is a process playing out. Yes, this process doesn’t work instantaneously. There are setbacks. But this isn't the end of the story. Over time, we can expect his profits will be eaten away. Again, we are going toward a competitive market.

Eventually, another person discovers what is going on and offers both Sam and Joe a better deal. The new prices make Sam and Joe better off, leading to smaller profits for the entrepreneurs as a group and much smaller for the original entrepreneur. Or maybe before entrepreneur number two comes on the scene but fearing a potential entrant, the original entrepreneur decides not to bargain too hard and give Sam and Joe “fair” prices.

Regardless of the exact timing, since the entrepreneur's arbitrage opportunity can be replicated whenever someone learns about it and money-making information has a way of spreading, other entrepreneurs will enter. Those competitors will drive the market to the competitive outcome, where the entrepreneurs are just covering their costs on transporting the goods.

Is this a competitive market? In the textbook sense, this isn’t competitive right away. It is competitive after the second entrepreneur enters since they compete on prices, and Bertrand competition is competitive. Instead of “competitive,” Alchian and Allen call this an “open market.” 

“Open markets” mean that access to markets is open to all people without arbitrary, contrived barriers— not that there are no costs involved in providing exchange-facilitating services.

Is it guaranteed to lead to competitive prices? No. Of course not. But we can ask, what would stop this process? We could imagine a few easy reasons. The group in charge of the camp could pass a rule that says people can’t freely trade. More realistically, they limit who can participate in trade. One may worry about the “exploitation” of Sam and Joe by this outsider, so he may not be allowed in. No foreigners allowed! That would stop the process or slow it down, at least. Now we can talk about barriers to entry.

Making it formal

If this all seems squishy, it can be made formal. Alchian and Allen provided a crystal clear example of this mechanism in 1964. A mere 60 years later Rafael Guthmann and I translated this basic idea into mathematics in a working paper that I’ve mentioned a bunch of times. Other work on market-makers does the same thing.

We start with two isolated “islands”—one where apples can be bought for $0 and another where they sell for $1. Each entrepreneur is likely to discover both markets and recognize the profit opportunity.

When only one entrepreneur discovers the arbitrage, she can charge monopoly prices. However, as more entrepreneurs independently discover the same opportunity, competition kicks in. They undercut each other’s prices, and those monopoly profits get eroded. Our model shows a predictable process with predictions about how fast profits disappear and what factors speed up or slow down the competitive process.

Perhaps most importantly, the model demonstrates that competitive equilibrium emerges not from some mystical “invisible hand,” but from the concrete actions of alert entrepreneurs who discover opportunities and then compete with each other.

Math or not, I think this is the most important parable in economics. Everything else about markets can be augmented onto this simple setup. We can see why advertising is used. We can see why middlemen or money emerge. When I draw my supply and demand graphs that I love, I need to remember that in the background is always an entrepreneurial process. I hope others can do the same.

From price theory to Debreu-Scarf

Let’s make one more mathematical connection. Vincent Geloso tagged me just this morning about Debreu-Scarf and how it relates to Kirzner’s market process (basically the stuff we are talking about today).

The refugee-camp parable helps us see how prices emerge: a few entrepreneurs spot opportunities, profits get chipped away, and (if entry is open) the market inches toward competition. That’s the story in miniature.

But how do we know where this process leads? This is where the concept of the “core” comes in. The core is the set of all possible allocations of goods that no group of people can improve upon by forming their own coalition and trading among themselves. If an allocation is in the core, it means there’s no subset of traders who can break away and all make themselves better off.

The core is beautiful because it shows every conceivable way people might try to gain an advantage. Can a group of buyers band together and bypass the entrepreneurs? Can sellers form a cartel? Can some subset of traders break away and create their own mini-market with better terms? The core includes only those allocations that survive all these tests—outcomes that no coalition, no matter how clever, can improve upon for its members. It takes competition seriously.

Debreu and Scarf showed that if you scale this process up because the market grows, the outcome gets sharper and sharper. In a small market, bargaining power matters. One middleman can set the terms, capture rents, and hide the knowledge. But in a large market—lots of Sams, lots of Joes, and lots of entrepreneurs—the bargaining power of any one group fades. Coalitions can’t do better than what the overall market is already delivering. The core of possible outcomes shrinks until only the competitive outcome remains.

This connects directly to our entrepreneurial story. Each entrepreneur searching for profit opportunities is essentially testing whether the current allocation is in the core. If Sam and Joe are trading water for granola bars at some rate, and our entrepreneur can offer both a better deal, then the original allocation wasn’t stable—it wasn’t in the core. The constant search for advantage, the endless testing of whether someone can be made better off, is precisely what drives the market toward the core and ultimately toward competition.

So, the camp example and the Debreu–Scarf theorem are two sides of the same coin. One shows the process in action with a few traders, and the other shows the logical endpoint when markets grow without bounds. Together, they drive home the essential point: competition is created, not assumed.