 Welcome to this Mises Academy course on competition and monopoly. I'm Peter Klein, and it's my pleasure to talk to you about some issues that are very important to the Austrian school. Austrian economics is known for many things, right? It's often associated with its very vigorous and distinctive defense of free markets and private property. And of course, those are important aspects of the Austrian tradition. Mises became famous in the English-speaking world for his penetrating analysis of socialism and the problems of economic calculation under socialism back in the 1920s. Hayek's road to serfdom helped to bring some Austrian concerns about central planning into the public mind during the 1940s. Murray Rothbard and many other Austrians, of course, have made pathbreaking contributions to the analysis of government intervention. These are not necessarily the essence of Austrian theory, however, while they're important sort of implications or applications of Austrian economics. Rather on the theoretical side, Austrian economics is distinct for its causal realist account of price determination. That's a term that several of us have been using in recent years to characterize the unique approach of Karl Manger and his followers. We call it causal realist because Manger's approach emphasizes cause and effect rather than a kind of formalistic, mathematical, engineering style, mutual determination, right? Manger is interested in what actions by human beings based on their beliefs and their expectations, the choices that they make, lead to certain outcomes in the market. Prices, exchanges, production decisions, entrepreneurial decisions, and so forth. So we're looking at the phenomena that we observe in the world and trying to understand those phenomena in terms of their fundamental causes. That's the causal part. The realist part of the term causal realist refers to the fact that Austrians are interested in real world market phenomena. We're not coming up with stylized hypothetical models of pretend markets that might exist under this or that set of weird circumstances. This or that kind of set of imaginary conditions. No, we're interested in actual real markets that we see every day. Go down to the corner store and you can buy a bottle of Coke. In the U.S., you might pay a dollar or a dollar fifty for that. Why? Why is it a dollar? Why not five cents? Why not five hundred dollars? Austrian economics is a set of tools, a body of theory, some ways of thinking that help us to understand the real prices that emerge in real markets all around the world. The Austrians are also somewhat unique for their emphasis on the entrepreneur. We'll talk about entrepreneurship a little bit later today, but most approaches to economics pretty much ignore entrepreneurship. The Austrians put the entrepreneur at the heart and center of their analysis of the market and that turns out to be very important. You may also be familiar with the Austrian theory of the business cycle. I talk a lot about that during this Mises Academy course, although we'll allude to it sort of in passing, but I want to mention finally one other aspect of Austrian theory and application, another side to Austrian economics that really is quite distinct from what you get in most other approaches, and that is the Austrian analysis of competition and monopoly. That's the subject of our lecture series of our Mises Academy course here. So what I'm going to do in three sessions is go over some basics about how Austrians view markets, how Austrians understand competition, what does monopoly mean, what is monopoly, where does monopoly come from, what are the implications of monopoly for how markets work, for what firms do, what kinds of public policies we ought to have, the analysis of government intervention in various ways. It turns out that many, many important issues and controversies and debates about free trade, about government control of money, even about the minimum wage, turn out to have something to do with underlying theories of competition and monopoly, and when we better understand the Austrian approach to competition and monopoly, I think we can understand these applications much, much better. So what do we mean by markets? What are the essential features of a market? Well, we can begin by discussing this in a fairly abstract way, right? So markets are specific venues or places in time and space where people can exchange goods and services, right? I mean, it might be a physical location like a flea market or a fruit market. It might be a virtual space, an online market. We have markets that are local, regional, national, even global, right? But we're referring to some sort of boundaries around particular exchanges of particular goods and services in particular times and places, right? So when I talk about the market or a market, I don't mean sort of all exchange that's ever taken place in human history, right? We might talk about the market for water bottles. Here's a water bottle right here. So I'm referring to a set of buyers and a set of sellers, each of whom has knowledge of other people's existence and who have goods or services that are available for sale or there are people who would like to obtain goods and services for sale. So there's some opportunity for exchange, right? That's what we mean by a market. Of course, fundamental to an analysis of market is the idea of property rights. So many economics courses, you know, they spend weeks or months or an entire year discussing different market outcomes without ever mentioning the fact that markets are based on private property. To exchange water bottles, it must be possible for someone to own a water bottle to have property rights in that water bottle and then to exchange those property rights for money or for another good, right? So you really don't have markets under socialism. In a state-controlled system, you may have something that kind of looks like markets, you know, where people are moving goods and services around, but absent private ownership in goods and services, producers goods, factories, machines, land and so forth, as well as consumer goods like bottled water, you really don't have exchange, right? So I'm assuming that people can have legal ownership title to goods and services and then they can offer to exchange those titles for other titles or for money, okay? In a world in which people differ in their preferences, in their beliefs and expectations, in their abilities, in what goods and services they currently possess, in the amount of labor they're able to supply and so forth, we would expect to see the emergence of exchange. Why? Because as many economists have pointed out over the centuries and Mises emphasized in particular, there are tremendous gains from exchange or gains from trade, right? Everyone can benefit from participation in the market, from exchanging goods and services that they possess for goods and services that other people possess. And we can all be better off when we specialize in the production or in obtaining particular goods and services and then exchanging with other people who specialize in producing or obtaining other goods and services, what Adam Smith referred to as the division of labor, right? A society with a lot of specialization and a rich division of labor is going to be a much more prosperous society than one in which individuals try to be self-sufficient, try to avoid trading with others. And of course, we could talk about applications of the gains from trade and the idea of the division of labor to government policy, tariffs and quotas, other kinds of interference with trade, just as we get tremendous welfare gains from allowing people to choose how to specialize and in what to specialize and what exchanges to make or not to make, just as that applies at the community level or the regional level. Of course, it applies at the national level as well. This is why Austrian economists have been first and foremost in their vigorous defensive free trade against government interference in trade. What David Ricardo called the law of association is what is sometimes described in the modern textbooks as the principle of comparative advantage, right? That's the idea, as Mises emphasized, that everyone has a role to play in the division of labor. Even people with very limited abilities or very limited skills or with access only to small amounts of resources themselves, right? It's not the case that we only benefit when highly accomplished people, when highly skilled people can participate in the division of labor. No, as a society, we benefit from all participation in the division of labor, even by or especially by those who have low skills, right? If nothing else, those who have limited abilities and limited resources are able to free up other actors, other agents from providing those resources or performing those services, which allows them to specialize in even more valuable activities, the production of more valuable goods and services. Mises uses the example of a skilled surgeon who, despite being able to maintain and clean his tools very quickly and efficiently, still benefits from hiring an assistant who can maintain the tools and clean the tools, even though the assistant is slower than the surgeon at cleaning the surgical instruments. It's still beneficial for these two to get together in exchange because the time the surgeon does not have to spend maintaining and cleaning the surgical equipment is time the surgeon can spend performing surgery, which is the highest valued use of the surgeon's time. There's great discussion by Mises in Human Action and elsewhere on how the principle of comparative advantage or Ricardo's law of association, thanks to that the benefits from trade are vastly greater than we otherwise could have imagined. And as all of you who have studied economics know, you put all this together, we get these terrific outcomes that, the market is not just a sort of inanimate means for performing some mundane exchanges that don't really have much of an impact on society. No, in fact, the market is this fantastic mechanism for coordinating a wide diversity of people and resources and actions and plans and efforts. If you've ever read Leonard Reed's famous little SAI pencil, you get a great sense of how free markets allow for this almost miraculous coordination of resources and people across great distances with high levels of complexity, across language barriers and so forth. So, you know, the market is really at the heart of an Austrian understanding of society and why property rights and freedom or the liberty to exchange in market, to engage in market activity is so crucial for human civilization. So, how are goods priced on the market? Karl Manger was famous for introducing a particular subjective approach to evaluation theory. You might know Manger as one of the three co-founders of the principle of marginal utility or the marginal utility approach, along with Jevons and Valras. Manger's approach is actually quite different and in the readings, you get a good sense of the way Manger understands the law of diminishing marginal utility. The idea that for units of a homogeneous good or service, the actor values additional units less than units that came before because units are allocated to successively lower-valued uses. So, it's not a psychological kind of principle, but a logical one, that if you have multiple units of a good or service, you allocate your first unit to your most highly-valued use, the second unit to the next most highly-valued use, and so forth. So, as you get additional bottles of water, you allocate those to lower and lower-valued uses. In other words, you might, if you had one unit of water, you would drink it. If you had two units of water, you might drink the first and cook with the second. You might bathe with the third and feed your pet with the fourth and so forth. So, the additional units of water are being allocated to lower-valued uses. Therefore, you would not be willing to pay as much for a fifth unit of water as you would a fourth. And you would not be willing to pay as much for a fourth unit of water as you would a third and so forth. So, from this, we can derive logically the law of demand, the idea that to induce consumers to purchase additional units of a good or service, the price has to be lowered. So, if you think of drawing a demand curve, if you plot price and quantity on a graph, you'd find that the demand curve is downward-sloping. Given price, at a lower price, the quantity demanded will be higher and at a higher price, the quantity demanded will be lower. There's some good discussion in our readings about how Bombavirk approaches exchange among multiple parties. The insight from Bombavirk was that when you have multiple potential buyers and sellers for different units of a good or service, the price that will be established on the market, the equilibrium price, is determined by the subjective valuations of marginal buyers and sellers. So, the last buyer who doesn't buy because the price is too high, the last seller who doesn't sell because the price is too low, their valuations establish a range within which the equilibrium or market clearing price will be set. One of the interesting things about this kind of analysis is that it's completely based on the subjective beliefs, valuations, expectations of consumers in the market, or we should say of individuals in the market because sellers, those who have units of a good and might be willing to give them up in exchange for something else, are also actors with subjective expectations, valuations, and beliefs. In other words, there's no role whatsoever in the Austrian analysis of price for objective cost. A water bottle does not go for $1.50 on the market because it costs $1.50 to produce it. No, a water bottle sells for $1.50 because at a price higher than $1.50, the number of units available for sale would exceed the number of units that buyers are willing to buy, so the price has to fall to clear that market. In other words, prices are set by how both buyers, prospective buyers and sellers or prospective sellers value marginal units of water. What it costs to produce this bottle of water, that's a cost that was incurred in the past. That cost has already been spent and so the seller cannot induce the buyer to pay for something simply because it costs a certain amount to produce it in the past. Sellers can certainly try to get prices that they desire based on their attempt to recover prior expenditures so they can post a sticker price of $3 or $5 or $10 on this bottle of water based on what it costs them to produce it. But sticker prices are not market prices. Market prices are those prices that clear the market are equilibrium prices in a fundamental sense. And objective cost, previously, previous expenditures of resources play no role whatsoever in determining those prices that clear the market. Also, of course, prices are not unilaterally set by sellers. It's sort of a common misconception. People think, well, sellers are large and powerful. Walmart is a big company, so Walmart can simply choose whatever price it wants for water. That's the price that obtains on the market. No, of course not. Walmart, like any seller, can ask whatever price it wants, but the price that prevails in the market is determined by demand and supply. If people will not buy the water that Walmart is selling and the prices that Walmart has posted, Walmart has got to lower those prices to clear the market. Otherwise, it ends up with a lot of unsold inventory on the shelves. Right of sellers could unilaterally set whatever prices they want. There would never be unsold inventory on any shelves. No sellers would ever lose money. No companies would ever go bankrupt. Of course, that's not the case at all. Mises like to use the term consumer sovereignty to emphasize that consumers always have the final say on what they are and are not willing to buy. I like Rothbard's use of the term individual sovereignty to emphasize that, yeah, the sellers are sovereign too. No one can compel a seller to sell just as no one can compel a buyer to buy. All individuals on the market are sovereign and it's their decisions to participate or not to participate in exchange that determine prices. By the way, notice that there's nothing in Bumbawerk's analysis or the Austrian analysis of markets and prices that assumes perfect knowledge or always correct expectations about the future. No, I mean buyers and sellers act based on what they know about the market. They can be wrong. They might not realize that there are other sellers around the corner they didn't know about. They might not know that some buyers might have paid a lower price or been willing to pay a higher price rather if only those buyers had been asked. Some sellers might refuse to sell at a particular price on the assumption that they can hold on to those units and sell them tomorrow at an even higher price, but they could be wrong, right? All that determines the price today is what buyers and sellers today believe about what may happen in the future and what present market conditions are. Of course, they could be mistaken about that, but they act based on the best knowledge that they have and that what explains the price is that we actually pay in actual markets. There are some important implications that come out of this very fundamental analysis. Prices allocate resources to their highest valued users and uses. Price controls, you know, government price floors and ceilings lead to misallocations of resources. And more importantly, as we'll see in just a moment, prices provide feedback to entrepreneurs on the accuracy of their forecasts and their prior investment decisions. Note finally that the allocation of resources under market competition, you know, in which these real market prices, real prices are paid, maximizes individual welfare in the only meaningful sense of that term. What does it mean to maximize individual welfare? There are lots of attempts by neoclassical economists to state this sort of formally or psychologically. All we mean by maximizing individual welfare is that by participating in free markets, individuals are made as well off as they possibly can be in an economic sense, right? Doesn't mean that, you know, markets lead to some kind of nirvana. It doesn't mean that people don't make mistakes, right? It means that, you know, if we want to understand what makes me better off, we can only observe all we need to do, all we can do is observe my decisions in the market to purchase or not to purchase. As long as I'm free to act in the ways that I think will make me better off, then there's no feasible intervention or institutional change that will in fact do any better than allowing me to do what I believe to be in my own best interest. So free markets maximize consumer welfare and consumer welfare in, you know, again, the only sort of scientifically meaningful sense of that term. Just as a footnote, Hayek famously described the price mechanism in terms of what he called signals, the idea that prices in the market provide signals to individuals about scarcities and shortages and that people sort of respond to signals and therefore we need to have free markets because we want these signals to be as informative as possible. I mean, I wouldn't say that's wrong, but that's not exactly the way I like to emphasize it. It's true that people do adjust their behavior based on prices they observe in the marketplace. But remember, prices don't come first. Prices are not prior to action. Prices are the result of action, right? So yes, I look at the prices that obtain in other markets as I think about what I want to do, but the prices in those markets arose from the behavior of actors in those markets. Prices are the result of human action, not the antecedent to human action. Let's move on from exchange to thinking about production. By production, we mean what Rothbard called the use of man by available elements of his environment as indirect means, as cooperating factors to arrive eventually at a consumer's good that he can use directly to arrive at his ends. So the idea here is one of transformation, right? The transformation of certain resources into other outputs, other goods and services, right? This transformation takes place through time, through space and so forth. And there's an emphasis on purposeful human action. In other words, goods and services don't just produce themselves. They are produced as the result of decisions by human beings to transform metal, iron ore and wood and labor and so forth into steel and into wooden beams and so forth, which can then be further transformed into building supplies and further transformed into a house, okay? One implication of this notion of transformation is that production takes time, right? It's not instantaneous. And that we can distinguish between original factors of production like land and labor and intermediate or produced factors of production, capital goods, machines, tools, et cetera, which then can be further transformed into consumer goods. So the business firm is where this production takes place. The firm is the locus of productive activity. And what is a firm? It's an entrepreneur or a set of entrepreneurs. Plus this had a factors of production that are owned and controlled by those entrepreneurs. The Austrian economists were famous for developing what was called the theory of imputation, the idea that the way we value factors of production on the market depends on how those factors will be used to produce goods and services. In other words, suppose there's some particular machine that is involved in the production of these water bottles. What's the value of that machine on the market? How much would a firm want to pay for the use of that machine or if you could buy the machine outright, how much would you pay? Well, the value of that machine, according to the Austrians, depends on the marginal contribution of that machine to the production of water bottles and the valuation by consumers of water bottles in the water bottle market. In other words, based on what consumers are willing to pay for these water bottles, we then impute backwards evaluation to the machines that are used to produce the water bottles. So if water becomes more valuable on the market, water bottle making machines will in turn become more valuable on the factor market. And the other way around, if people decide they no longer want to consume bottled water, they just want to drink water out of a tap. The value of machines, specialized labor, and other factors into the production of bottled water will fall because they're now being used for a consumer good that is not as important on the market, is not as valuable to consumers on the market as before. This is important as we think about entrepreneurship, what entrepreneurs do, why firms earn profits and losses. In the long run, in a kind of long run equilibrium state, factors of production earn their discounted marginal revenue products. The discounted marginal revenue product is the dollar value or the monetary value of the contribution of one unit of a factor to production, discounted by the rate of interest depending on how long it takes for goods and services to be produced. So if one more hour's worth of the use of that machine produces, say, 10 bottles of water and they sell for a dollar each, then the marginal contribution of that one hour's worth of running the machine is $10, forgetting about the discounting for a moment. So the marginal revenue product of an additional hour's use of that machine would be the 10 water bottles that are produced times the price of each water bottle, say $1. So how much would an entrepreneur be willing to pay for one more hour's use of that machine? Well, no more than $10 because you get $10 worth of output from using that machine for an hour. The entrepreneur would like to pay less, say $5, in which case he would have $5 left over of profit. But he would be willing to pay up to but not beyond $10 the marginal revenue product of that machine for one hour's worth of use of that machine. So in this long-run equilibrium state where entrepreneurs are competing with each other, bidding against each other for the use of factors of production, the prices of those factors of production will be equal to their discounted marginal revenue products. Capitalists will earn interest in this world as a reward for foregoing current consumption, making funds available now in exchange for repayment in the future. But there are no profits and losses. Why? Because there's no money left over for the entrepreneur to keep his profit or for the entrepreneur to give up as loss because everything is just sort of equalized. Entrepreneurs pay exactly the discounted marginal revenue products for the use of factors. So all of the revenue that comes in from selling goods and services is then paid out to factors of production and there's nothing left over. But that's not the real world that we live in. We're not in a kind of long-run equilibrium. Rather, we're in a short-run competitive situation in which entrepreneurs earn profits and losses based on their anticipations of future prices. Again, when the entrepreneur has to decide whether to rent that bottled water-making machine for an hour, he's doing it based on his beliefs about what price he can get in the market from selling the water. If I believe that I can sell water bottles for a dollar each and using this machine for an hour will produce 10 more bottles, well, I wouldn't pay $15 to use that machine because I would expect that would lead to a $5 loss. I pay $15, I get $10 worth of stuff to sell. Suppose someone is offering to me the use of that machine for $8. I think, well, I believe that using that machine for an hour will generate $10 worth of revenue. I only have to pay $8 to use the machine. Well, yeah, of course I should do it. If I'm correct, I end up with a $2 profit on that particular set of transactions. But of course, what if I pay the $8? I produce the 10 bottles of water, I take them to market, and I can only get people to pay $0.50 each. So instead of earning $10 of revenue, I only earn $5. Well, I paid $8 to get those 10 bottles of water. I walk home with $5 of revenues. I've just earned a loss of $3. Right? So day-to-day, entrepreneurs earn profits or losses based on how accurate are their expectations, how accurately they can anticipate what the future prices of consumer goods will be. So the unique role of the entrepreneur in a competitive market system is to arrange the factors of production under conditions of uncertainty about the future. That's exactly the way Ludwig von Mises described the entrepreneurial function. The American economist Frank Knight also articulated a view of the entrepreneur this way. Knight's view is much better known than Mises, though Mises I think also articulates the same view. In my own work on entrepreneurship, I've also described the entrepreneur's unique role this way, arranging the factors of production under uncertainty. Now, this is slightly different from Joseph Schumpeter's notion of entrepreneurship as innovation and slightly different from Israel Kirschner's notion of entrepreneurship as discovery or alertness. Rather, it implies ownership of resources, of factors of production, and judgment about the future, the ability to anticipate prices and other market conditions in an uncertain future. It may be useful to clarify for a moment what profit is not. So first profit is not the same thing as interest, even though they both appear as money income on the firm's income statement, right? Because interest is based on time preference. Interest is the reward for forgoing consumption, whereas profit is the result of this wedge between what entrepreneurs pay for inputs and what they receive for selling their outputs. So profit is a reward for successfully bearing uncertainty. And as economists, as theorists, when we look at the firm's income statement, we have to sort of think through ourselves how much of that is really interest, how much of that is actually entrepreneurial profit. Because entrepreneurial profit does not appear as its own line on the income statement. That's something we have to sort of infer from analysis and observation. Likewise, profit is not identical to accounting income, rather to be more complete. Accounting income includes profit, interest, and some piece of what we call the entrepreneur's implicit wage. In other words, some component of that income has to go to the owner, entrepreneur, as compensation for not working as an employee in some other job. What's left over after that, after you take out interest and the entrepreneur's implicit wage, anything that's left is economic profit or economic loss. So we're talking about the economic notion of profit as a functional category, not just a line item. It's also important to remember that profit is not some kind of automatic return to capital, which is what many people seem to think, that, well, the way you get profit is you have some capital and you invest it, and capital generates a percentage return every year, you know, 5% or something. So profit is the 5% automatic return you get from owning capital. I mean, this doesn't make any sense, right? Of course, if by capital you mean financial capital, you mean investable funds, yeah, you can invest those in the bank and earn interest, but the same thing is profit, right? Profit is an amount, not a rate, and profit is the amount that entrepreneurs obtain. It could be positive or negative, profits and losses, right, as they attempt to combine factors of production in different ways to produce valuable consumer goods and services. And as we sort of hinted before in this notion that, in pointing out that sellers don't unilaterally set the price, profit is also not a workup over production cost, right? Profit is the difference between total revenues and total costs, and profits are earned and losses are earned by entrepreneurs according to their success in sort of making wise decisions in how much to pay for factors in the present based on their anticipations of prices they'll receive in the future. Okay, so all of this is sort of background towards thinking about competition. So what then is competition, right? What do we mean to say a market is competitive? Well, competition in the ordinary language sense means rivalry, right? Like runners competing in a race, whoever is the fastest runner wins the prize, right? Notice you don't have to have 10 runners or 1,000 runners or a million runners for a race to be competitive. With just 2 runners, a race can be competitive, right? Or maybe only one person is on the track but other people could potentially join the race. There's a competitive aspect to that as well. So competition refers to, you know, rivalry or some outcome is contested where multiple actors are trying to achieve some particular goal. They compete against each other. A useful way to think about competition then is freedom, right? A market is competitive if anyone is free to enter that market and give it a shot, right? As long as anyone is legally, as long as no one is legally prohibited from trying to produce bottled water, trying to sell bottled water, you know, offering to my customers a price that's lower than what I'm giving them or trying to bid away water bottles from other buyers, right? Then that market is competitive. As long as people are free to engage in buying and selling, to engage in production and entrepreneurship without governmental interference, then we say that market is competitive, right? Notice of course that we're not saying that everyone can compete, right? You know, if I happen to see Usain Bolt walking down the street, I can certainly challenge him to a 100-yard dash. I probably would not be very smart in doing so, right? So we would say I competed against him in this race. I'm guessing that I would get absolutely destroyed by Usain Bolt, right? So when we say a market is competitive, we don't mean that every player, you know, every competitor in the market has an equal shot of being successful, right? We don't say every firm can earn a profit. No, of course not. Competition refers to, you know, the ability to try to buy and sell. It doesn't say anything about how successful any particular buyer or seller could be. So you might have a market in which only one firm is profitable, and there are lots of other firms in the market that are trying but are not profitable. Is that market competitive? Absolutely, of course it is. As long as these other firms are free to enter the market and to try to compete with the dominant firm, then that market is competitive, okay? You don't need equal outcomes to have competition. So what then is monopoly? Well, I mean traditionally in, certainly in the Anglo-American common law sense, monopoly is the term that goes with a government license or a government grant that gives the license holder the exclusive legal privilege of producing a particular good and service, right? If I were the exclusive supplier of bottled water to some town, because I got a royal charter or a royal license, said, you know, if anybody else tries to supply bottled water in that town, they'll have their head chopped off. Then I have a monopoly, right? So monopoly is not based on market share. It's not based on my profitability relative to other firms, right? Monopoly obtains in this sense only when there are legal restrictions on entry. We'll talk a little bit more in the next session about how we can make this characterization a little bit richer and what are some other ways that different Austrian economists have tried to characterize monopoly and monopoly price. But I just want to note for the outset that, you know, what we're talking about here has absolutely nothing to do with what a lot of economics textbooks call perfect competition. So many of the textbooks distinguished between perfect and imperfect competition, but this is something entirely different from competition in a causal realist sense. So-called perfect competition and imperfect competition are imaginary constructions. They're abstract theoretical concepts. They don't exist in reality. There's no such thing as a perfectly competitive market or even an imperfectly competitive market in the real world. Now, Austrians are not opposed to the use of imaginary constructions, but imaginary constructions have to be useful. And these two are not, right? These are not useful constructs. What the economics textbooks mean, what neoclassical theorists mean by a perfectly competitive market is a market that's characterized in a particular way. So mainstream economists will say, well, for any given market, you know, the market for water or the market for shoes or beef or whatever, we want to look at the type of product. Are all the products in the market homogeneous, perfect substitutes, or are they differentiated? Is there some unique product that's in the market? What are the numbers and sizes of buyers and sellers? What are the entry and exit conditions, including non-legal constraints on entry and exit? What are the conditions of information? Is information perfect or not? And based on that, we will classify the market as falling into one of these categories. It's either perfectly competitive or it exhibits monopolistic competition or oligopoly or monopoly. This is a very different way of categorizing markets than the way Austrians understand things. Right, again, for an Austrian economist, a market is competitive as long as there are no legal restrictions on entry or exit, whether it has two firms or 200 firms, equally sized firms or some large and some small firms, you know, low capital requirements for entry or high capital requirements for entry. In any of those conditions, as long as there are no governmental barriers, that market is competitive. But mainstream economists want to characterize each market according to this sort of finer set of distinctions. So many of you have studied this in school. The mainstream understanding of markets starts with the analysis of the so-called perfectly competitive firm. Right, so the perfectly competitive firm exists. It is a firm that is so small relative to other firms in the market. I mean, literally, this firm is infinitely small. It produces zero output, right? So you have a perfectly competitive market as one with an infinite number of infinitely tiny firms. So if you sum up the production of all these firms, it adds up to the total quantity that's produced in the market. But because each firm is infinitesimally small, in the limit, each firm produces zero output. It's kind of a weird, I mean, go figure, right? But the idea is that, you know, if the market for water bottles were perfectly competitive, yeah, there'd still be water bottles being bought and sold, but each producer would be so small that it has no impact on market outcomes whatsoever. The idea is that the demand curve facing an individual seller of water is perfectly horizontal, is horizontal or perfectly elastic, as they call it, meaning that each supplier is so small, he can supply as many units or as few units as he wants without having any impact whatsoever on the market price. And so in this model, each firm looks at its cost of production, the marginal cost of producing water, and chooses a quantity where the marginal cost of producing water is just equal to that exogenously given magically determined price decides how much to produce and is sort of done. Firms in this imaginary construction all earn zero profit. Every firm earns zero profit because all firms are identical. They all produce where the price is equal to marginal cost, there's no residuals, no profits, no losses. It's a very, very strange model. Of course, it doesn't describe any actual markets, right? And, you know, you might think it's sort of an interesting intellectual exercise to think through, well, what would a world look like if all firms were infinitesimally small? No firm could influence the market at all, but collectively these firms determine the quantity supplied and hence the price in the market. I mean, you might think that's sort of an interesting thing to think about, but really doesn't have any impact whatsoever on how we would analyze actual markets. What we're going to see in the coming sessions is this is precisely the problem that neoclassical economists have taken this kind of sort of strange, obscure model of a market and elevated it to the level of being kind of some sort of market ideal. So the idea is, well, the best of all worlds is one in which markets are perfectly competitive. And so any deviation from perfect competition represents an inefficiency, a flaw, some kind of a problem that the government needs to step in and solve. Unfortunately, we are told by our mainstream economist friends in the real world firms are not perfectly competitive, but some firms have so-called market power. What is market power? Market power exists when an individual firm does not face a horizontal or a perfectly elastic demand curve, but rather a downward sloping demand curve. And as you can see from the diagram here by looking at any conventional economics textbook, if a firm faces a downward sloping demand curve, it also faces a downward sloping marginal revenue curve. And when the firm tries to maximize its profits by producing where price is equal to marginal revenue, it is able to mark up the price over this marginal revenue amount. So when the firm chooses to produce the quantity where marginal revenue is equal to marginal cost, that's QM in my diagram, rather than charge a market price of P2 where it would just break even, it's able to charge a price that's, it's able to charge whatever the market will bear, which is a higher price, PM. And so the difference between PM and P2 times the quantity of units sold, QM, gives a monopoly profit. And so in this model, in this world, the only way firms earn a profit is by having market power, by facing a downward sloping demand curve, such that they can restrict their quantity below the perfectly competitive amount, Q1, and therefore jack up the price and put some monopoly profit in their pocket. So profit in this view of the world comes from the possession of market power. And market power, again, is not having a government license. In this meaning, it's simply having the ability to raise price over marginal cost. You know, it's very unclear in this world why firms earn losses, right? Of course, lots of firms earn losses, firms go bankrupt every, you know, all the time, but according to mainstream economists, as long as the firm faces a downward sloping demand curve, which would apply pretty much to every firm in the real world, firms can just earn whatever profits they want, right? They can earn as much monopoly profit as the market will bear. And that's the source of profit. Profit comes from market power, not as we've been saying, as the Austrians say, from having better insight, better foresight about prices in the future. By the way, there's no uncertainty in this market power model whatsoever. There's no passage of time. There's no entrepreneurship. There's just maximizing profits using given data. There are many problems with the market power approach to explaining profit, right? I mean, first of all, as Rothbard pointed out, every firm faces a downward sloping demand curve. Even the one small Iowa wheat farmer faces a downward sloping demand curve. If that farmer doubles, triples, quadruples his output of wheat, it will have some impact on the market price. There's no such thing as a perfectly elastic demand curve because there are no infinitesimally small units. Markets are all about exchanges of discreet units of goods and services. Another problem is that this neoclassical analysis assumes that overall well-being would be increased if firms with market power were somehow compelled to increase their output beyond QM, right, beyond the level at which they maximize their profits to produce the higher or perfectly competitive level of output. But of course, it can't be the case that compelling a producer to increase quantity can improve overall well-being because that violates the property rights of the producer, right? I mean, it's sort of like, you know, imagine a movie star, you know, with beautiful face or incredible acting skill that, you know, who brings great joy, satisfaction to his or her fans. You know, if this movie star would make twice as many or three times as many movies as he or she already does, this would greatly add to social utility, right? It would greatly benefit all the fans of this movie star. Well, I mean, but what if the movie star doesn't want to work that many, doesn't want to make that many movies? Does it want to enjoy time with family or consume some leisure or enjoy hobbies or whatever? I mean, you know, it would be obvious to all of us that if we were to go to some famous movie star and kidnap that person and drag that person in front of the camera and force the movie star at gunpoint to make even more movies than the movie star is currently making, that this would be a violation of the movie star's rights and that, yeah, maybe some fans would be delighted to have more, you know, have more screen time for their favorite star. This would obviously be greatly harmful to the movie star. But yet people think, well, you know, the company that's making these water bottles is producing 1,000 of them per week, but that's because they have market power. If they produce 1,200 per week, that would increase overall social well-being. Well, I mean, that's crazy. It's the same thing. You'd be then compelling the producer to produce more than what the producer wants. In other words, there's no magical, perfectly competitive quantity that's sort of the right quantity, such that some other quantity, the so-called monopolized quantity is wrong, right? I mean, the quantities that firms produce, the quantities that are exchanged on the market based on the free and voluntary interactions of buyers and sellers, that those are the optimal quantities. We can't say that more is better or that less is better. The other thing too is that, you know, there's nothing wrong with having a downward-sloping demand curve. There's absolutely nothing inefficient or unjust about the demand for some particular firm's product being, say, fairly inelastic from having a steep demand curve, right? I mean, people's willingness to substitute other goods and services is based on their own preferences, their own beliefs, their own expectations, their own desires, right? So in other words, suppose it's the case that, you know, this is a very unique brand. There's something about this water that makes it really special and consumers only want this brand. They're not satisfied with any competing brand. Therefore, mainstream economists say the seller of these water bottles has a lot of market power and can jack up the price and take advantage of the consumer. Well, I mean, if the consumers are willing to pay more because they strongly prefer this brand, well, that's their right. And of course, consumers are free to choose to prefer some other brand, right? So, you know, how steeply sloped is the demand for a particular demand curve for a particular firm's product? How elastic or inelastic is the demand for a particular firm's product? That's totally based on the voluntary preferences and choices of consumers, okay? Another point is that even if a seller, if there's only one seller in the market at the moment, that doesn't mean the market is not competitive, right? Sellers are constrained by potential competition as well as by actual competition, right? I might at present be the only seller of bottled water, but I can't just choose, you know, any arbitrary price that I want. If I try to charge a super high price, well, either people won't buy or they'll buy and sort of grumble about it, but then other firms will see that I'm able to get these high prices and they'll then enter the bottled water business as well and they'll try to bid away from me the use of the machines and the labor and so forth, and they'll then bring bottles of water to market and try to get my customers to buy from them instead, right? So, even if competitors are not currently doing that, the fact that they could do it, the fact that they're capable of doing that limits or constrains what I can do, okay? So, just to summarize for this session, markets depend on private property and economic freedom. A free market is one in which buyers and sellers, investors, entrepreneurs, lenders and so forth are free to interact on a voluntary basis under whatever terms and conditions they choose, right? Under those conditions, the market is competitive. Competition means nothing other than that. Competition refers to the freedom to act, the freedom to buy or sell, the freedom to invest, to produce, to transform inputs into outputs. And of course, in any market in which those conditions obtain, and of course they obtain to a greater or lesser extent in all real-world markets, depending on how much the government intervenes, to the extent that those conditions are present, those markets are competitive. And the entrepreneur is at the heart of the competitive process. So, if that's all we mean by competition, it seems like to have a competitive market and therefore a market that maximizes consumer well-being, all we need is the absence of government intervention into that market. Now, as we'll see in the next session, there's lots of literature by economists going back for many years challenging this common-sense notion of competition and claiming that well-known competition requires something else, like the model of perfect competition we just saw. And that because markets don't meet some sort of arbitrary conditions, the government has to step in and try to fix them. So we'll review and critique some of these alternative understandings of monopoly in the next session, and then we'll conclude with a session on some applications.