Economic Reasoning, Lecture 2

The Austrian Method and How It Applies to Competition and

Monopoly, Part 2

Utility

●Judged by the quiz, I didn’t succeed fully in showing how easy the Austrian view of utility is.

●When you have money, you have to decide which products you want to buy.

●When you buy something, you will buy a particular amount of it. You will buy a pound of apples or one car, not “apples” or “cars”.

Ranking Goods

●How do you decide what to buy? You rank the different products available to you. The rank depends on how you value what you can do with the products. Then, you will spend money on your list, until your money runs out. You will pick your highest ranked product first, then go down the list.

●This ranking is what we mean by “utility”. Its ranking on your list is a good’s utility to you.

Units of a Good

●There is one more thing we need to know to understand utility.

● If you keep buying more of the same product, the new units will rank lower on your list. Why? Because you will use each unit you buy for the highest valued goal then available on your list. As you buy more units, you will reach a lower-ranking goal.

●This principle is called the law of diminishing marginal utility. It applies to money too.

The Basic Mistake

●We can determine how much pain we are feeling, at least roughly. E.g., a doctor can ask you to estimate how much pain you feel on a 1 to 10 scale.

●We might construct a scale like that for how happy we feel, going from, e.g., being mildly in a good mood to being ecstatically happy.

●Jeremy Bentham used the word “utility” to mean scales of pleasure and pain.

The Mistake Continued

●This is not what we mean by utility in Austrian economics.

●All we mean by utility is how you rank your goals, or the products that enable you to reach these goals.

●Your goals can include getting pleasant feelings and avoiding pain, but they don’t have to.

The Mistake Concluded

●When people say you can’t measure utility, this is often misunderstood. You should not think that means there is something there to measure, but we just can’t do it.

●There is nothing to measure. It’s not that we can’t find the right unit of measurement---there is no unit. All that we have is a ranking of goods.

Prices

●It’s important to understand the Austrian view of utility because the neoclassicals take a different view. This is one reason their view of competition differs from the Austrian position.

●First we have to look at prices. Suppose you are trying to sell something, e.g., a bucket of golf balls. What price should you charge?

Prices Continued

●Suppose you select a price. If you lower your price, you will sell either the same amount or more. You won’t sell less.

●Why? People can use money to buy other things. At a higher price, they have to give up more other goods.

●Some goods are more responsive to price changes than others. Goods that are very responsive to price changes have an elastic demand curve. Those that aren’t have an inelastic demand curve. The demand for salt is inelastic.

Prices and Monopoly

●Suppose there is only one seller of a good. I own all the golf balls. When I set a price for them, I estimate how much people will buy at each price. I compare my estimate of what I will make with the costs of selling the golf balls at that price.

● If the demand curve is inelastic in some range, I can raise the price and make more money.

Prices and Monopoly Continued

●If I do that, then the price I am charging will be above my costs. If there were other firms competing with me, then I couldn’t raise the price. If it tried to do it, the other firms would take my customers away.

● Is monopoly bad? Neoclassical economists say it is. They say that when prices are above costs, you can increase utility by lowering the price.

The Neoclassical Argument

●You might think that the neoclassical argument is obviously wrong. If you can’t measure utility, how can you say that utility has gone up?

●But the neoclassicals have an answer to this. They say that without measuring utility, they can still show that the monopoly price has lower utility than the competitive price. This is called the “deadweight loss” from monopoly.

The Austrian Response

●The neoclassical arguments depend on knowing how much of a good would be demanded at various prices, and what the cost of supplying the good at that price would be.

● In my example, we would have to know how many golf balls I would sell at my price when I am the only seller. We would have to know how many golf balls would be sold at the lower, competitive price. We would also have to know the costs of supplying the golf balls at these prices.

The Austrian Response Continued

●How could we find out these things? All we know is the actual price and cost, and how much is bought at that price. Estimates of other prices are at best speculative. Also, even though the neoclassicals say they aren’t trying to measure utility, they seem to be taking utility to be more than just ranking of goods.

●Suppose the neoclassical argument is correct. So what? Why should we demand that the market meet the ideal of increasing utility? Why do prices have to conform to this standard?

Ethics and Economics

●It’s extremely important to keep ethical judgments, views about what should be the case, apart from judgments of what is the case.

● In the Austrian view, competition exists so long as there is free entry and exit into an industry. We don’t impose requirements on the market. George Reisman calls the neoclassical position “Platonic competition”.

An Objection

●But isn’t it obvious that an increase in total utility is a good thing? Even if it is an ethical judgment, isn’t it a non-controversial one?

● Is the view that we should always act to increase utility really non-controversial? We can say that if people give each other presents, there is a deadweight loss from presents that people don’t like. We could eliminate this deadweight loss if people just gave instead of a present the cash they intended to spend. It isn’t obvious this would be a good thing.

An Important Distinction

●If something has good consequences, that gives you a reason to do it; and if it has bad consequences, you have a reason to avoid it.

●But these are not conclusive reasons. Other reasons can override them, e.g., people’s rights. Neoclassical economists often take for granted the view that utility is the only standard.

The Neoclassicals and Competition

●There are not many cases of monopolies. Most products have more than one seller. But the neoclassicals have extended their concept of deadweight loss far beyond monopolies.

●They say that in order to eliminate deadweight loss, there must be an extremely large numbers of firms that sell the identical product.

Pure and Perfect Competition

●In this situation, the seller can sell any amount he wants at the market price. He is a price taker, i.e., he has no influence at all on the price. The demand curve facing each seller is perfectly elastic, i.e., it is a horizontal line. If he raises his price, he will lose all his business. His price isn’t above his costs, so he won’t lower it.

●This is called pure competition. If we add that all the people in the market have complete knowledge of prices and quantites, then we get perfect competition.

Problems with Perfect Competition

●Almost nothing qualifies as perfectly competitive. Agriculture is probably the closest.

●The perfect competition model has major problems. If everyone is a price taker, where does the price come from? It must be set by someone.

Another Problem

●Also, demand for the whole industry can’t be perfectly elastic. Some people would want the product, even if the price were to rise. But you get the industry demand curve by adding up the demand curve for each firm, which is perfectly horizontal.

●This is a contradiction.

Monopolistic Competition

●Since almost nothing qualifies as perfectly competitive, neoclassicals need to have an account of the rest of the economy. Some members of the Chicago School, such as Milton Friedman, think that the actual economy isn’t too far away from perfect competition. (Remember, Friedman doesn’t think a model must have completely true assumptions.)

●Aside from monopolies, the structure of the market is either monopolistic competition or oligopoly.

Monopolistic Competition Continued

●In monopolistic competition, there are many firms, but each has a slight influence on price. The firms aren’t price takers.

●The products are slightly different, e.g., brands of toothpaste.

● In the neoclassical view, each firm has a slight degree of monopoly power, because it isn’t a price taker. Monopolistic competition theorists often criticize advertising as a wasteful effort to show that a product is different from what close competitors offer.

Oligopoly

●An oligopoly has a few very large firms that compete with each other.

●Each firm has a great deal of influence on price.

●Each firm must try to estimate what its rivals will do when it decides on prices and production.

The Austrian View

●Once again, the Austrian view of competition is much simpler than the neoclassical view.

●We don’t have to worry about market structure at all. Whatever people freely decide to do counts as competitive.