In the essay below, Dieter Van Esbroeck, discusses competing theories on market efficiency of Pareto, Hayek and Schumpeter. The different insights in the operations of the market lead to rather diverging policy recommendations to harvest the gains of free competition and efficiency. His essay won the Montaigne-Essay contest of 2019 organized by the Institute for Education in Philosophy and Social Sciences (Ifese).
General reflections on the efficiency of markets
The question what it means for a market to be efficient and how this can be achieved, is one of the most fundamental questions in economics. Economics can be defined as the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses. Almost naturally, one could ask how these scarce means can be put to its best use to achieve the ends. How to assess if a market is efficient, is the topic of a lot of heated discussions between economists, which will be elaborated in this paper. However, it boils down to finding the allocation of available resources that best fulfils people’s needs.
The concept most widely spread concerning market efficiency, is that of Pareto efficiency [Pareto V., 1906]. The framework developed by Pareto was known by both Hayek and Schumpeter and both have criticized and elaborated on his model. Therefore, it will be taken as starting point of this paper to better understand the lines of reasoning and achieve a deeper comprehension of the contributions by the authors under consideration. Pareto efficiency is defined as the economic state where resources cannot be reallocated to make one individual better off without making at least one individual worse off. Pareto efficiency implies that resources are allocated in the most efficient manner. A Pareto improvement occurs when a change is made to a different allocation that makes at least one individual better off without making any other individual worse off, given a certain initial allocation of goods among a set of individuals. In other words, an allocation is not Pareto efficient when there are Pareto improvements possible. The concept of Pareto efficiency is closely linked to the theoretical construct of perfect competition, since a market that fulfils the assumptions of perfect competition, will also achieve Pareto efficiency. In the following chapters will be first elaborated on the general views of F.A. Hayek and J. Schumpeter on market efficiency and afterwards similarities and differences in their thoughts will be investigated.
Friedrich August Hayek
Hayek’s critique on mainstream economics and on the framework of Pareto, was more a critique on methodological grounds. According to Hayek, the model only states the conditions which a rational allocation of resources would have to satisfy, and then points out that these were essentially the same as the conditions of equilibrium of a perfectly competitive market. The problem how these conditions are achieved in reality remains open. Not only is this a huge deficiency of the model, it can also be dangerous, he says, because it allows for economists to believe that this equilibrium can be found artificially. The role of the market could be ignored, and calculation takes over. Hayek even accused Schumpeter of making this mistake. Instead of formulating assumptions that allow for a mathematical approach to calculate the efficient solution, Hayek adopts a rather practical approach. Interesting in this respect, is that Pareto already warned for the limits of his framework, and explicitly denied that he solved the practical problem nor that it could be solved without the help of the market.
The problem of how to allocate the resources to its best use, is considered by Hayek as the problem of the use of knowledge in society [Hayek F.A., 1945]. There are different kinds of knowledge. Knowledge is normally thought of as scientific knowledge. For scientific knowledge, a body of suitably chosen experts is probably in the best position to do research and command all the most advanced knowledge available. Nevertheless, this is only one type of knowledge. Apart from that, there is a large body of unorganized knowledge, the knowledge of the specific circumstances of time and place. This knowledge is very important for the working and advancement of the economy, which becomes for example very clear when a student leaves university and starts his/her first job. The learned theoretical knowledge is very useful, but creating a network, knowing the practicalities of the job itself and the environment is something you have to start learning afterwards. It is the knowledge of particular circumstances of time and place which will be mainly discussed.
The available resources are part of this knowledge. Imagine a person building a new apartment block in Paris. For her, the roof top should just have a proper isolation. However, when she talks about her plans to a friend who owns a bar, the friend sees a business opportunity to open a brand new roof top bar. The example shows that the resource stock is not fixed. What a consumption product is to some person, can be a resource to another. The same reasoning can be made for the preferences. Nobody can claim to know all people’s needs, because everybody has a different view on how to live the good life. Therefore, the question of the allocation of resources that best responds to people’s preferences boils down to the use of knowledge in society, as mentioned before. A body of experts is not able to manage all knowledge. It is dispersed as incomplete and frequently contradictory bits over all society. Knowledge is also often tacit knowledge. People act upon it in an implicit way, so it can’t be codified. Hayek highly emphasises the immense complexity of society and the economic system [Hayek F.A., 1967]. The information is decentralized, so the solution to the problem of efficiency is the decentralization of economic decisions. To make use of the knowledge of the roof top, the bar owner needs to be able to negotiate a contract to obtain the property rights of it. The first important step of establishing a decentralized economic order is the proper definition and protection of property rights and contracts by a regulatory agency, or the government.
In a decentralized economy, the actions of individuals need to be coordinated. The coordination of separate actions is achieved through the pricing system. An example Hayek uses in “The use of knowledge in society” will clarify:
“Assume that somewhere in the world a new opportunity for the use of some raw material, say, tin, has arisen, or that one of the sources of supply of tin has been eliminated. It does not matter for our purposeand it is significant that it does not matter-which of these two causes has made, tin more scarce. All that the users of tin need to know is that some of the tin they used to consume is now more profitably employed elsewhere and that, in consequence, they must economize tin. There is no need for the great majority of them even to know where the more urgent need has arisen, or in favor of what other needs they ought to husband the supply. If only some of them know directly of the new demand, and switch resources over to it, and if the people who are aware of the new gap thus created in turn fill it from still other sources, the effect will rapidly spread throughout the whole economic system and influence not only all the uses of tin but also those of its substitutes and the substitutes of these substitutes, the supply of all the things made of tin, and their substitutes, and so on;” [Hayek F.A., 1945, p.526]
The pricing system serves as a mechanism to convey the relevant information. The example shows the most important factor of the system, how little the individual participants need to know to be able to make the right decision or in other words how much information is contained in the price. Of course, prices are less able to fulfil its function when they become more rigid. What is important to note here, is the spontaneous nature of the system [Hayek F.A., 1973]. The pricing system has spontaneously grown as a mechanism for division of labour and knowledge. Man has stumbled upon it without understanding it, according to Hayek.
Hayek expressed the same methodological criticism on the notion of perfect competition, that is closely related to the notion of pareto efficiency [Hayek F.A., 1976]. Hayek argues that the state of affairs the theory of perfect competition describes, makes all activities commonly described by competition virtually impossible. The modern theory of competitive equilibrium can be useful for the further development of models. However, seeing perfect competition as the ideal involves great dangers. Firstly that it describes a state, denies the dynamic nature of competition. In fact, the idealised state of perfect competition is the effect of the competitive process which a true explanation ought to describe. Furthermore, perfect competition presupposes a homogeneous commodity. In many practical domains however, no two services or products are perfectly alike. Think about which doctor, hotel or grocery store to choose. Less homogeneity doesn’t mean less fierce competition. Although compulsory standardization has its benefits in some cases, in most real life domains it would mean a disregard of the variety of people’s tastes and suppressing the constant experimentation with improvements, that in the framework of perfect competition would be seen as differentiation, and thus undesirable. Finally, perfect competition presupposes complete knowledge of relevant factors by the participants in the markets, which has been extensively discussed before. It is actually through the process of competition that the knowledge of the facts will be discovered.
Now it is clearer what is meant by competition in the writings of Hayek, the role of competition in achieving efficiency can be further explored. In following citation from “Law, legislation and liberty” Hayek explains the value of competition:
“Competition, if not prevented, tends to bring about a state of affairs in which: first, everything will be produced which somebody knows how to produce and which he can sell profitably at a price at which buyers will prefer it to the available alternatives; second, everything that is being produced is produced by persons who can do so at least as cheaply as anybody else who in fact is not producing it; and third, that everything will be sold at prices lower than, or at least as low as, those at which it could be sold by anybody who in fact does not do so.” [Hayek F.A., 1979, p.74]
In conclusion, market efficiency is achieved through the market. Well-defined and protected property rights and contracts make sure every individual can make use of the knowledge of particular circumstances of time and place he/she possesses. Prices should not be constrained nor manipulated, as it neglects the function of the pricing system. Finally, competition should prevail.
Joseph Alois Schumpeter
Schumpeter is the founding father of the concept of dynamic efficiency. He accepted the model of Pareto efficiency as the optimal solution of the static problem, but in reality, efficiency changes through time. An economic system that endeavours to fully utilize its possibilities to the best advantage at every point in time, may inhibit its capabilities for the level or speed of long-run performance [Schumpeter J.A., 1942]. The process of innovations is the fundamental driver of increased efficiency, which is the most important factor of economic progress. Schumpeter characterizes the process in “Capitalism, socialism and democracy”:
“The opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory to such concerns as U.S. Steel illustrate the same process of industrial mutation—if I may use that biological term—that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in.” [Schumpeter J.A., 1942, p.83]
Schumpeter coined the term creative destruction, so often used nowadays. The process of innovations is not a peaceful process, where all businesses can change to the new environment. Instead, it is a process that disrupts existing industries. Innovations cause existing workers, businesses or even whole sectors to suffer a loss. It has to be tolerated, because it allows money to be freed up for more productive uses.
Schumpeter has thoroughly investigated how the process of creative destruction works and especially who brings about the innovations. The figure of the ‘entrepreneur’ plays a central role [Schumpeter J.A., 1911]. Entrepreneurship is considered as the driving force behind increasing efficiency and thus of economic progress. The entrepreneur is an economic agent, the change creator. Schumpeter describes the entrepreneur in “the theory of economic development”:
“But whatever the type, everyone is an entrepreneur only when he actually ‘carries out new combinations,’ and loses that character as soon as he has built up his business, when he settles down to running it as other people run their businesses. This is the rule, of course, and hence it is just as rare for anyone always to remain an entrepreneur throughout the decades of his active live as it is for a businessman never to have a moment in which he is an entrepreneur, to however modest a degree.” [Schumpeter J.A., 1911, p.83]
The indication entrepreneur is thus not used for a class of economic agents. His definition is functional. Every economic agent can become one at some point in his/her life by performing functions or activities related to the innovation. The notion of carrying out new combinations is also interesting. The distinction has to be made between invention and innovation. The advancement of scientific knowledge leads to new inventions. Innovations however, are sudden changes in business methods and practices, including the commercial application of new inventions. When innovations are carried out successfully, the competitive free market will lead to imitators copying the innovation. This way, new ideas spread rapidly through the economy. As seen before, the innovations are revolutionary in the sense that they destroy former business methods or practices.
In his later works, Schumpeter developed a rather different view on innovation and the entrepreneur [Schumpeter J.A., 1942]. The entrepreneur is not anymore the individual who launches a new business idea but indicates giant companies. Modern industries are characterized by non-competitive market structures, according to him. The big companies have the resources and economic power to manage innovations from development until implementation or bringing them to the market. Monopolies, having the most market power, are at the highest end.
Companies can, or even should, acquire through innovation a temporary monopoly position. For a period of time they can make extra profits, until imitators have taken over the idea. A company who has achieved this monopoly position will try to reinforce their position with the profits made, extending the benefits. Therefore, the big firms are induced to seek innovation to strengthen its position and most importantly, have the resources to do it. The monopoly is thus the most rewarding form for the purpose of increased efficiency. Schumpeter’s views on monopolies will be further discussed in the chapter on the differences with Hayek. Both theories of entrepreneurship can be seen as complementary. The first theory looks to explain what is an entrepreneur more at individual level, while the second looks at a company level. That mostly the monopolies invest heavily in R&D, doesn’t have to mean that an individual can’t start a new company and strive to acquire the temporary monopoly position while in the process destroying the businesses of existing monopolies.
In conclusion, market efficiency is achieved through a dynamic process of continuous improvement. Innovations are not implemented gradually and peacefully, but form a process of creative destruction. The entrepreneur is the crucial change agent. In Schumpeter’s early works, the entrepreneur is defined on an individual basis. The entrepreneur tries to carry out new combinations. In the later works, the emphasis moves to the big companies. They have the power to work out and implement the innovations and are incentivized to do so to keep their power.
Similarities in thoughts
The reasoning of Hayek and Schumpeter is largely compatible. Both authors belonged to the Austrian school of economics and although they both focus on different aspects, the general gist is very much alike. Two common points of thought are worth noting; individualism and dynamism.
Schumpeter is said to be the founding father of methodological individualism in economics. Methodological individualism has characterized the movement of the Austrian school. As one of the most important advocates, Hayek followed Schumpeter in his own works to theorize on economics. The belief that macro phenomena are just the sum of all the micro processes lies at the heart. One should analyse individual choice and action to understand the bigger picture. When
Hayek talks about the use of knowledge and competition, he investigates the topics on a low level. The knowledge is knowledge of ordinary life. The question is how every individual can be incentivized to make use of it. Competition is not about a market who fulfils certain conditions, but it’s about people trying to be better than their competitors on a daily basis. The same applies to Schumpeter. When he talks about the entrepreneur and innovations, he is also analysing how individuals try to improve the situations in their daily life. Both authors have expressed critiques on the static and more mathematically oriented general equilibrium models. The use of many hypotheses leads to oversimplification and renders the attained results useless. It also differentiates them from the use of statistical aggregates, that for example characterized the works of Keynes.
Dynamism lies at the core of the thinking of Schumpeter. His critique on Pareto was mainly that it’s a static model, while efficiency is a dynamic concept. Creative destruction is a process. Dynamism has also become one of the main characteristics of the Austrian school and plays an important role in Hayek’s works too. Hayek explained that even if it would be possible to collect all the information about the resources available and people’s preferences, it is useless, because a few moments later, the information is completely out of date. His rational economic order is a dynamic one. Prices need to constantly adapt to changing market circumstances. As been discussed before, one of the most important differences between his notion of competition and the commonly used notion of perfect competition is that it doesn’t describe a state. Since the methodology of both authors is a less hypothetical one, the assumption of a static economy is not made. Therefore, many other examples can be found because their theories are inherently dynamic.
Differences in thoughts
Hayek and Schumpeter wouldn’t be real economists if they didn’t differ on several topics. Concerning what has been discussed before and the topic at hand, two major differences of thought will be elaborated. First, the use of knowledge in society and second, their views on monopoly.
For Schumpeter, the knowledge is more concentrated. In his view on society, the entrepreneurs are the agents who carry out new combinations of new or existing knowledge, resources, equipment, and other factors to attempts at commercialization. They are the ones using the knowledge. Although the entrepreneurs can of course make use of scientific knowledge, the invention is not the innovation. They need to see the business opportunities. The necessary knowledge is thus as Hayek describes it, the knowledge of particular circumstances of time and place. The entrepreneur is contrasted with the manager, who runs the business from day to day. For Hayek, the manager would definitely be an important user of knowledge. Running the business means constantly looking for cheaper suppliers, better ways to bring the product to the customer, a more efficient organization, … All of these activities require information about the context in which the business operates. The manager is thus, although often unconsciously, using knowledge. Where the use of knowledge is restricted to the entrepreneurs in Schumpeter’s works, Hayek will handle a much more wide and dispersed view on the use of knowledge in society.
Hayek sees competition as the mechanism to attain efficiency. However, as has been discussed before, it differs from the commonly used notion of perfect competition. This also means the distinction between the two different extremes of perfect competition and monopoly disappears. Hayek acknowledges that competition can bring about monopolies. He doesn’t see the harm in the bare fact that a producer can meet the demand at prices which nobody else can match, so long as the inability of others to do the same is not due to them being prevented from trying. Monopolies in itself are thus not harmful, but the prevention of competition is. Therefore, Hayek has his doubts about giving so-called privileges to certain companies, as it gives unique rights. Patents for inventions, copyright, trade-marks, … take away possibilities for competition. In particular in the field of patents, it should be investigated if there is no more appropriate and effective form of reward for the risk companies take by investing in R&D than to award them a monopoly privilege. Schumpeter will certainly disagree here. Innovations are the core of achieving efficiency. Companies that invest in R&D should be able to claim the benefits of their money spent. Schumpeter sees patents as a good thing because it incentivizes companies to innovate and enables them to earn profits if they succeed. Furthermore, by creating a monopoly, it will also further incentivize companies to try to maintain their position. The monopoly profits allow them to invest more into risky scientific research and the limited time of the patents gives them the reason to do so.
About the author of this essay:
Dieter Van Esbroeck is doing his master’s degree in business engineering at the KU Leuven.
References
Hayek F.A. (1945). The use of knowledge in society. The American Economic Review, 35(4), pp. 519530.
Hayek F.A. (1946). The meaning of competition. Stafford Little Lecture at Princeton University. In: Individualism and Economic Order. University of Chicago press, pp. 92-106 (1948).
Hayek F.A. (1967) Chapter 4: The Theory of Complex Phenomena. Studies in Philosophy, Politics and Economics. Routledge & Kegan Paul Ltd., pp. 22-42. In: Edited by Martin M. and McIntyre L.C., Readings in the philosophy of Social Science. The MIT Press., pp. 55-70 (1994).
Hayek F.A. (1973). Law, legislation and liberty. Volume 1: Rules and order. Routledge & Kegan Paul Ltd., pp. 180 (1998).
Hayek F.A. (1979). Law, legislation and liberty. Volume 3: The Political Order of a Free People. Routledge & Kegan Paul Ltd., pp. 208 (1998).
Pareto V. (1906) Manuale of political economy. English translation: Manual of political economy. Oxford university press academy, pp. 664 (2014).
Schumpeter J.A. (1911). Theorie der wirtschaftlichen Entwicklung. In: The theory of economic development: an inquiry into profits, capital, credit, interest and the business cycle. Transaction publishers, pp. 255 (2008). Based on adapted English translation: The theory of economic development: an inquiry into profits, capital, credit, interest and the business cycle. (1934).
Schumpeter J.A. (1942). Capitalism, socialism and democracy. Harpers & Bro, pp. 437.
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