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The Efficiency of Free Competition


at motivates the predator in
the first place.
Strangely, whenever people bring up predation scenarios,
they always imagine General Motors (or another huge firm)
preying on a tiny Mom&Pop store. But why assume this? After
all, if a dominant firm is big and making big profits, then
would-be competitors will be similarly large and well-
funded. In the modern world economy, even the largest firm
is small relative to all of the investment capital in
existence. So if a clear profit opportunity exists, why
wouldn't a new giant be able to get funding? For that
matter, if a bank saw that a tiny Mom&Pop store would make
lots of money if it could survive a short-run assault, why
wouldn't the bank approve the loan? Just because a firm is
small does not mean that a large bank or other source of
funds would not be happy to fund it so long as their
expected income stream is positive.
Most economists who think about predation conclude that it
could only work as a deterrent. That is, a firm might
suffer huge losses once in the hope that they need never do
it again. This too lacks plausibility. There is reason to
doubt that predation could work the first time. And even if
it does, the threat to repeat the predation would be, as
game theorists say, "incredible" if the new entrant's
funding were comparable to that of the predator. And there
is every reason to think such funding would be forthcoming
if the expected income stream were positive.
Think about predation from another angle. Isn't it
downright silly to try to make profits by perpetually
cutting prices, suffering gigantic losses, driving your
competitors out, jacking up prices, and then repeating this
pattern each time a new competitor shows up? Wouldn't it be
easier to simply keep prices reasonable? This seems
especially likely when we consider that it is usually the
dominant firm that is a potential predator. But to become a
dominant firm, one must first become big the difficult way:
by pleasing consumers better than anyone else. Since
dominant firms have or at least once had a comparative
advantage in efficiency, their best strategy would probably
be to simply maintain this advantage.
Here is another peculiarity about predation: the act is
solely in the mind of a firm's managers. By this I mean
that two firms might pursue equally aggressive strategies,
but one firm merely competes to the best of its ability and
the other practices predation. The common view that a firm
that sells below cost must be a predator is mistaken; after
all, new entrants often knowingly lose money for their
initial years, considering it an investment in a
name-brand. Similarly, an established firm might willingly
sell below cost to break into a new area or maintain its
current market share. And none of these activities are
predation as commonly understood.
This fact -- that whether or not something is "predation"
lies solely in human intentions -- has a vital practical
consequence: it is nearly impossible for an outside
observer to distinguish predation from earnest competition.
Both give consumers a better deal, and thereby harm one's
rivals. It is therefore likely that if one criminalizes
predation, one also winds up punishing normal competitive
behavior. Suppose I want to cut my prices to get a larger
share of a market. But if I do so, this will harm my
competitors; perhaps one will even go bankrupt. And isn't
the effect of that identical to that of predation? And
doesn't that mean that the law will likely interpret it as
such and punish me for it? Perhaps I won't cut my prices
after all, to my customers' loss.
Economic theory alone, therefore, gives us strong reason to
doubt whether predation exists at all; and to the extent
that it does exist, the unintended consequences of
prohibition of predation are alarming. Let us then turn to
the second way that firms could potentially earn high
profits non- productively: collusion.
It is important to remember that collusion is not
cooperation as such. After all, the firm itself is a form
of cooperation between individuals who would, if
self-employed, likely be competitors. No, the whole problem
of collusion is that it is cooperation not designed to
realize productive efficiency, but rather to benefit the
firms at the expense of allocative efficiency.
This kind of behavior, prima facie, is much more likely
than predation. Why? In game theory there is an important
conclusion that tells us that in repeated games the best
strategy for everyone is usually the "nice" one of
cooperation. The reason is that in long-term relationships,
what goes around comes around, so if you don't cooperate
now, your opponents will not cooperate with you later. And
since rational people figure this out, everyone cooperates.
While this conclusion is ordinarily heartening, since it
implies that cooperation can evolve without central
authority, it makes the problem of collusion seem dire
indeed. For a moment's reflection tells us that if an
industry only has a few firms, and if each of these firms
has a long lifespan, then they are likely to cooperate to
raise prices and restrict output at consumers' expense.
Indeed, it seems that collusion might easily erupt without
any explicit communication among rivals.
But things aren't as dire as they first appear. First of
all, the repeated game strategy only yields cooperation
when information is fairly certain; if I can't ever know if
my foe cheats me, the rational strategy for him is to cheat
me every time. But if I realize this, then the rational
strategy for me is to cheat him every time too. So no
cooperation develops. Of course, firms do have some idea
about whether or not their rivals compete more fiercely
than they agreed upon, but this knowledge is far from
certain. And if a firm retalitates mistakenly, cooperation
may well break down altogether.
Another difficulty is division of spoils. A group of firms
may know that they can all increase their profits if they
all raise their prices in concert. But once this happens,
how will they split up the extra profits? Everyone is
likely to want a large cut. Large firms will demand more on
account of their current large market share; small firms,
in contrast, will demand more in order to grow. Established
firms will likely want to stick to the status quo, while
up-and-coming firms will request an ever-
increasing share of the cartel profit. It is also likely
that within each cartel there will be one or two firms that
believe that they would do better than their fellows if
collusion should ever break down. On account of this they
will be less eager to keep the cartel together.
Next is the problem of the hold-out. This occurs when there
are three or more firms, all of which seek to collude. But
each of these firms recognizes that it would benefit most
if the other firms colluded with each other, but did not
itself participate. And as the number of colluders
increases, the problem worsens. Often, all that would be
necessary for an agreement to fail is if one firm refused
to join the club. Moreover, the temptation to be the
hold-out is there for each firm. This could make collusion
quite difficult.
Next there is the problem of cheating, alluded to above.
Assuming that the collusion is merely tacit and not
contractual, each firm has a strong incentive to make its
rivals believe that it colludes, but secretly compete
instead. It might, for example, give under-the-table
discounts, sell over its quota, or give a higher quality
product for the same price. The demand curve to each firm
will probably be quite elastic, sweetening the temptation.
But of course if every firm succumbs to this incentive,
then collusion collapses.
Partners in collusion might add a monitoring and
enforcement component to get rid of cheating. But the
problem is that this markedly increases the transaction
costs of striking the deal. Indeed, the more intense the
monitoring and enforcement, the more likely it is that each
firm will decline to join because the costs of enforcing
the deal outweigh the benefits. After all, if a single firm
were really the most efficient structure for an industry,
it would have evolved naturally. So in industries where
this hasn't happened, it must be because the costs of
greater size (information, administration, etc.) exceed the
benefits. The stricter a cartel becomes, the more the
industry begins to act like a single firm. But the very
fact that one firm did not naturally outcompete all of its
rivals implies that a monopoly structure is productively
inefficient. And productive inefficiency exceptionlessly
hurts the profits of firms regardless of other factors.
I have left the strongest check against collusion for last:
new entrants. It is a general rule that industries that
earn an above-average rate of return attract new firms. And
since the very purpose of collusion is to give all industry
members an above-average rate of return, new firms will
almost surely spring up. At this point, the cartel has two
choices: either they can let the new firm join the cartel
-- which means that each current member will lose a share
of its cartel profits -- or they may compete with the new
entrant. If they try the former, then they will surely find
the whole business community knocking on their door, asking
for their quotal portion of the market. The cartel will
swiftly dissolve under this pressure.
Alternatively, the cartel may compete with new entrants
rather than cutting them in on the deal. But standard
competition with new entrants defeats the whole point of
the cartel, since the members can no longer earn above-
average profits. And since the transaction costs (plus
integration, monitoring, and enforcement costs) are
positive, most members of the cartel would probably benefit
by simply dissolving it. And of course if the cartel turns
to predation, it faces all of the problems discussed
earlier, plus the problem of coordinating the cartel's
strategy. Other methods of handling new entrants seem
equally impotent. If one tries to buy up all competitors,
then this creates an incentive for people to build new
firms just to extort "blackmail" money -- as John D.
Rockefeller learned when he tried this tactic.
It is true that new entry does not occur instantaneously as
the theory of contestable markets demands. Perhaps this
gives cartels some finite duration during which they can
work. Perhaps. However, in the real world exit is not
costless either. So if a few firms form a cartel, earn
monopoly profits for a year, and then a new entrant shows
up, they are going to have to deal with this new rival for
a long time, maybe permanently. And in the process of
competing with the cartel, the newcomer may earn a long-
lasting advantage over them in terms of market share and
reputation. One historical example that comes to mind
involves Ford's early near-monopoly over the American
automobile industry. Ford was unresponsive to consumer
demand, in particular to the preference for model and color
variation. General Motors entered the market and satisfied
this demand, eventually becoming the industry leader. At
this point, Ford changed its ways, but too late: ever
since, GM has retained the ranking position. This
possibility should give pause to any firm intent on earning
a short-run profit by exploiting a temporary monopoly or
forming a cartel.
Perhaps the critical reader finds me excessively optimistic
about the power of new entrants. Are there not formidable
"barriers to entry" that stand in their way? My answer is
that the only real barriers to entry that should concern us
are legal barriers, which prevent otherwise qualified firms
from competing. Other so-called "barriers to entry" are
indeed barriers, but they are the same barriers that all
producers must face, incumbents as well as new entrants --
barriers such as economies of scale, advertising costs,
brand loyalty, and the most spurious of all, superior
efficiency. Why should we think that these costs impose a
unique penalty on new entrants? The only value of new
entrants, from an economic perspective, is if they can do
the job better than incumbents. Entry as such is neither
good nor bad; it is the entry of more efficient firms that
is desirable. It is true that there are definite start-up
costs that new firms must bear (for example, the cost of
training a work-
force). But as always, costs tell us something: that
letting new firms appear uses social resources, and those
resources are scarce. Even if a new entrant could compete
successfully after its initial start-up period, it does no
favor to consumers if they must subsidize or otherwise help
the entrant; for surely there are many firms that could be
successful "if only for" one other crucial factor (e.g., a
great manager, a brilliant innovation, enthusiastic
workers, etc.). But consumers benefit only from firms that
really are efficient, not firms that could have been
efficient if circumstances differed. I suspect that
economists' obsession with new firms' difficulties stems
more from their egalitarian values that any economic
Out of the triad of collusion, predation, and superior
efficiency, only superior efficiency can consistently cause
above-average profits. While predation or collusion might
give supernormal profits on occasion, they are riddled with
difficulties. Indeed, their difficulties are so great that
they might very well correlate with below average profits.
Just because firms that use these tactics want to earn more
money does not mean that their plans won't utterly
backfire, especially when the means are so poorly fitted to
the end. My reasoning thus far yields the following formal
1. Predation, collusion, and superior efficiency exhaust
the possible causes of supranormal profits under free
2. The connection between efficiency and profit is
3. The link between predation/ collusion and profit is
dubious at best.
Supranormal profits are almost always the result of
superior efficiency and of no other factor; or, put another
way, the only attribute that is evolutionarily strategic
under free competition is efficiency in satisfying
4. Regulation versus Competition
Reflection on most regulation shows that it directly leads
to less efficient satisfaction of consumer preferences.
Since free competition maximally encourages service to
consumers, any legislation regarding a product's quality,
price, or method of production blatantly harms its alleged
beneficiaries. To illustrate: If the law decrees that only
cars with seat belts may be sold, consumers who would
rather save some money than pay for the extra safety
suffer; if the law orders that no gold may be sold at over
$1/lb., consumers willing to pay more money for additional
gold lose utility; if the law prohibits off-shore drilling,
then consumers indirectly suffer from firms' sacrifice of
productive efficiency. None of this would be worth stating
if this analysis were not so completely ignored by
economists and laymen alike. Economists typically try to
rationalize (with little plausibility) that these laws
correct market failures; but the real reasons for such
regulations are paternalism (workers don't value safety
enough, consumers aren't smart enough to avoid fraud, etc.)
bolstered by the Marxist view that capitalists are all-
powerful and therefore don't need to supply safety,
quality, etc. Regulation of third-party effects (i.e.,
externalities) is the exception to this rule, because it
does have a plausible economic rationale; but the argument
against government involvement even in this case I save for
a later work.
More interesting are the indirect effects of regulation.
Free competition is a continuous evolutionary process,
while the standard effect of regulation is to make the
status quo permanent. For example, under free competition
there is an inexorable tendency for rates of return to
equalize as firms enter high-profit and exit low-profit
industries. But if regulation caps profits in high-return
fields and subsidizes low-
return ones, this beneficent process ceases -- to the loss
of all consumers. Another instructive example is
government- protected cartels. The standard result of free
competition, we have seen, is to erode and stop cooperation
between firms when there are no significant gains to
productive efficiency. But when the government declares
entry illegal, punishes cheating, forces recalcitrant
hold-outs to join the cartel, and so on, it short-circuits
the market's spontaneous checks against collusion.
More interesting still are the harmful consequences of
legislation whose announced purpose is to help consumers by
"increasing competition," such as the American anti-trust
laws. Under the influence of the doctrine of perfect
competition, these laws have arbitrarily singled out the
attribute of "bigness" as harmful to consumers. And yet,
far from hurting them, firms that win large market shares
under free competition thereby demonstrate that they
gratify many consumers, and that large size is probably
vital to that effort. Even if there are no important
economies of scale, consumers benefit when firms that
figure out how to satisfy them can freely expand. On top of
this, there is no clearer case of injury to consumers than
if the anti-trust authorities decide to narrow the range of
available suppliers, even if they do so in the name of
Many people favor strict limits on market concentration in
order to increase competition and thereby benefit
consumers; for example, Ralph Nader once favored an
absolute limit of a 12.5% per firm maximum market share
across all markets. Aside from the arbitrariness of what
constitutes a "market" (in the real world, all goods
compete with all other goods to some extent) the clear
effect of this would be to encourage restriction of output.
If I have 12.4% of the market, I am certainly not going to
try for more under Nader's system. In fact, I should raise
my prices and cut back on output to make sure that my firm
doesn't accidentally exceed the limit and get dismembered.
Considered this way, proposals of this kind are really a
multi-pronged attack against consumers. Not only do they
positively encourage firms to restrict output, they also
limit consumer choice, prevent the most efficient firms
from growing, and reduce the incentive of all firms to do
their job well by putting a ceiling on their ambition.
Since one of the chief rewards of innovation is market
leadership, dynamic efficiency drops as well.
We have never implemented the Nader proposal, so we have
never witnessed its dire effects. But the same analysis
holds true of many actual laws and rulings whose sole
function is to attack market concentration that arises
under free competition. In each case, the result is that
big firms get the perverse incentive to restrict production
before they become big enough to become anti-trust's next
5. The Hard Cases
Try this mental experiment. Congress passes the following
statute: "Productive inefficiency is hearby declared
illegal. Violation of this statute shall be punishable by 5
years in jail, or a $100,000 fine, or both. Consumers
damaged by the inefficiency may file a separate private
suit for treble the damages. The Department of Productive
Efficiency is hereby established to interpret and enforce
these provisions." How could any economist, qua economist,
possibly oppose such a law?
I see two chief objections to such a law. The first is that
free competition already discourages productive
inefficiency, so there is no need for such a law; in fact,
such a law weakens the market's response by making it less
necessary. The second objection is that it is very
difficult to correctly identify productive inefficiency,
especially for an outside observer like the government; the
probable result will be to punish many business practices
that are actually efficient but which the government does
not understand. From a slightly different perspective: the
market's spontaneous tendency is to eliminate productive
inefficiency, whether anyone correctly identifies it as
such; regulators, in contrast, must make a more difficult
direct determination that something is inefficient. We know
from economic theory that whatever practices the market
weeds out are inefficient; in contrast, regulators must
individually investigate each alleged inefficiency before
they can possibly identify it as such. These two objections
give us a solid economic case against such a law.
There is no law forbidding productive inefficiency; but
there are many laws with comparable initial plausibility
that nevertheless turn out to be a bad idea from a purely
economic point of view, and for the same reasons. Three
such cases are natural monopoly regulation, merger
restrictions, and prohibition against price-fixing. Almost
everyone agrees that such regulations are necessary, vital,
and surely helpful to the consumer. But as Bastiat
explained, that is because they focus on what is seen, to
the detriment of what is not seen -- and good economics
demands that we focus on both.
Let us begin with natural monopoly regulation. Supposedly,
there exist industries whose cost curves are such that more
than one firm is inefficient. But if there is only one
firm, there will be monopoly pricing, which is also
inefficient. Therefore in order to get the benefit of both
efficiencies, the government permits the monopoly to exist,
but regulates its rates, typically to give it an average
rate of return.
This story sounds wonderful until we apply the same
objections to natural monopoly regulation that we did to my
hypothetical anti-
inefficiency regulation. The first objection is that when
regulation prevents some problem, it crowds out the
market's solution. No longer will the natural monopolist
have to fear potential competition -- its profits have a
guarantee. No longer will the natural monopolist have to
fear inter- industry competition either. The regulation
also weakens the other important effects of the market:
there is no longer any incentive for productive efficiency
or innovation, because the rate of return is fixed no
matter what.
If this seems implausible, think about the thousands of
local monopolies in small towns that only have one grocery
store, one hardware store, etc. They are not subject to
natural monopoly regulation; but natural monopolies they
are. What checks their behavior? The answer is that market
forces do the job. There are potential entrants who will
start business if local monopolists charge excessive
prices; as in every other case, above-average rates of
return attract new entrants. Inter-industry competition
also checks their behavior. Farmer Smith may have a
monopoly over poultry, but he must still compete with the
farmers who have monopolies over beef, pork, and dairy. And
I have yet to hear anyone who believes that every small
town needs an army of natural monopoly regulators, so there
is no reason to think that the market's checks here are
We now come to the second problem, the problem of
knowledge. How do you really know that an industry requires
a monopoly if you never allow competition? How do you know
that new entrants won't appear if you never legally open up
the option? And even if an industry requires a natural
monopoly at one time, that hardly proves that it requires
monopoly in perpetuity. But as soon as natural monopoly
regulation in general springs up, you can be sure that it
will sometimes be applied when it is not necessary. The
problem is that regulation requires direct judgments about
complex phenomena. Unlike the market, which we know tends
to do the right thing whatever it is, natural monopoly
regulators must weigh a mass of specifics -- a more
challenging task by far, and hence more likely to wind up
in error. Next we come to merger regulation. We know that
mergers sometimes lead to large increases in productive
efficiency. But we also know that mergers increase
concentration, thereby making output restriction and
collusion easier. Therefore, most economists conclude, the
government's approval should be necessary for mergers, and
the government should prohibit mergers whose costs to
allocative efficiency exceed the benefits to productive
Again, there are two key objections to this approach.
First, it undermines the market's checks against
unproductive mergers. Analytically, a merger with no gains
to productive efficiency is almost identical with
collusion. And we have seen that the market penalizes
collusion. But if the law addresses the problem too, it
makes the market's checks superfluous. The result is more
reliance on the government to solve problems, and atrophy
of spontaneous market solutions.
Second, there is the problem of knowledge. We know from
economic theory that unproductive mergers get punished by
market forces, without knowing which particular mergers are
unproductive. The government's position is different: in
order to deter unproductive mergers, it must know the
efficiency characteristics of each and every merger. A
complex judgment like this is likely to err. The result is
that many productive mergers may be forbidden, to the loss
of consumers. This fact becomes even clearer when we
remember that the essence of entrepreneurship is to see an
opportunity that no one else sees; all innovation must
begin with an individual who disagrees with what most
people think. To subject entrepreneurship to bureaucratic
veto is virtually to abolish it.
What about price-fixing? Unlike mergers, this seems to have
no possible benefits. But appearances deceive. Many
economists have argued, for example, that resale price
maintenance could enhance efficiency. If there had been
free competition, the market would have preserved resale
price maintenance but punished inefficient price-fixing.
However, since the issue was resolved bureaucratically,
both are illegal.
The problems of price-fixing regulation are the same as
those of natural monopolies and mergers. When the law
punishes price-fixing, the market's natural checks on it
atrophy. More interestingly, the market has no incentive to
invent more effective checks. Jay Gould, the nineteenth
century industrialist, made much of his fortune by locating
pockets of collusion in the railroad industry and then
entering those markets. He lived when price-fixing was
legal, so he had an incentive to discover a better way to
profit from other firms' collusion. There isn't much
incentive to do so today.
And as the resale price maintenance example points out,
there is the problem of knowing when to apply the law. At
least some forms of price-fixing might enhance efficiency.
Note further that firms must avoid actions that look like
price-fixing, even at the cost of efficiency gains. An
example of this is joint ventures. When firms cooperate on
a single project, they open themselves up to the charge
that the meetings are merely a front for price-fixing.
Fearful of the law, they may sacrifice an otherwise
lucrative endeavor. If we left market forces to check
collusion then whatever is efficient would tend to survive,
even though we could never directly figure out whether a
particular practice is harmful or beneficial. Regulation,
however, must make particular judgments if it is to
regulate at all. The result in this case, as in all others,
is that the law ends up punishing efficient business
practices out of ignorance.
Perhaps the critical reader finds my argument for
unregulated mergers plausible, but not my argument for
unregulated price-fixing. I think that accepting the first
logically requires the second; here's why. Imagine that my
rival and I want to fix prices, which is illegal. Then one
of us remembers that all mergers are legal, so we decide to
merge, knowing full-well that the merger is unproductive,
in order to legally fix prices. Unfortunately, our
price-fixing is now more stable than it would have been
otherwise: Before, we were two firms, with the
corresponding problems of cheating, division of spoils, and
so on. But now we are one firm, so the only check on us
comes from external competition, not from internal
breakdown of cooperation. The result of the selective
prohibition has been to encourage stronger collusion over
weaker. Wouldn't it have been less inefficient if we could
have simply legally fixed our prices without merging? The
indirect result of the joint policy of unregulated mergers
and regulated price-fixing is to encourage substitution of
unproductive mergers for price- fixing. It is as if a firm
reprimanded embezzlers but fired people who showed up for
work five minutes late -- the more severe harm gets
punished mildly and the less severe harm gets punished
sternly. Accordingly, there is no good reason to think that
consumers are better off under this alternative scheme, and
at least some reason to think that they are worse off.
In conclusion, let me clarify what my theory claims. It
does not claim that inefficiency does not exist on the free
market. It does not claim that markets are always perfect
at every moment in time. It does not claim that checks
against collusion operate instantaneously. What it claims
is something more modest: Free competition always tends
toward efficiency; there are market forces that counteract
both allocative and productive inefficiency; and these
forces act regardless of whether or not outside observers
can know if any inefficiency exists. My theory is also a
critique of using government to supplement the market's
checks on inefficiency. It does not say that no regulations
ever increase efficiency. It does not say that we can never
know whether a market is inefficient. What it does say is
that regulation atrophies and crowds out market checks on
inefficiency, and that regulation suffers from an
inevitable knowledge problem whenever applied to the
complex real world. My defense of free competition
parallels the utilitarian arguments for free speech. No one
claims that under free speech, people utter only wise,
logical, or thoughtful words. But laissez-faire in the
realm of ideas nevertheless better promotes (or rather
permits) wisdom, logic, and thoughtfulness than any brand
of censorship. The case for free competition is actually
stronger, because efficiency merely requires that the
market satisfy whatever preferences consumers happen to
have, whereas free speech only yields intellectual fruit if
people have a preference for truth -- and, alas, few people
really do.
There is a final component to my critique of government,
which I have saved for the last section. Even if our
regulators were perfectly informed, they would still not
necessarily do the right thing from an economic point of
view. Why not? Because when you bestow vast power on any
body of people, especially a group of "experts" whose
reasoning most people cannot follow, there is the
temptation to abuse that power. The last section explores
this temptation in depth.
6. Regulation: A Public Choice Perspective
No one believes that workers would work very hard if they
were not paid, or that entrepreneurs would establish and
run firms if they could not keep their profits. The reason
is that they would lack the incentive to do a good job.
There might be a few people who love working so much they
would do it for free, but not many. Imagine a more extreme
case, in which workers not only aren't paid but are charged
for the privilege of working. With perverse incentives like
this, only fanatical workaholics would show up at their
jobs. The market solves this problem, of course, by giving
positive incentives to do the right thing; that way, we
rely on a very common attribute -- desire for money --
rather than the rare love of work for its own sake.
Economists usually see the task of politicians and
bureaucrats as the promotion of economic efficiency; they
then leap from this normative judgment to the descriptive
judgment that that is what actually happens. The inference
is invalid. There is no reason to think that in fact
politicians and bureaucrats always strive to promote
efficiency, any more than there is a reason to think that
all workers always work hard. In the later case, the market
completes the syllogism by providing incentives that link
the workers' earnings to their effort. But is there any
parallel incentive for politicians and bureaucrats? If
there isn't, then economists' trust in government amounts
to a pure act of faith.
Some people say that democracy -- and voting in particular
- - gives the proper incentives. And if voters were well-
informed, issue-
oriented people, this might work. But that is a very big
"if." Think about almost any economic issue, and ask
yourself if many voters could even explain the issue, much
less offer arguments for one view or another. The answer is
clearly no. On top of this, how many voters care about
issues anyway? Issues are never irrelevant, but even casual
observation of American election campaigns shows that they
are only one of many factors that determine success.
Images, emotions, looks, prejudices, and honeyed words are
On top of this, there is an obvious economic explanation
for the voters' debased condition. It is that intelligent
voting is a pure public good. We all benefit if voters
inform themselves about issues and decide on the best
available evidence. But no individual voter has any
incentive to do so. The benefits of good voting are public,
but the costs are private. So why should we think that
democracy gives politicians and bureaucrats good
incentives? I don't see any reason at all.
But the situation is actually worse. While the voting
public does not give politicians and bureaucrats positive
incentives to promote efficiency, other factors give them
positive incentives to promote the opposite. The clearest
is the motive of power. Most people love power almost as
much as they love money; and the people who go into
politics are likely to be those who have an unusually
strong love of power. And how does one expand one's power?
One does it by extending the range of human activity over
which one rules. There is therefore a clear and constant
incentive for politicians and bureaucrats to claim dominion
over progressively wider jurisdictions. Mightn't this have
negative consequences for efficiency? Naturally -- but the
government workers do not individually pay the price. Their
incentives are mis-aligned, perverse. More regulation gives
them more power, which they like, but harmful regulation
costs them little or nothing in either money or power.
There is a second perverse incentive built into democracy.
Because elections are primarily emotional and not
intellectual contests, voters can be easily swayed by
advertising. And advertising costs money. One easy source
of money is campaign contributions. But few people want to
give a campaign contribution for nothing; they want
benefits in exchange. And in a mixed economy, politicians
are quite able to bestow many benefits on their supporters.
Some benefits are direct -- subsidies, government
contracts, and so on; other benefits are indirect -- like
those that injure the actual and potential competitors of a
politician's supporters. Both kinds of benefits clearly
harm consumers.
Interest group theory shows us that narrow groups seeking
concentrated benefits tend to be the most successful. The
reason for this comes from public goods theory. The larger
a group, the more difficult it is to organize its members
into a coherent force, and the less individual incentive
they have to join up. Smaller groups, in contrast, are easy
to organize, and each member has a big stake in the
outcome. An example should make this clear. If Chrysler
lobbies for a bailout worth $250 million to it, it will be
very difficult to organize 250 million Americans to stop
it. The reason is that individually, we have only a tiny
stake in the issue; and even if we were interested, the
transaction costs of organizing a lobby would be
insurmountable. Yet Chrysler doesn't need to organize at
all -- it already is organized -- and it has a huge stake
in the outcome. Legislation of this sort, accordingly,
usually succeeds.
The upshot is that politicians and bureaucrats get positive
incentives mainly from groups that have no interest in
economic efficiency or any other abstract value. They get
positive incentives from people who want government
benefits, cost what it may to the general public. And most
of the evidence is that politicians predictably heed these
The critical reader may agree with me thus far, but then
object with Winston Churchill's famous line: Democracy is
the worst system, except for all of the others. What is my
better alternative? I agree that I have no better method of
government in mind; what I do have in mind is non-
government, what the Marxists call "the anarchy of
production," and what throughout this paper I have called
"free competition." If someone objects to censorship, he
does not need to offer a "better" kind of censorship; he
may also favor the simple abolition of censorship, the de-
politicization of the realm of ideas. This is precisely
what I recommend in the realm of production and trade.
This public choice analysis neatly complements the earlier
sections. These showed that politicians and bureaucrats
cannot normally improve upon markets; public choice theory
tells us that due to perverse incentives politicians and
bureaucrats do not want to improve upon markets. The former
shows that government lacks the ability to increase
efficiency, the latter that it lacks the will.
But public choice theory explains something more. It
explains the existence of massive quantities of anti-
competitive legislation that economists frequently
overlook. (Of course, law-makers try to invent efficiency
justifications for their policies; but these are
transparently pure rationalization.) Politicians can pay
back their supporters by hurting their competitors, actual
and potential. For virtually any regulation, one need not
look too deeply to figure out which special interests
benefit from it: tariffs, farm cartels, licensing,
immigration restrictions, and so on. The supposedly
beneficial natural monopoly regulation we discussed earlier
is another example. Curiously, such regulation almost
always makes competition with the monopolist illegal. But
if competition were truly impossible, what would the point
of such a law be? In rare cases where there are no
transfers of wealth, there remain transfers of power --
transfers of power to the politicians and bureaucrats who
support the law.
Public choice theory has a final insight to bestow upon us.
Why is it that there is such a double standard applied when
people compare markets and government? Brief reflection
tells us that virtually any imperfection or failure
"justifies" regulation of markets in the public mind; but
government failures, no matter how massive, merely "show"
that we need to spend more money, or elect more trustworthy
people. This paradigm is absurd on its face -- why are
market failures always systemic, and government failures
always coincidental? To clearly state the question would
answer it. One of the reasons for the persistence of this
double standard is simply economic self-interest. Behind
every piece of regulation there are politicians and special
interests who benefit from it; but who benefits simply from
opposing other people's pork barrels? A good illustration
of this is Congressional testimony. Out of an average of 16
witnesses, there are typically .5 opponents of the
proposal. Yes, that means that half of all proposals have
zero hostile witnesses. One makes political "profit" by
harming politically weak groups in order to favor
politically strong ones. It is no wonder that the
proponents of regulation always speak more loudly than its
I am not proposing the crude materialist doctrine that
people support whatever ideas monetarily benefit them.
There are too many counter-examples. Nevertheless,
pecuniary interest is a clear factor behind regulation, and
this factor is one of the chief causes for the pervasive
double standard regarding markets and government that most
people accept as self-evident. It is true, of course, that
most people who espouse this double standard do not have
any financial interest in it. But most people pick up their
ideas on issues from prominent public and private
activists, and these activists usually do benefit from the
laws that they impose.
7. Conclusion
The sole focus of this paper up to now has been efficiency,
both allocative and productive. Its conclusion is that free
competition should be economists' welfare ideal, and that
there is every reason to think that real-life regulation
always tends to make things worse. But what is so great
about efficiency anyway?
All that economic efficiency means is that whatever
preferences consumers have get satisfied as well as
possible. But what if consumers have bad preferences?
Wouldn't inefficiency be better in that case? Here lies the
only real market failure; but it is not an economic
failure. It is a moral failure.
Some economists like Demsetz, Stigler, and Posner have
implausibly argued that wealth- maximization just is the
same thing as morality. This is absurd. If Hannibal Lecter
will pay more to eat orphans than the orphans will pay to
not be eaten, should we hand over the children to him? A
system's efficiency is not a reason to support it; indeed,
the sole reason for supporting something must be the
intrinsic value of the end which it achieves.
What exists then is an obvious logical gap between
concluding that free competition maximally satisfies
consumer preferences and concluding that free competition
is the morally right system. Can this gap be bridged, and
if so, how?
My short answer is as follows. The best society of all
would be one composed of good people who would all have
good preferences whose efficient satisfaction we should
favor. So in this society we should surely choose free
competition. But what about less perfect societies such as
our own? I apprehend that the right way to perfect our
society is through voluntary, rational persuasion; for of
what value is a person who speaks and acts rightly if he or
she does it out of fear of punishment, or forced ignorance,
denied any opportunity to judge right and wrong with his or
her own intellect? That this process is slower and less
sure than repression is irrelevant; for it is also the only
route to genuine moral advancement. Liberty, then, is a
necessary though not sufficient condition of a good society
populated by good people; and this, I think, shows why free
competition (which is the application of liberty to the
field of production and trade) is better than all the
alternatives. In any case, it is precisely in the most evil
societies that the value of liberty becomes greatest. The
reason is that authoritarian societies run by evil people
make a good life impossible for everyone, good and bad
alike. But a free society lets good individuals create
regions of autonomy for themselves no matter how debased
most people are, allowing good people to profit from their
virtues and bad people to bear the harm of their vices.
This practical demonstration of the contrast between virtue
and vice would more improve the human character than any
coercive social experiment. 


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