ENTREPRENEURIAL ECONOMICS Market Processes and Competition

1. ENTREPRENEURIAL ECONOMICSMarket Processes and Competition Prof. Dr. Stefan Kooths UE, Campus BerlinWinter term 2018/2019 www.kooths.de/bits-mpc

2. Contact data Prof. Dr. Stefan Kooths Head of Forecasting Center Kiel Institute for the World Economy Office Berlin In den Ministergärten 8 10117 Berlin 030/2067-9664 stefan.kooths@ue-germany.com www.kooths.de

3. Outline • Introduction and Overview • The Market System as an Economic Order • Equilibrium Analysis: “Imperfect Competition” • Process Analysis: Entrepreneurial Competition

4. Outline • Introduction and Overview • The Market System as an Economic Order • Equilibrium Analysis: “Imperfect Competition” • Process Analysis: Entrepreneurial Competition

5. General perspective • “Austrian” Economics? • Methodenstreit with German Historical School • Pronounced pro-theory approach in economics • Cradle of modern economic thinking • Marginal revolution, concept of opportunity costs • Subjectivist theory of value • Methodological individualism • Next significant stage of economics after the classics • Criticism of homo oeconomicus and Neoclassics • Over-simplistic assumptions (economic core is assumed away) • “Pure-and-perfect competition” as model without true competition(e.g. problem of representative firms) • Problematic macro-micro-dichotomy • Economics as a social science, comprehensive view on entrepreneurs

6. Curricular context

7. Curricular context: Sequence Goods and valueBuilding blocks (isolated and social economy) Exchange and PriceSocial interaction (basically in any economic system) Market Processes and CompetitionSocial interaction in (real-world) market economies

8. Reading • Coase, R. (1990): The Firm, The Market, and the Law; University of Chicago Press: Chicago. • Hayek, F.A. (2014): The Market and Other Orders; The Collected Works of F. A. Hayek, Vol. XV (ed. by Bruce Caldwell), University of Chicago Press: Chicago. • Economics and Knowledge; Economica IV (new ser. 1937), 33-54. • The Use of Knowledge in Society; American Economic Review, Vol. 35, September 1945, 519-530. • Hayek, F. A. (1948): The Meaning of Competition; in: Hayek, F. A., Individualism and Economic Order, University of Chicago Press: Chicago 1948, 92-106. • Competition as a Discovery Procedure; in: Hayek, F. A., New Studies in Philosophy, Economics and the History of Ideas, University of Chicago Press: Chicago 1978 (1968), 179-90. • Liebowitz, St. J. and St. E. Margolis (2001): Winners, Losers & Microsoft – Competition and Antitrust in High Technology; The Independent Institute: Oakland/California. • Kirzner, I. M. (1973): Competition and Entrepreneurship; The University of Chicago Press: Chicago and London. • Machovec, F. M. (1995): Perfect Competition and the Transformation of Economics, Routledge: London and New York. • Varian, H. R. (2014): Intermediate Microeconomics – A Modern Approach; 9th edition [7th edition (2005)], Norton & Company: New York and London.

9. Outline • Introduction and Overview • The Market System as an Economic Order • Equilibrium Analysis: “Imperfect Competition” • Process Analysis: Entrepreneurial Competition

10. The Market …? Source:Varian (2005), p. 1 [left] and p. A35 [right]

11. The market …? (cont.) • Missing entries • International Encyclopedia of the Social Sciences (1968) • The New Palgrave: A Dictionary of Economics (1987) • Ronald Coase • What is studied is a system which lives in the minds of economists but not on earth. I have called the result "blackboard economics". The firm and the market appear by name but they lack any substance. The firm in mainstream economic theory has often been described as a "black box". (…) Even more surprising, given their interest in the pricing system, is the neglect of the market or more specifically the institutional arrangements which govern the process of exchange. As these institutional arrangements determine to a large extent what is produced, what we have is a very incomplete theory. Lecture to the memory of Alfred Nobel, December 9, 1991

12. Coase on economic coordination and market institutions • The Firm, The Market, and the Law • The Nature of the Firm • Industrial Organization: A Proposal for Research • The Marginal Cost Controversy • The Problem of Social Cost • Notes on the Problem of Social Cost • The Lighthouse in Economics

13. Economics and the key allocation problem • Human needs • Subjectively felt uneasiness (reason for action) • Generally unlimited • Goods • Means for (direct or indirect) satisfaction of a need • Generally limited • Scarcity (allocation problem) • Not all needs can be fully satisfied • Selection inevitable • Ranking needs • Matching with disposable means (production possibilities) • Economic growth: Reduction of “uneasiness”(more satisfaction by expanding the pool/efficiency of means)

14. Alternative allocation mechanisms • Violence (military campaigns, robber barons) • Discrimination (Sex, Nationality, Age, …) • Greyhound racing („First come, first served“) • Communism („Each according to his/her need”) • Egalitarianism („Each the same“) • Market (competitive exchange mechanism) • Property rights • Voluntary exchange • „Each according to his/her preferences and performance“(ability-to-pay resulting from market income = valuation by others)

16. Property rights and the primary role of government • Property rights • Usus • Abusus • Ususfructus (includes: accountability!) • Role of government:Defining and guaranteeing property rights (legal framework)

17. The market signal system: Profits, Losses, Bankruptcy • Profits • Revenues (value creation) > Costs (value destruction) • Net creation of value • Agent stays in the game, activity can be expanded • Losses • Revenues < Costs • Net destruction of value • Yellow card (warning): activity should be reduced/modified • Bankruptcy • Revenues << Costs • Net value destruction ongoing/at large scale • Red card (sending-off): activity must stop

18. Origin of markets Source: Frank Fetter (1928|1915), Economic Principles, p. 57 f.

19. Instincts vs. extended order (Hayek, Popper) • Atavistic instincts • Solidarity, altruism • Aggression against outsiders • Stabilizing small groups (families, tribes, clubs) • Extended order • Contracts, exchange, money • Trust, reputation • Competition • Non-aggression, openness, voluntary cooperation • Enabling anonymous societies • Efficiency = Use of dispersed knowledge • Justice (fairness) = Supremacy of abstract rules Marketsystem

20. Mercantilist atavism: „Buy German“

21. Market diagram

22. Demand and supply: Marshallian vs. Austrian value theory • Marshallian scissors • Subjective demand side(consumer preferences) • Objective supply side(costs) • Austrian value theory • Universal subjectivism • Cost = opportunity cost Über den Ursprung und die Hauptgesetze des wirtschaftlichen Werthes (1884)Der natürliche Werth (1889) / Natural value (1893) Friedrich v. Wieser(1851–1926)

23. Demand theory without psychology: Law of marginal utility Marginalutility 1st best use 2nd best use 3rd best use 4th best use 5th best use Demand 6th best use 7th best use Quantity

24. Supply theory without “production cost”: Cost as universal social opportunity cost Part II, Section II, Chapter 2 Marginalutility Supply last-9th best use … … of available resources(relative to a given body oftechnological knowledge) last-8th best use last-7th best use last-6th best use last-5th best use last-4th best use last-3rd best use last-2nd best use last-1st best use last best use Quantity Schumpeter, A.: Das Wesen und der Hauptinhalt der Theoretischen Nationalökonomie. Leipzig 1908: 213ff.

25. Market coordination for resource allocation Marginalutility S D 1st best use last-9th best use 2nd best use last-8th best use last-7th best use last-6th best use 3rd best use last-5th best use 4th best use 5th best use last-4th best use last-3rd best use 6th best use last-2nd best use last-1st best use 7th best use last best use Quantity

27. Real world markets • Short side of the market dominates • Disequilibrium(arbitrage trends towards coordination) • Equilibrium(full coordination) • Maximum trade volume • Maximum social welfare Price S D x

28. Workable economic coordination What are markets expected to do? • Static functions • Consumer sovereignty • Efficient factor allocation • Performance-based income distribution • Dynamic functions • Flexible adjustment to changing conditions • Technological progress/innovations • Coordination efficiency

29. Market process view: Product life cycle (market phases)Ernst Heuß (1965): Allgemeine Markttheorie sales experimentation expansion maturity stagnation/decline time Static efficiency Dynamic efficiency

30. Market structure scheme (v. Stackelberg)

31. Free-market prejudice and market failures • Voluntary exchange • Implies gains from trade (for the parties involved) • Market failures • Technological externalities (impact on third parties) • Natural monopolies (sub-additivity of cost functions) • Information deficiencies (asymmetries) • Instability (deficient adjustment processes) • [Non-rationality] • Relevant alternative allocation mechanism?

32. Outline • Introduction and Overview • The Market System as an Economic Order • Equilibrium Analysis: “Imperfect Competition” • Process Analysis: Entrepreneurial Competition

33. Conditions for „perfect“ competition • Atomistic market structure • Large number of small buyers and sellers (no market power) • Price taker/autonomous decisions • Rationality • Consumers/households: Utility maximization • Producers/enterprises: Profit maximization • Self-interest with fair means (no opportunistic behavior) • Homogenous goods • No personal/spatial/physical preferences • No indivisibility • Stationary world • Given resources, constant technology • No growth analysis, no process/product innovations • World without frictions • Zero transaction costs (no costs for making an exchange of goods) • Perfect factor mobility (unrestricted market entry/exit) • Freedom of choice • No involuntary/compulsory transactions • No technological external effects • Perfect information/total transparency • Full knowledge/free information about alternatives and prices • No uncertainty • Infinite speed of response • Focus on equilibrium analysis • Transactions only at equilibrium prices (no “false” trading)

34. “Imperfections” • Market structure* • Polypolistic (many) • Oligopoly (few) • Monopoly (one) • Product characteristics • Homogeneous(not differentiated) • Heterogeneous(differentiated) • As consumers see it! *Here: Supply-side (demand-side analysis works in a similar way)

35. Categories of “imperfection”:Market structure and product differentiation Cartel (collective monopoly)

36. Categories of “imperfection”:Market structure and product differentiation Cartel (collective monopoly)

37. Monopoly • Market demand = firm demand • Price setting (consumers choose the quantity) • Quantity setting (consumers determine the price) • Static inefficiency • “Marginal revenue = marginal cost” still holds • BUT: price ≠ marginal cost (inframarginal units matter!) • Deadweight loss

38. Monopoly diagram

39. Monopoly behavior • Price discrimination • First-degree (perfect price discrimination) • Second-degree (non-linear pricing) • Third-degree (group-specific pricing) • Separating customers according to willingness to pay • Bundling • Packaged offers • Reducing dispersion of willingness to pay • Two-part tariffs • Option pricing (fixed and variable component) • Charging consumer surplus separately

40. Monopoly: Non-linear pricing • Self-selection (in terms of quantity or quality) • Airline industry: Business and economy class tickets

41. Monopoly: Bundling • Offering all-or-nothing packages (bundles) • Software industry: Office suites

42. Monopoly: Two-part tariffs • Fixed (admission) and variable (quantity) price component • IT industry: Device (printers) and spare parts (toner)

43. Special case: Natural monopoly • Technology • Market size • Both matter simultaneously!

45. Categories of “imperfection”:Market structure and product differentiation Cartel (collective monopoly)

46. Monopolistic competition • Small (atomistic) firms • Product differentiation • “Tangent” solution

47. Categories of “imperfection”:Market structure and product differentiation Cartel (collective monopoly)

48. Cartels (collective monopolies) • Collusion • Instability (“prisoner’s dilemma”)

49. Categories of “imperfection”:Market structure and product differentiation Cartel (collective monopoly)

50. Oligopolistic interdependence • Noticeable impact of one competitor’s action on other competitor(s) • Conduct • Autonomous/passive • Conjectural/strategic • Strategy • Simultaneous (Cournot/Betrand) • Leader/follower (Stackelberg) • Competition (Bowley) • Collusion Homogeneous: Quantity Heterogeneous: Quantity or price