Competition &

Entrepreneurship
for Freedom University

By Paul F. Cwik, Ph. D.

Mount Olive College &
The Foundation for Economic
Education
What do you think of when someone
says, competition?
Competition
When we observe the world around us, we notice that
there is competition and trade.
So, why do we compete? And, why do we trade?
We compete because there is not enough to fulfill all
of our wants and desires.
We compete in the economic arena.
We compete in the political arena.
And there is only one Stanley Cup.
However, when I think of competition, I like to think
of a Pixar short called One Man Band
One Man Band
Analysis: What do we learn?
Who had the power?
Who was competing with whom?
In a market the consumer is sovereign.
The consumers are the real bosses. They are the true kings
and queens.
No one can tell the consumer what to buy or not buy. Each of
us has our own Subjective Preference Scale, which changes
whenever we change our minds.
When we trade, we trade UNequal valuations.
We subjectively value costs. E.g., $1 is NOT the cost of the
Mountain Dew bottle; it is the price. The relevant cost is the
opportunity costthe next best thing that could be done with
the $1.
The producer has to produce something worth our while or we
might just toss the coin into the fountain.
How do consumers determine what
should be built?
In the previous lecture, we introduced the Preference
Scale.
The preference scale is not set in stone and it can
change from moment-to-moment.
The producers job, from an economic point of view,
is to transform resources into useful things.
But not just randomly useful things.
The items at the top of scale need to be produced
first, and then we work our way down it.
How do consumers determine what
should be built? continued
Consumers are the ones who ultimately determine
what should be produced, in what quantity and in
what quality, and who should own the capital and run
the plants.
But how? Maybe its best to use an example
Suppose that we want to build a bridge.
We know how to build bridges. Technology is the
knowledge of how to produce goods and services, but
this is not enough.
Should we build the bridge out of wood? Stone?
Concrete? Steel? Titanium? Some combination?
Which combination?
We Need Entrepreneurs
To solve this problem, we need entrepreneurs.
Entrepreneurs are the undertakers.
The entrepreneurs purpose is to make profit. No
more, no less.
There is no doubt that the entrepreneur is the captain
of the ship. He gives the orders.
However, the consumers are the navigators of the
ships. They set the course.
Producers do not simply produce for themselves; they
produce for the market.
Thus, they must follow the directions of the
navigators or they will hit the rocks and sink.
Consumers Signal Entrepreneurs
Heres an obvious observation: Consumers are fickle.
They do not care about past merit. Or how production is done
(within limits). Or how hard the workers work.
They do not care who the entrepreneur is or who the workers
are who lose their jobs.
We dont call Walmart ahead of time and warn them we are
coming.
But they had better have what we are looking for. And at the right
quality. And at the right price. Or what happens?
The consumers, who buy Good A at a price that justifies the
input decisions, signal and provide the justification for using
the inputs in that manner.
With the profit motive, the entrepreneurs are compelled to
supply the most urgent wants and desires of the consumers.
They cannot waste resources.
The Role of Entrepreneurs
Entrepreneurs who perceive the future correctly are
rewarded with profits. (More on this later.)
Losses are the result of bad judgment and/or luck.
With ceaseless change in the economy, there will
always be profits and losses.
Capitalism is the only system that allows for an
objective appraisal of the social division of labor and
allocation of resources (i.e., Economic Calculation).
That is how consumers determine what should be
built.
The problem to be solved in the conduct of economic
affairs
How is this:
does There are countless
Mises see kinds
the ofproblem?
material factors
of production, and within each class they differ from one
another both with regard to their physical properties and to
the places at which they are available. There are millions
and millions of workers and they differ widely with regard
to their ability to work. Technology provides us with
information about numberless possibilities in regard to what
could be achieved by using this supply of natural resources,
capital goods, and manpower for the production of
consumers goods. Which of these potential procedures and
plans are the most advantageous? Which should be carried
out because they are apt to contribute most to the
satisfaction of the most urgent needs? Which should be
postponed or discarded because their execution would divert
factors of production from other projects the execution of
which would contribute more to the satisfaction of urgent
needs?Mises, in Bureaucracy, page 22.
Economic Problem of Allocation
To solve the problem about building the bridge, we
need to solve the Economic Problem of
Allocation.
The problem each country faces is that it must
employ factors of production in such a way that only
those goods should be produced which are fit to
satisfy the most urgent demands of the consumers.
No good should remain unproduced on account of the
fact that the factors required for its production were
usedwastedfor the production for another good
for which the demand of the public is less intense.
Mises, in Planning for Freedom, page 111.
Allocation continued
If someone says that we should produce more
of good X, should we?
If we produce too much X and not enough Y,
we are wasting.
It is a violation of the Economic Problem of
Allocation.
In order to solve this problem, we need a
method to objectively measure relative
scarcities. Luckily we do, and it is called
Economic Calculation
Economic Calculation cannot be done without
a common denominator.
In capitalism, all designing and planning is
based on market prices. They are the guide.
Through calculating and comparing Marginal
Costs with Marginal Benefits, we can
determine if we should engage in more or less
of an activity.
Who is to actually follow the signals?
Entrepreneurs read the market signals (price and
quantity relationships) and thereby attempt to follow
the consumers wishes.
Those who successfully meet the consumers
demands are rewarded with profits.
Those who do not, suffer losses. If enough losses are
accumulated, the entrepreneur loses his position of
control over the means of production. He ceases to
be a decision-maker. He must go to work for
someone else.
Only successful entrepreneurs are able to maintain
their position as entrepreneur.
Markets are Value-Free
The market does not judge or place any moral
value on an object or activity.
Some may say, What we should really do
But this is NOT the task of government or the
entrepreneur.
If one wants to get people to do things or
abstain from things, he can persuade others,
but NOT use the law and force.
Economic Valuations
The ultimate basis of the market is peoples subjective
valuations, and these valuations can be flawed.
Unfortunately, there is no better way.
If all people are flawed, then who can be the ultimate arbiter of what is
right or good or just?
Even the majority can reflect all our short-comings and weaknesses.
Markets reflect our subjective valuations.
Prices allow calculation of the best use of resources as we
define it by our economic choices.
They allow entrepreneurs to solve the Economic Problem of
Allocation.
Economic Calculation makes it possible for entrepreneurs to
constantly adjust to the demands of the consumers.
A Return to the Bridge Problem
Should we build the bridge out of wood? Stone?
Concrete? Steel? Titanium? Some combination?
Which combination?
But which combination is best?
Entrepreneurs do not only use new technology
(know-how), they must use the best combination of
the lowest costing technology.
Where there are no markets, there are no prices and
no economic calculation to be done.
The Knowledge Problem
Hayek pointed out in 1945 that there isnt one person, one
computer, or government bureau that can contain all of the
knowledge necessary to calculate the scarcity ratios of all goods
and servicesIts
in anprices
economy.that guide
The knowledge is dispersed and decentralized across all of us.
How much thedo youentrepreneur.
value your toothbrush?
How much does your neighbor value his?
Prices
Imagine asking help
that question the
about every single good, service
and resource out there in the economy.
And what entrepreneur
about the value of youruncover
time?
Such a calculation without a common denominator is impossible.

and exploit profit

How should we build the bridge? And do it in a manner so that
we dont waste resources. I think that we can all agree that waste
opportunities.
is bad.
Luckily there is a tool that helps the entrepreneur coordinate the
economy.
Prices and Profits Drive the Economy
We live in a world of change.
Can there ever
Economic be are
profits suchthe
a thing
rewardas
The source of economic profit
excessively
for removing coordinating
maladjustments the Price
is economic coordination. Supply
economy?
from the economy. Or, in other
As entrepreneurs correct the
words, they are theand
maladjustments reward for
coordinate
coordinating
the economy, thethey
market.
receive
No.economic
Therefore, there
profit.
is no such Pe
thing
They as excessive
cannot profits.
come about any
The larger the discoordination,
other
theway.
larger the profit.
As an aside, once
However, rewarding by
they adjust
production
serving is the processes, the to
only fair way Qe Quantity
opportunity
allocate for economic
resources.
profit disappears.
The Use of Knowledge
The entrepreneurs compete for resources.
The prices signal their relative scarcities.
Am I too scarce for you?
An entrepreneur
And neverwhogetdoes
madnot
at calculate
a high correctly will
price.
suffer losses andPrices
have tomeasure relative
close shop.
scarcity. Getting angry with a
Only those who
high are is
price successful at meeting
like getting mad the
consumers at wants and desires
a thermometer for stay in business
it being a and can
hot day.
expand their control over the means of production.
Prices are Information
It is the Price System that allows for rational
economic calculation.
Prices are packets of information that communicate,
to all who wish to look, relative scarcities of all goods
and resources.
The price system tells us the relative scarcities of
goods, services (including labor), resources, and
everything that we value.
The price system shows how to allocate resources.
Hayek uses an example of a tin mine
The Famous Tin Mine Example
IfSuppose
the pricethat
risesyou
3 cents, then
nomanufacture
big deal.
contains tin.
a productifthat
However, it
jumps up 300%, then thats a
For some reason, the price Price S Supply
different
rises. story.
Do you care if it is because
The
of aprice tellsdisaster
natural entrepreneurs
or P2
not only inofwhich direction P1
because strikes? Not to
really,but
move, notbyfrom
howan economic
much.
point of view.
Demand
When
Whateach entrepreneur
matters is that youreacts
cut
like
backthisoninyour
the market, weand
use of tin see Q2 Q1 Quantity
plans
lookcoordinated and resources
to use substitutes.
allocated. We move toward
Economic Harmony.
Price System Summary
With a market price system, there is an
economy of knowledge.
We dont have to know how or why the price
of a resource has gone up.
All that we need to know is whether we should
use more or less of a resource and by how
much.
Spontaneous Order
No one person created the price system.
No one could.
It is the result of human action but not of
human design.
The price system was not created by any
government or by civilization.
It is the price system, itself, that allows the
division of labor and thus civilization to exist.
So how do we build the bridge?
We set the parameters of how strong it needs to be
and then use the materials in the cheapest
combination to achieve that goal.
If we use any lesser materials, it will collapse; and if
we use any more, then its wasting and violating the
Economic Problem of Allocation.
It is only through the competitive process that we
discover what the true relative scarcities are.
Neo-Classical Competition
If you look at a standard economics textbook, their
conception of competition is in the form of a
noun.
It usually gives some lip service to entrepreneurs,
but quickly moves to the model of Perfect
Competition.
Assumptions:
1. Homogeneous Goods
2. There are so many Buyers and Sellers that all are Price
Takers
3. No Barrier to Entry or Exit
4. Perfect Knowledge
The Demand Curve of the
Competitive Firm

P P
S

Pe Pc d=AR=MR

Qe QIndustry QFirm
Short-Run Profit Maximization by
the Perfectly Competitive Firm
$/Unit
MC
ATC
AVC
d = AR = MR
Economic Profit

AFC
q1 Output (Q)
 Suppose that there is an Increase in
Demand. What happens?
Economic Profits
P P
are a myth in this
S
model, because we Economic Profit MC ATC
AVC
P2 all have Perfect P2
P1 Knowledge. P1 d=AR=MR

Firms will always be at the

point where MC = MR D
D

Q1 Q2 q1 q2 QFirm
QIndustry
Flaws in the model of Perfect
Competition
The problem
There that faces
are several us is a problem
shortcomings with this of
how to secure
highly stylizedthe best use of resources
theory:
known
1. Theto any of the
assumption members
of Perfect of society, for
Knowledge.
ends whose relativesays
This assumption importance onlyofthese
we know the shape not just all
our cost curves, but all the demand curves too.
individuals know. Or, to put it briefly, it is a
This assumption says that no mistakes are ever made.
problem of the utilization of knowledge
There is no reason to advertise or market your product.
which However,
is not given to anyone
most significantly, in its away the
it assumes
totality.Hayek (1945)is supposed to solve:
problem that economics
2. Competition in this model is used
as a noun, not as a verb.
Competition is a rivalrous process.
Imagine two sports teams. We play the game precisely
because we dont know the outcome. If we didnt have to,
then the beloved Red Wings would be hoisting the Stanley
Cup today.
There isnt any competition in equilibrium.
In fact, in equilibrium, there isnt any action.
How often to we reach equilibrium in the real world?
Then why study a model that is always in equilibrium?
Nevertheless, this is the first model that economists turn to.
3. What is Actually Needed to
Achieve Perfect Competition?
[F]or the sellers to be price takers, it requires each of them to hold
Only if theset
a particular sellers in this
of ideal perfect market
typifications view themselves
of themselves and othersand in their
the
rivals in this way, will they act like price takers. Regardless,
market, such that each passively adjusts his quantities offered for sale of the
objective
at whateverconditions, if any
price he finds of thetosellers
offered him; nor think they
does hecan influence
attempt to the
price by modifying
differentiate the quantity
his product relative they
to thebring
onestobeing
the market;
sold byifhisthey think
rivals.
they
Theycaneach make
mustconsumers
have in theirview theirof
minds product as being
the typical differentinthan
consumer theirthe
ones
market offered
who willby their competitors;
immediately stop ifallthey
theirbelieve
buyingtheyfromcan
anyreap
oneprofits
of
for some period of time by introducing cost-saving
them and purchase this good from other sellers in the market if the techniques, then
they
pricewill act in ways
he charges wereinconsistent
raised by him withevenwhat bythe
theobjective conditions
smallest amount. He
lead the economist to expect from them. Merely
must believe that the consumers think of his commodity as being adding up the
numbers
exactly noofdifferent
sellers infrom
a market, merely
the ones sold comparing the physical
by his competitors, and
characteristics of the goods
therefore the consumers are sold, and merely
indifferent estimating
as to whether thebuy
they ease with
from
which
him or asomeone
new cost-cutting
else. Each technique could
seller must be physically
believe that theirintroduced
actual and into
all the sellers
potential rivalsproduction facilities,
have the ability tells us
to adjust nothing
their about methods
production how sellersand
will act or how consumers will react to a change in any
activities so rapidly to any change he may try to introduce to cut costs one or more
sellers
or improvebehavior.Ebeling
the quality of his(1999, pp. that
product, 130-1),
any profits that he hoped to
reap from such innovation would be immediately competed away by
his rivals instantaneously matching whatever he does.
4. Any Profit is BAD
Persistent profits are a sign that we are not perfectly
competitive.
There must be something hindering the ability of
the market to compete away any lingering profits.
Compare this to what Mises said about profits.
How do Austrians view profit?
Profits and losses are essential tools to coordinate
and organize the allocation of scarce resources.
Finally, persistent profits are bad sets up the Neo-
Classicals perspective on monopoly theory.
I believe that Pongracic will address this issue later
this week.
For Further Reading:
Here are the ones you should start with:
Armentano, D. T. (1986). Antitrust Policy: The Case for Repeal.
Ebeling, Richard M. (1999). Human Action, Ideal Types, and the
Market Process: Alfred Schutz and the Austrian Economists, in
Schutzian Social Science, pp. 115-134. http://books.google.com/
Hayek, F. A. (1945). The Use of Knowledge in Society, American
Economic Review.
http://www.virtualschool.edu/mon/Economics/HayekUseOfKnowledge
.html
Kirzner, Israel M. (1973). Chapter 2 The Entrepreneur, Competition
and Entrepreneurship, pp. 30-87.
Kirzner, Israel M. (1976). Equilibrium versus Market Process, in The
Foundations of Modern Austrian Economics, edited by Edwin G.
Dolan, pp. 115-125.
http://www.econlib.org/library/NPDBooks/Dolan/dlnFMA7.html#Part 3,
Essay 1
Rothbard, Murray N. (1993). Man, Economy and State, Chapters 8 &
10. http://mises.org/books/mespm.pdf
Competition &
Entrepreneurship
By Paul F. Cwik, Ph. D.
PCwik@moc.edu