How Competition Creates Economics: Comparing Capitalism to the
Alternatives
Benjamin Lyons
George Mason University
Email: [email protected]
Abstract:
This paper considers Alchian’s evolutionary model of competition under
conditions of uncertainty and imperfect foresight and the implication that
economics is based on competitive selection forces, not individual optimizing
behavior. Competition is shown to be fundamentally selection, and that other
views of competition such as perfect competition or competition as a discovery
process do not capture the essence of competition. It is then shown that the
correct measure of monopoly is the degree to which a firm is subject to selection
pressures along some margin, and therefore a firm is competitive to the extent
that it is forced to obey the predictions of economics in order to survive. Turning
that statement around reveals that economic prediction is based on the
competitiveness of the firm, and therefore not economists but only the economic
system itself can scientifically determine the relative viability of different survival
strategies. Economic competition is shown to be identical to the scientific
method, and this conclusion is applied to the question of monopolistic central
banking versus competitive banking, showing that a competitive system might be
changed and improved but it cannot be replaced by monopoly.
1. Introduction
The critical question of economics is the question of competition; what it is, what
it does, and what role it should play in shaping our society. Oh, certainly
economists like to say that the logic of individual maximizing behavior or the
allocation of scarce resources is the critical question of economics. They’ll quote
Lionel Robbins, who wrote, “Economics is the science which studies human
behavior as a relationship between given ends and scarce means which have
2
alternative uses,” but he was wrong. Economists clearly don’t study human
behavior, with the exception of behavioral economists under very limited
circumstances, which bears little relation to the clean, rational, direct optimization
of their models, nor have economists ever been able to predict human behavior
except in broad, sweeping patterns1. On the whole it might be more correct to
say that economists show a remarkable lack of curiosity about human behavior.
And as for the allocation of scarce resources, economists have already tried their
hand at applying their science to manage the allocation of scarce resources: it
was called “central planning,” and it was a disaster.
Economists may talk a lot about human behavior and allocating scarce
resources, but they don’t actually know much about either of those things. Those
subjects are more the domain of psychologists and businessmen. So what do
economists know? Let’s look at a prediction that economists like to make: the
marginal price of a good sold by a firm will be equal to the marginal cost of that
good. How do economists know that, if they don’t know very much about human
behavior or the allocation of scarce resources?
The answer is competition. It is competition that gives economists all their
knowledge about human behavior: economists don’t know what different people
will choose, but they know a lot about which outcomes will win the competition.
Economists often imply that they can predict that people will try to maximize
profits or make a lot of money, but they can’t, and many people don’t. What
economists can predict is that people who maximize profits will outcompete
people who don’t maximize profits, and so the best description and prediction of
businesses is that they are profit-maximizing entities, even if nobody in the
business is trying to or knows how to maximize profits. Competition selects for
the profit-maximizing firm, and economists know that; hence they know that
businesses are “profit maximizing,” or perhaps more accurately “profit
maximized.” It has nothing to do with his or her ability to predict human behavior,
which is no greater than anyone else’s. It is competition, not rational optimizing
behavior, which is the predictive basis of economics.
The best explanation of just what exactly competition is and its role in economics
comes from Alchian’s justly famous paper, “Uncertainty, Evolution, and Economic
Theory.” Alchian was taking on a controversy in microeconomics where some
economists thought they had evidence that marginalist economics was wrong,
and other economists were trying to reconcile the data with their old theories.
They were all wrong, as Alchian explained, because the whole controversy was
based on the false assumption that marginalist economics makes predictions
1
Haye, F. A. Prize Lecture: The Pretense of Knoweldge. Nobelprize.org. Retrieved Aug 25,
2013 from http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1974/hayeklecture.html.
3
about individual human behavior. Actually, Alchian showed, marginalist
economics only makes predictions about competitive phenomena: economists
predict that marginal cost will be equal to marginal price because that’s the trait
that wins the competition, not because any individual is trying to or knows how to
set the marginal price of some good equal to its marginal cost.2
Although Alchian’s paper may have settled the controversy, some of the most
important implications of that paper have largely gone unrecognized. Primarily,
Alchian’s model revealed the essential nature of competition: by showing that
competition is in no way dependent on individual behavior, competition is
therefore only a selection process. Competition as only a selection process is
important on at least two levels. First, if we understand competition as
fundamentally a selection process, then we can see that other methods of
analyzing competition that look at, for example, the number of competitors, are
actually really analyzing the conditions under which the selection process occurs
and what outcomes will result given the selection process under said conditions,
which is distinct from analyzing the nature of competition itself. Second, and this
will require further elaboration, analyzing competition’s fundamental essence as
a selection process reveals the identical nature competitions shares with the
scientific method.
The scientific method is a competitive method, and the competitive method is a
scientific one. The fundamental underlying process of both the scientific method
and economic competition is the same: different attempts to answer a question
are compared to each other, and the better attempt survives while the inferior
attempts are eliminated. In science the “attempts” are called “hypotheses,” and in
economic competition they are called “firms.” The differences are, however,
entirely superficial; the underlying process is identical. Another superficial
difference is that while scientists submit hypotheses to answer all kinds of
questions, the only question that is ever asked in economic competition is, “How
can realized positive profits be earned?” Any firm that successfully earns realized
positive profits survives, and any firm that does not goes out of business.
For the most part the scientific method has been a huge boon to humanity, and
economic competition is no exception. Under what might be called “market
conditions,” essentially the absence of externalities, economic competition is
unparalleled in its power to promote human welfare through what is called the
invisible hand mechanism. When externalities are in place, however, economic
competition can be harmful. Economic competition is still the scientific method,
but the best answer to the question of how realized positive profits can be
2
Alchian, Armen. A. (1950). Uncertainty, Evolution and Economic Theory. Journal of Political
Economy 58 (June): 211–221.
4
achieved when externalities are present is an answer that requires actions that
impose net costs on humanity.
Externalities or no, what must be recognized is that the scientific method and
therefore economic competition have no substitute. Nuclear weapons and the
horrors of the Nazi scientific experiments prove that science does not inherently
promote human welfare. Nevertheless, humanity would not be better off if we had
decided that we should do without science and seek some alternative method of
mastering the universe. Science is the method; it can be improved, tweaked,
altered, but it cannot be replaced. The same is true of economic competition.
Economists must strive to improve competition, to make it work for humanity and
not against, but they must not think they can replace it for it has no substitute.
Nevertheless, in the egregious case of banking, economists near-unanimously
support a replacement for competition: central banking. In order to better
understand why, whatever the flaws of competitive banking, central banking
cannot be a substitute, we must go through the full analysis of Alchian’s model
that I have only briefly summarized here.
2. What Competition Is
A very long time ago, back in early dawn of modern 20th century economics,
economists thought crazy things like, “Businessmen choose so as to maximize
profits” and “Firms set the marginal cost of their workers equal to the marginal
product revenue of their workers.”
Critics noticed the problem right away: people observably don’t make decisions
to do things like maximize profits or set MC equal to MR. Economists responded
by saying that people somehow implicitly used rules like “maximize profits” or
“set MC equal to MR” as guidelines for behavior.
Then in 1939 a group of Oxford economists decided to test the theory: do firms
use “set MC equal to MR” as a rule for setting the pay of workers? They sent out
questionnaires to firms asking them how they set their workers’ pay.
The responses they got back were highly disturbing. Firms didn’t know what this
marginal cost and marginal revenue business was, and they didn’t much care.
They used a kind of pricing called “full-cost pricing” which basically amounted to
pricing a good according to its average cost plus a small markup, although the
details of full-cost pricing are not very important in the end. What is important is
that the results of the questionnaires struck a huge blow to marginalism and
economic theory as it then existed. Firms aren’t using marginal cost to make
decisions!
And so the full-cost pricing controversy was born.
5
There was a huge debate in the profession. Was marginalism wrong? Are firms
not profit-maximizing entities? Some of the greatest economic minds of that
generation took part in the debate from Joan Robinson to George Stigler. They
came up with explanations ranging from attempts to prove that full-cost pricing
was actually an application of marginalist economics to statements that the
accuracy of economic assumption is not important so long as the predictions the
theory yields are correct. But for all their effort there didn’t seem to be any
satisfactory way to explain the data that would also preserve most of the
advances in economic theory since the 1870s.3
Then Armen Albert Alchian entered the fray. In eleven elegant pages he ended
the debate and changed economics forever.
It so happened that there was a certain assumption common to all the
participants of the full-cost pricing controversy, an assumption that turned out to
be false. That assumption was the belief that economics is as much a science of
individual action as it is a science of the economic system. So, for example, if
economics predicts that the marginal cost of producing a good is equal to the
marginal revenue of selling that good, that must be because economics predicts
that individuals will knowingly and deliberately set the marginal revenue of a
good equal to its marginal cost.
Alchian challenged this assumption. First he pointed out that it is only in a world
of certainty and perfect foresight that it even makes sense to attempt to maximize
profits or set MR equal to MC. Neither of these things are actions, they are
outcomes; there is no button that anyone can press to maximize profits or set MR
equal to MC. In the world of certainty and perfect foresight, however, there may
as well be a button; anyone can just look down all the paths their different actions
lead to see which path leads to the highest profits and then choose that
sequence of actions. It is easy for someone with certainty and perfect foresight.
However, in our world of uncertainty and imperfect foresight, it does not even
make sense for an agent to try to maximize profits. Maximum profit is not a goal
they can aim at when choosing an action. In our world of uncertainty, economic
agents cannot simply look down the paths of all the various choices available to
them and choose the one path that leads to higher profits than any other path.
Rather,
“Under uncertainty, by definition, each action that may be chosen is identified
with a distribution of potential outcomes, not with a unique outcome. Implicit in
uncertainty is the consequence that these distributions of potential outcomes are
3
Lee, Frederick. S. (1984). The Marginalist Controversy and the Demise of Full Cost Pricing.
Journal of Economic Issues 18 (Dec.): 1107-1132.
6
overlapping. It is worth emphasis that each possible action has a distribution of
potential outcomes, only one of which will materialize if the action is taken, and
that one outcome cannot be foreseen. Essentially the task is converted into
making a decision (selecting an action) whose potential outcome distribution is
preferable, that is, choosing the action with the optimum distribution, since there
is no such thing as a maximizing distribution.”4
In our world of uncertainty economics cannot possibly rely on treating economic
actors as rational profit maximizers with accurate understanding of and control
over economic variables. The result for economic theory is that “The only way to
make “profit maximization” a specifically meaningful action is to postulate a
model containing certainty. Then the question of the predictive and explanatory
reliability of the model must be faced.”5
So what is to become of economic theory if firms can’t choose to maximize
profits and set MR equal to MC? How can marginalism be saved?
Alchian’s innovation was the discovery of an approach to economics that is able
to “[dispense] with ‘profit maximization’; and...does not rely on the predictable,
individual behavior that is usually assumed, as a first approximation, in standard
textbook treatments,” because “the analytical concepts usually associated with
such behavior...are not dependent upon such motivation or foresight.”6 Instead of
models based on individual foresight and rationality, Alchian realized, “There is
an alternative method which treats the decisions and criteria dictated by the
economic system as more important than those made by the individuals in it.”7
This method treats “...the economic system as an adoptive mechanism which
chooses among exploratory actions generated by the adaptive pursuit of
“success” or “profits.”8
Alchian developed a model in which entrepreneurs behave randomly without any
foresight or even motivation to maximize profits. Without paying any attention to
goals like maximizing profits or setting marginal revenue equal to marginal cost,
they still manage to build firms that compete for profits, although it may take
either a very large number of entrepreneurs or a very long period of time. Despite
the random behavior of the entrepreneurs, there will still be an average rate of
profit in the economy, and many firms earning more or less than this amount. A
firm earning the average amount of profit is earning zero economic profits. A firm
earning above the average amount is earning positive profits. A firm earning
4
Alchian, “Uncertainty, Evolution, and Economic Theory,” p. 2.
Ibid., p. 3.
6
Ibid., p. 1.
7
Ibid., p. 3.
8
Ibid., p. 1.
5
7
below the average amount is earning negative profits. Alchian’s model shows
that “Even in a world of stupid men there would still be profits.”9
Profits are more than a mere statistical certainty. Profits are also “the criterion
according to which successful and surviving firms are selected.”10 The economy
rewards firms that earn positive profits with survival, and it culls firms that earn
negative profits. Moreover, because profits exist even in an economic system of
extreme stupidity, Alchian proves that “It does not matter through what process of
reasoning or motivation such success was achieved. The fact of its
accomplishment is sufficient.”11 In other words, the economy pays no attention to
whether entrepreneurs try to maximize profits or set marginal revenue equal to
marginal cost. Results, not intentions, are all that matter.
If profitable firms are not the result of entrepreneurs seeking profits according to
rational economic analysis, then where do profits come from? Firms profit by
doing better than other firms at succeeding in the given economic environment.
Firms that are better suited to the economy than other firms will earn positive
profits. They will survive, and the more poorly adapted firms will disappear. Even
if the entrepreneurs have no motive to profit and have no knowledge or
intelligence, the result still holds because by sheer chance some entrepreneurs
will outperform others.
By stripping competition down to its essentials, Alchian solved the full-cost
pricing controversy. Economists can’t predict that individual firms will set
marginal cost of their workers equal to the marginal revenue they produce, but
they can predict that the evolutionary process of competition will select for firms
that do a better job of matching MC to MR because economists know that
matching MC to MR is a maximum success criterion in the environment since
one cannot do better than to match MC to MR. More generally,
With a knowledge of the economy’s realized requisites for survival and by
a comparison of alternative conditions, [the economist] can state what
types of firms or behavior relative to other possible types will be more
viable, even though the firms themselves may not know the conditions or
9
Ibid., p. 3.
Ibid.
11
Ibid.
10
8
even try to achieve them by readjusting to the changed situation if they do
know the conditions.12
Beyond solving the full-cost pricing controversy, Alchian’s stripped-down model
of competition reveals the essence of what competition is. Competition is an
evolutionary process of selection. Rather than successful reproduction, as is the
case in biological evolution, economic evolution selects for realized positive
profits, which are earned by outperforming one’s competitors. Finally,
competition, not rational foresighted behavior, is the basis for prediction in
economics.
3. What Competition Is Not
By making clear exactly what competition is Alchian’s model reveals what
competition is not. Competition is only an evolutionary process that selects firms
according to realized positive profits and “kills off” firms that have realized
negative profits.
Therefore, if competition is only a selection process, then in a system of so-called
“perfect competition,” which requires perfect knowledge and foresight on the part
of the economic agents, there is no competition at all. Firms will perfectly adapt
themselves to the environmental conditions, there will be no realized positive or
negative profits because no firm will be outperforming or underperforming other
firms, and so there will be no evolutionary selection process. “Perfect
competition” is the complete absence of competition. This is very similar to
Hayek’s argument that perfect competition is not competition13, however, it is
stronger because it proceeds directly from analyzing the true essence of
competition rather than any appeal to the ordinary meaning of the word
“competition.”
Competition also has nothing to do with the number or size of the competing
firms nor the extent of collusion among the firms nor the homogeneity of the
goods the firms are selling, neither prior to the selection as a set of firms from
which competition will select some firms and eliminate others nor after the
selection as the set of selected firms. Prior to the competition, these factors all
are part of the conditions under which competition occurs, but they are not
competition itself. After the competition, these results are indicative of the
conditions under which the competition occurred, but they are not even per se
12
Ibid., p. 6.
Hayek, F. A.. (2010, March 15). The Meaning of Competition. Mises.org. Retrieved August
24, 2013, from http://www.mises.org.
13
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evidence that competition occurred, let alone the essence of competition itself.
What economists have often taken to be requirements of and evidence for
competition are neither. Competition refers only to the process of selection. Even
collusion, although its successful practice might lead to the elimination of
competition, is not in itself an anti-competitive practice. The extent to which a firm
can successfully collude is one of the conditions that will lead to realized positive
profits and therefore survival in the selection.
Competition is also not, contra Hayek, a discovery process. Competition can
exist in a system where nobody knows or learns anything. By sheer random
chance some firms will earn realized positive profits and other firms will not.
Perhaps one will discover which firms outperformed which other firms (although
even this is unnecessary), but if one does not know why one firm outperformed
the other this information is completely useless. Competition can be an important
source of information, but that depends on the capabilities of the economic
agents in the system. It is not inherent to competition itself.
Alchian’s model of competition shows that what economists have traditionally
confused with competition are actually either sets of various factors affecting the
process and outcome of the competition, such as whatever conditions allow for
the emergence of so-called perfect competition or else outcomes of the
competitive process under certain conditions, such as discovery. Competition is
only the selection.
4. The Place of Perfect Competition and Monopoly
What economists have thought of as competition, which requires intelligent costminimizing agents in perfect lockstep and harmony, is more like the complete
opposite.
If what economists have called competition is really the opposite of competition,
then it should not come as a surprise that concepts like “perfect competition”
have no place in the real economics of competition. There is no such thing as a
perfect competitor. A competitor might be perfect according to its own values and
yet earn realized negative profits in the economy. There is also not a clear
meaning of a perfect competitor according to the sole value of competition,
realized positive profits. Is it a perfect competitor if they earn anything less than
infinite positive profits? How instantly must the other competitors be eliminated?
In fact, if there are only two competitors and they are both doing as well as could
possibly be imagined, i.e. perfectly, then they would match each other in the
competition, they would both earn equal profits and therefore, being the only two
competitors, zero realized positive profits, which can only be earned by
outperforming the competition. Are they not perfect competitors because
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competition would take no interest in either of them? In fact, competition would
die at that moment, since any possibility of selection would end.
Perfect competition is also not a state. What economists call perfect competition
refers to an arbitrarily chosen set of market conditions that affect the selection
and are themselves selected for under some other set of market conditions.
From a positive standpoint this set of conditions is no more or less perfect than
any other. Nor is there any clear purpose in calling that state of being “perfect”
from a normative viewpoint. Among other impossibilities, perfect competition
requires that the “competing” firms all be selling a completely homogenous good.
This would require that the different goods all occupy the same space, a physical
impossibility. As long as the assumptions of the model violate the laws of
physics, why not assume away scarcity itself and call that perfect?
As for monopoly, it is useless to define a monopoly by the extent to which it can
raise prices and reduce output as compared to the so-called “competitive
equilibrium.” Perfect competition is no such thing, and so it is insignificant to
define monopoly by a comparison to an arbitrary set of physically impossible
market conditions. Monopoly also is not defined by being a single seller, despite
the etymology. For two firms to be selling completely homogeneous goods
requires a violation of the laws of physics. Therefore any firm is a monopoly if it is
defined by being the sole seller of some good. The truth of the matter is that the
categorization of different firms into the “same industry” is a mere convenience.
Competition cares not for these distinctions. All firms will be selected according
to their ability to earn realized positive profits and so are all in the same industry,
the industry of realized positive profits. Any firm, no matter how alone it may be
according to more standard methods of categorizing firms by industry, may still
earn realized negative profits and be eliminated by competition.
What monopoly is, if it is anything at all, is the extent to which a firm is not
subject to selection pressures. The more a firm can avoid matching MC to MR,
for example, or avoid maximizing profits, and still not be outcompeted, the more
the firm is monopolistic. Generally speaking, the more a firm can avoid meeting
the maximal success criteria of the environment and still survive, the more it is a
monopoly. Monopoly in this sense is entirely a quantitative degree. It is not a
dichotomous quality where some firms are to be labeled monopolies and others
competitive. Nor is a firm simply “0.6 monopolistic” or something to that effect. A
firm may be highly monopolistic on one margin and very competitive on a
different margin. For example, a firm might be able to survive without matching
MC to MR, but it might not be able to survive without earning rents from the
government. It would be highly monopolistic on the margin of matching marginal
cost to marginal revenue but highly competitive on the margin of earning rents
from the government.
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Monopoly therefore is measured by the extent to which the laws of economics
cannot explain reality. Economics predicts that marginal cost will equal marginal
revenue and that profits will be maximized. Monopoly is the degree to which that
will not be true. Furthermore, by reversing this measurement of monopoly, we
arrive at the measure of competitiveness: the extent to which economic
predictions are in fact borne out. This follows from the fact that competition
creates economics and not the other way around.
5. Competition as the Basis for Economic Prediction
So far the analysis has proceeded to show that the competitiveness of a firm,
industry, or market is measured by the extent to which it will conform to the
predictions of economics and that these predictions of economics are founded in
selection effects, not analysis of individual behavior. Reversing these statements,
we can see that the extent to which the predictions of economics that are based
on selection effects, not individual behavior, come true is dependent on the
degree of competitiveness in the unit of analysis. The curious result implies that
economics is a result of competition and not the other way around: competition
creates economics, and competition is the basis for economic prediction. Put
another way, nothing in the laws of economics requires or gives economists the
ability to predict individual human behavior. Rather, economics gives economists
the ability to predict which individuals will survive whatever selection pressures
they will be subjected to. This requires some knowledge of the conditions of the
system.
If individuals were not subject to any selection pressures, economists would have
no ability to predict their behavior. Although the laws of economics requires
agents to do less of what costs more, this makes no predictions at all. A sadist
will do more of what hurts more. An opulent and status-conscious individual will
buy more of a good as the price rises. What constitutes a cost is entirely
subjective and so saying that an agent obeys the laws of economics, i.e.
minimizes costs, does not make any specific predictions. What calling something
an economizing agent predicts is that the agent is rationally pursuing the
fulfillment of its utility function given all the constraints on the system it is
operating within. It predicts that the agent’s behavior is explainable in principle,
but it does not allow economists to predict any particular behavior without
knowledge of the agent’s utility function and some of the facts of the economic
system, nor does it predict but rather assumes the existence of economic agents.
Therefore, we have two questions:
1. Why can economists expect to find economizing agents in the world?
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2. How can economists predict what humans who obey the laws of economics
will do?
The answer to the first question is based in selection pressures, in humanity’s
case evolution by natural selection. Biological evolution by natural selection is a
selection process like economic competition is, but biological evolution only
selects for successful reproduction of viable offspring, not realized positive
profits. Biological evolution created an unfathomably large number of organisms
and subjected them all to a harsh series of competitions over a billion years.
Apparently, cost-minimizing agents outperformed agents lacking consistent utility
functions. The laws of physics do not require that agents minimize costs.
However, the universe will kill off any agents that don’t, so we only observe
agents who do. Anywhere the universe did not make disappear agents who do
not minimize costs, economists would not be able to expect that the laws of
economics would be found there.
The answer to the second question is very similar. The laws of economics only
allow economists to make predictions given sufficient knowledge of the economic
agent’s utility function and circumstances. In our reality, economists almost never
have enough information to predict individual human behavior except in very
general patterns, such as predicting that if the cost of apples rises, people will
buy less of them. This is merely a pattern, however, and may easily not apply to
the individual. If the cost of apples rose 5% and someone did not buy fewer
apples than they did before, economists would not take that as a falsification of
their theory.
Economists are not very good at predicting individual human behavior, but as
Alchian showed they don’t have to in order to predict a great many things. His
solution to the full-cost pricing controversy was not to attempt to reconcile the
observed individual behavior, full-cost pricing, with the marginal-cost pricing that
economists predicted. Instead he demonstrated that firms that did a better job of
having the appropriate qualities for the economic environment would outcompete
the firms that did a worse job. Matching marginal cost to marginal revenue is one
such appropriate quality, and so economists could predict that firms would match
marginal cost to marginal revenue as a function of a selection effect, not of
individual behavior. Firms could even be deliberately trying not to match MC to
MR and the selection effect would still hold.
It is a principle of scientific investigation that a hypothesis that can predict
everything, predicts nothing. Prediction comes from the extent to which a
hypothesis excludes alternative outcomes. The more possibilities included in a
distribution of outcomes, the lower the probability of predicting a particular
outcome. When a hypothesis predicts everything, there are an infinite number of
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outcomes in the distribution and the probability of predicting a particular outcome
becomes zero. When the distribution is reduced to a single outcome, the
probability of that outcome becomes a certainty, 1. When non-certain
distributions between hypotheses overlap, you have uncertainty. Thus prediction
comes from the extent to which one can eliminate outcomes from the distribution
of outcomes yielded by the hypothesis. The analogue to biological evolution is
that prediction comes from organisms being “killed off” i.e. failing to reproduce of
viable offspring. The laws of physics allow a virtually infinite number of different
organisms and behaviors, but evolution will kill most of them according to certain
predictable criteria, allowing for biologists to predict what will evolve. The
analogue to economic competition is that prediction comes from firms going out
of business. The laws of physics allow a virtually infinite number of different firms
and strategies, but economic competition will put most of them out of business in
according to certain predictable criteria, allowing economists to predict what
strategies will be observed. That is how even though it is not within the power of
economics to predict individual behavior economists can still predict what
qualities are selected for and therefore obtain accurate predictions about a
number of important phenomena. In a world without selection effects, economic
science would not exist since nothing in the universe would exist to restrict the
number of possible qualities and behaviors of agents. It has been thought that
competition is a product of economics, but it is actually more like competition that
creates economics. This result follows from Alchian’s model.
6. Competition as the Invisible, Alien Scientist
By following the implications of Alchian’s model, we can see that economists
predict outcomes, not strategies. They can proceed from the initial conditions
straight to the end point insofar as the unit of analysis is competitive, but
economists have little ability to predict which strategies, behaviors, qualities, etc.,
will actually succeed in the competition, even though they know what criteria
those strategies, behaviors, and qualities have to fulfill. Nor do businessmen and
consumers know much about which strategies, behaviors, and qualities are likely
to yield success. The question that must be asked is just then do superior
strategies, behaviors, and qualities get separated from inferior ones?
The answer is that all the different attempted strategies, behaviors, and qualities
are submitted to the test of competition, and those that do better than average
spread and those that underperform are eliminated. Thus competition is a
method for systematically investigating the unknown answer to a question by
submitting various answers to a test and retaining the answers that performed
best while eliminating the answers that underperformed. In other words,
competition is the scientific method.
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The scientific method is indistinguishable from competition. The scientific
method’s essence is in two parts. The first part is submitting hypotheses and the
second part is testing hypotheses.
According to the scientific method, what a scientist first does is submit a
hypothesis for experimentation. This is analogous to when an entrepreneur in the
economy builds a firm based on their information about the world. It is a
hypothesis about what is most likely to profit in the economy. The scientist’s
hypotheses are set in competition against the null hypothesis and other
competing hypotheses just like the entrepreneur’s firm is set in competition
against other firms.
What a scientist does next is test the hypothesis. They perform the experiment. If
the hypothesis passes the experiment, it survives to the next round of testing. If
the hypothesis is wrong, it is discarded. This is analogous to economic
competition, which subjects all the “submitted hypotheses,” i.e. different firms
created by entrepreneurs, to the test of realized positive profits. Those
“hypotheses” that earn realized positive profits pass the “experiment,” and
survive. Those “hypotheses” that earn realized negative profits are “falsified,”
they do not fit the “data”, i.e. economic conditions, as well as other “submitted
hypotheses.” The failed hypotheses are then discarded, which is to say, go out of
business.
What makes economic competition different from what we usually consider the
scientific method is that there is not an intelligent agent behind it. The individual
agents in the economy submit the hypotheses, but they do not perform the
experiments. The economy performs the experiments, as if competition is led by
an invisible scientist. The economy is not intelligent, it has no goals, and it does
not act in the literal sense, being merely a metaphor. However, the fact remains
that the economy goes through the same essentials of the scientific method and
so is an incarnation of the scientific method.
The economy, the invisible scientist, adapts firms to it in the same way that
human scientists adapt hypotheses to their experimental results. The invisible
scientist who experiments with competition, however, is an alien. It has very
different values from human scientists. Human scientists employ the scientific
method in pursuit of status, wealth, knowledge, and the ability to help others. In
doing so, they add to an ever-growing body of knowledge and increasing human
mastery over the universe. The economy, on the other hand, is only interested in
realized positive profits. It is as single-minded in its pursuit of realized positive
profits as biological evolution is in its pursuit of successful reproduction of viable
offspring. The economy is a scientist pursuing a project unrelated to human
values. However, the economy is not intelligent and so may be mastered and put
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to work for human benefit by sufficiently intelligent humans in much the same
way that we have already done with horses. It is the task of economists to lead
humanity in this project.
7. Symbiosis with the Invisible Scientist
Now the question we must turn to is how competition may be tamed and ridden,
how the scientific powers of the economy may be directed to humanity’s benefit.
The invisible scientist is interested in realized positive profits and only realized
positive profits. Under different market conditions, competition will, in the pursuit
of realized positive profits, achieve different degrees of human welfare. Under
some conditions, like those of the Prisoner’s Dilemma, competition will pursue its
own goals while no human gets what they want. Under other conditions, like
those of conquest, competition will achieve its goals and, by doing so,
accomplish the values of some humans at the expense of other humans. Finally,
under the conditions of the market, which excludes externalities, competition will
pursue the goal of realized positive profits and, in doing so, promote the values of
the vast majority of human participants. Under the conditions of the market, the
invisible scientist’s research benefits humanity because realized positive profits
are achieved in the market by supplying the values of others. Competition will
eliminate the inferior hypotheses and all that will remain are the submitted
hypotheses that most promote human values. In the market, the invisible
scientist is led by the invisible hand to promote human welfare.
8. The Alien Scientist Vs. The Human Philosopher
Now that we understand its essence and function, to understand what role
competition should play in society, we must go back several thousand years to a
an ancient time, before there was even any such thing as economics, when
philosophers thought perfectly sensible things like, “Everything is fire,” and
“Everything is water.” These were not bad hypotheses, and in fact modern
science has confirmed that entities ranging from trees to planets to machinery to
people are all fundamentally made of the same type of thing that obeys simple
universal rules no matter where it is or what is happening to it. Although the
fundamental building block of matter did not turn out to be fire or water, the idea
of everything being fundamentally made of the same stuff obeying the same
rules is a true one and a watershed moment in the history of the development of
human knowledge and mastery over the universe.
Of course, this watershed moment did not occur in ancient Greece millennia ago.
It occurred in Europe several centuries ago. The idea of inquiring about nature in
order to trying to understand its fundamental laws was not a new one invented by
the scientists of the Enlightenment. The Greeks beat them to it by quite the
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margin. What made the scientists of the Enlightenment different from the
philosophers of ancient Greece is that the scientists subjected their hypotheses
to experiment, to falsification. A hypothesis that had not been tested was not
worth much. A hypothesis that failed the test was discarded. In ancient Greece,
the philosophers did not test their hypotheses. And so the scientists got the right
answer and the philosophers got stuck on the wrong answer. The scientists were
not smarter or more motivated to discover the truth than the ancient philosophers
were. But the scientists had a better tool: the scientific method.
A long time ago, after the ancient philosophers of Greece but before the
scientists, people thought whatever Aristotle thought. Aristotle was one of the
philosophers of ancient Greece, one of the most talented and curious, who
applied his uniquely powerful mind to problems of physics, politics, biology and
even economics. He was wrong about almost everything. The lack of evidence
for Aristotle’s usually false hypotheses did not stop him from being the greatest
and most incontrovertible authority of medieval thought.
Somehow eventually people started saying that Aristotle was wrong about
everything, that hypotheses should be tested and that it doesn’t matter whether it
comes from Aristotle or from the Pope, anyone could be wrong. Only the
experiment would decide. The personality, intelligence and motivations of the
individual behind the hypothesis are irrelevant. Even the strength of the
arguments they could offer in favor of their hypothesis was no rebuttal to the
outcome of the experiment. Other people said, no, Aristotle is the best and
greatest, and no one can outdo his work. They were wrong. The scientific
method outdid the best and brightest humanity had to offer. Once they were
allowed to directly compete, it wasn’t even a contest. Aristotle’s brilliance and
curiosity were no match for science.
Science works and commands such authority because it substitutes the scientific
method for the intelligence, curiosity, honesty, and skillful logic and argument that
philosophers relied on for millennia. Philosophy relied on people, and science
relies on its method, which operates even in the absence of human intelligence
and motivation. Yes, just as economic competition is an incarnation of the
scientific method, the scientific method is an incarnation of a competitive system.
Scientists submit hypotheses just like entrepreneurs create firms, and just like
the entrepreneurs, scientists don’t absolutely require intelligence or motivation to
submit hypotheses, although it certainly helps to be intelligent and motivated.
Then the hypotheses are put into competition with each other, including the null
hypothesis, and the hypotheses that are the least fit for the data of the
environment are eliminated. That is the scientific method, and that is a
competitive system fundamentally identical to the competitive economic system.
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The scientific method itself competed with what might be called the philosophical
method, which depends on the capabilities of its practitioners rather than its
method, and the scientific method handily won. To put the contest another way,
first observe that the philosophical method does not eliminate hypotheses on the
margin that they are wrong, which is to say that the philosophical method
provides a high degree of monopoly to hypotheses on the margin of being wrong.
Thus the contest between the scientific method and the philosophical method is a
contest between competition as the scientific method and monopoly as the
philosophical method. Naturally one would expect economists to be most
supportive of the competitive system over the monopolistic system, and usually
they are.
In a few peculiar cases, however, economists do not support the competitive
system over the monopolistic system, the scientific method over the ancient
philosophical one. In the case of central banking, for example, the central bank
has wide support among economists over a competitive system of banking.
Those following the analysis I have offered so far should be able to see that
whatever the problems of competitive banking, central banking cannot be a
solution to those problems. Even if the scientific method inherent in competitive
banking is not completely aimed at human values (and if it is the case for
competitive banking becomes insurmountable), the philosophical method
inherent in monopolistic/central banking is no substitute. The scientific method
did not simply outperform the philosophical method, the scientific method got the
answer and the philosophical method did not and never would have. The
philosophical method got us stuck on Aristotle for a thousand years. The
philosophical method can distinguish between different qualities of thinkers, but it
offers no way to distinguish between different qualities of hypotheses.
The central bank has no ability to imitate or adopt the scientific method as it
exists in the competitive economy. It lacks the experimental apparatus. The
central bank is limited to testing a set of different and distinctly inferior set of
hypotheses than the competitive system.
The central bank can select its own values, and monitor the success of a
hypothesis relative to its own values insofar as those values correlate extremely
strongly with certain easily tracked variables. For example, the central bank can
decide that it wants the unemployment rate at 5%, and say that its strategy
succeeds or fails to the extent to which unemployment deviates from that target.
However, this becomes more difficult when there are multiple goals to satisfy,
e.g. an unemployment rate and an inflation rate. More critically, these values are
only the central bank’s values. The extent to which achieving a certain level of
unemployment is actually optimal for humanity is not something that can be
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known by the central bank, nor does the central bank have any knowledge of
what it is giving up by achieving that level of unemployment beyond what it can
see in other easily measured variables like inflation.
The point is that the central bank’s experimental ability is restricted only to what it
already knows about. This difference is because the central bank itself is acting
as the experimental scientist, whereas under the competitive process the
economy itself is the scientist. The central bank’s ability to reject the null or to
compare the success of different hypotheses is limited to the extent to which the
central bank understands the economy, which is in fact very limited and cannot
grow very fast, certainly not faster than the economy changes. The central bank
has very little knowledge of the different values of the tremendous amount of
individuals who make up the economy or how to best trade off those values
against one another. The central bank also knows very little about other
economic variables, even the ones it can track, let alone the tremendous number
of variables it cannot track or whose very existence is not even known to the
central bank. The central bank can try this or that strategy, but it can only judge
the hypothesis’s success insofar as it manages to approach some proxy variable
that at best is a very weak representation of true goals of the multitude of
individuals who make up the economy. Whereas the competitive system calls
upon a great deal of decentralized information in comparing different hypotheses,
this method is not available to any individual firm but only to the system the
entirety of the firms are operating within. Any individual firm can for the most part
only explain its success or failure by reference to luck, and this will be even truer
for the central bank, which is trying to solve a much larger, and more abstract
and difficult problem than an individual profit-seeking firm. In short, the difference
between the scientific power of central banking versus competitive banking is
very much based on a competitive system’s dramatically superior access and
ability to react to decentralized tacit information as explained by Hayek.14
Beyond the central bank’s inability to employ a scientific method capable of
solving the problem it faces, the position of the central bank as a monopoly
raises another difficulty: applying economics to the central bank. That the central
bank may do a very bad job and still survive, as indicated by Great Depressions
and Recessions, Lost Decades, and stagflation, not to mention the normal
booms and busts the economy tends to experience under central banking,
suggests that “good hypotheses” is currently a very weak criterion of survival for
central banks. That means central banks are highly monopolistic on the margin of
“good hypotheses,” and therefore economists have only a very weak ability to
predict what kind of hypotheses the central bank will output. Economists will have
14
Hayek, Friedrich. A. (1945). The Use of Knowledge in Society. American Economic Review,
39(4), pp. 519-530.
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to turn to psychology to predict the actions of the central bank, and the
psychology of the central bank is not promising. Self-interest, the availability
heuristic, the natural tendency to conform to one’s social surroundings, and
pressure, overt or otherwise, from political powers predict that the central bank
will provide for itself, its friends, and its political masters (no matter how
monopolistic a central bank may be, pleasing the government will always remain
its most significant immediate survival criterion, if not for the bank itself than
certainly for individuals employed at the bank). Hypotheses will only be aimed at
the utilitarian goals of the supporters of central banks to a very limited extent. If
the central bank does too badly, the public will demand its elimination, and
central bankers themselves will be displeased by their own performance.
However, the long lists of crises and downturns that have occurred under the
central bank suggest that the minimum standards of the public and central
bankers are very low indeed.
So what do economists do about banking problems, if their intelligence and
curiosity is insufficient to solve the problem? The answer is that they should use
the scientific method—competition. The scientific method does not always
perform well, and not all scientific experiments and discoveries have been to the
benefit of mankind. But the scientific method cannot be replaced. The correct
response to the evils that have resulted from the scientific method is to address
those specific problems, not to regress to the philosophical method, which is not
merely inferior to the scientific method but is in fact accomplishing something
entirely different. The near-unanimous support economists show for central
banking represents not a move from Einstein back to Newton, strange as that
would be, but in fact a much weirder shift from Newton back to Aristotle. This
strange phenomenon does not stand up to serious intellectual scrutiny. No
economists can put themselves in the place of the invisible scientist. It is simply
out of reach.
9. Conclusion
This paper starts with Alchian’s stripped-down model of competition as an
evolutionary selection process under conditions of uncertainty and imperfect
foresight and proceeds to draw a number of conclusions. First, Alchian’s model is
the model of the fundamental nature of competition, and so other attempts to get
at the true nature of competition by reference to “perfect competition” or
“discovery processes” are in fact identifying potential inputs and outputs of
competition, which is distinct from the quiddity of competition. This understanding
of competition makes it easy to see that “perfect competition” is in fact the
opposite of competition, and monopoly refers to the absence of selection forces
rather than a single seller or the ability to deviate from the so-called “competitive
equilibrium.”
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From that line of argument a new and surprising analysis flourishes. If monopoly
is the absence of selection forces, then competition is the presence of selection
forces, and if, as Alchian’s model demonstrates, the predictive power of
economics is based on selection forces, not individual behavior, then competition
creates economics, and monopoly is the absence of economics. Thus a portion
of the economy is inherently walled off to the economist: the strategies,
behaviors, and qualities that may be inputted into a competitive process are
beyond the economist’s power to predict, nor can they predict which strategies,
behaviors, and qualities will win the competition. Thus it is up to the competition
itself to solve the problem; economic competition behaves identically to a
scientific process, albeit one governed by no intelligent agent and one that is
aimed only at realized positive profits with no concern for human values.
However, through the invisible hand mechanism, the invisible scientist’s power is
brought to bear on promoting human welfare, to the benefit of mankind. With
competition revealed as fundamentally identical to the scientific method, the
competitive system must be seen as not merely superior to a monopolistic
attempt (such as central banking) to answer the questions the economy poses to
humanity but in fact irreplaceable. The scientific method has no alternative, it is
the systematic method of inquiry, and so economic competition as well can have
no substitute. This grand conclusion is merely an implication of Alchian’s subtle
and powerful model of the essential nature of competition.
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Alchian, A. A. (1950). Uncertainty, Evolution, and Economic Theory. The Journal
of Political Economy, 58(3), 211-221.
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Hayek, F. A. (1945). The Use of Knowledge in Society. The American Economic
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Hayek, F. A. (n.d.). The Meaning of Competition - Friedrich A. Hayek - Mises
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