Capitalism has become a rather wide description of anything and everything what is considered to be part of economics. Economic science provides people a great variety of different views on market capitalism. This collection has made any use of the words of market capitalism and free markets open to interpretation.
Most important element of capitalism is commonly misunderstood. It is the concept of free markets. Before one is able to argue any economic policy it must undoubtedly become clear what someone has in mind when the words capitalism and free markets are used.
Science is dominated by discussions and it always comes down what definition is used. This part deals with defining important terminology. It is about how economists approach economic markets, and it questions how economic markets function. Are all markets the same? How are they interpreted as free?
Capitalism is a general reference to the mode of organization of a society. Since materials, goods, services, and human efforts are available in limited amounts, there is scarcity. Scarcity forces people to deal with the allocation of resources. The manner in which this allocation, or distribution of scarce items is coordinated, characterizes the mode of organization. In capitalism this coordination is performed by the intermediation of free markets. Everyone who wants to supply or buy a certain product or service is free to do so.
Contrary to capitalism, it is possible to opt for a non-capitalist organization of society. This is what communism attempted to accomplish. Instead of letting markets coordinate the allocation of scarce items, it became the task of the state. Bureaucrats had to coordinate this distribution.
Communism failed to a very great extent. State intervention replaced competition and it made the mode of production highly inefficient. Markets were not eliminated, competition was.
Economic markets are about one thing: supply and demand. There are many different typologies of markets, but it is essential to know at least three of them: perfectly competitive markets, oligopolistic markets and monopolies. These are idealized typologies of (almost) possible real-world market conditions that allow an understanding in price-mechanisms.
Economic theory largely focuses on capitalist modes of organization, and consequently, it studies the exchange of goods and services on markets. Markets are abstract references to places where supply and demand come together. It does not matter what the product is, it does not matter where the transaction takes place, it does not matter how many suppliers or consumers are involved, it is only about supply and demand.
In reality, one is able to go to a supermarket, but the abstracted market as it is theorized, does not exist. It is a result of a couple of assumptions of product homogeneity, symmetric information and costs, and rational agents. Although these assumptions do not hold when reality is taken into account, it enables economists to use these abstracted ideas of markets to assess how prices are formed.
Free Markets: Perfectly Competitive Markets
Perfectly competitive markets have a great number of suppliers. When one supplier is going out of business, it will have no influence on total supplies because others will fill the gap. In perfectly competitive markets, prices are driven by marginal costs, which are the cost to produce the last product that is produced. In other words, products are sold for the lowest price possible.
If we were to take mathematical representations used in micro-economics, there is a very simple conclusion: profits are non-existent.
The logic behind this conclusion is simple. Profits attract more suppliers, it increases competition. Profits are a result of a lack of competition, contrary to the popular belief they are an automatic result of free markets.
Competition is a function of the number of suppliers available for consumers to choose from. The more suppliers available, the fiercer the competition is. As a consequence of competition, only those with the lowest of cost-structures (and the best products) survive competition. They can only remain a competitor as long as they set up their business to most efficient and effective standards manageable. This is the only way to make sure that competitors cannot undercut prices. As a result, one must see any profits made as costs to consumers. In other words, profits are costs, profits are excess income.
This is the most important insight one must remember. Perfectly competitive markets – referred to as free markets by economists – do not generate profits. But, this is a theoretical conclusion. It is not necessarily true in the real-world.
Nevertheless, the rule by which such a market can be characterized is something like “everybody-is-a-winner“. This rule can be motivated by the fact that everybody can utilize its income to the most efficient standard around. Perfectly competitive markets ensure wealth optimization through maximizing the propensity to consume. Profits cause income accumulation to become distributed disproportionately.
Perfectly competitive markets perform a role in society that not only generates the highest level of prosperity, it allocates wealth most proportionately. This implies something completely different than wealth distributed equally. An equal distribution of wealth necessitates state intervention through fiscal policies (income redistribution through income tax). A proportionate distribution of wealth is a result of competitive rewards for skill and effort. It nears an equal distribution, but they will never be exactly the same.
All by all, competitive markets ensure that everybody wins. Businesses are competitive and can continue their activities, ensuring the highest of employment levels. People thereby have the highest level of income certainty, and can buy the best products for the lowest of prices. More important, free markets provide all participants to enjoy the maximum number of (economic) opportunities.
In oligopolistic markets the number of suppliers is limited to a few. Generally, it is considered a market with four competitors having a 70% market-share in total. This percentage is quite arbitrary, but it is a measure that can be used nonetheless.
But important to remember is that competition is dominated by a few suppliers that have a substantial influence on supply conditions. If one of these suppliers were to change its quantity of supply or the price it charges, it would have a great effect on its competitors. This influence is considered a form of market power.
Oligopolistic markets have a few distinctive key characteristics. Oligopolistic markets consist of a small number of firms, supply mostly branded products (making advertisement important), and have significant barriers of entry. These barriers of entry can be induced by branding, economies of scale, customer loyalty, exclusivity of certain contracts, licenses, pricing strategies (targeting specific time-frames, or forms of price-discrimination), patents, geographic locations, or access to scarce resources. All by all, these market-characteristics create market conditions with a high degree of interdependency between firms.
Interdependency among firms beholds a two-fold manner of competition. When firms want to increase their profitability they can either choose to compete on (1) prices or (2) on market-share. Strategies to increase profitability are not without risks, they can backfire and ultimately lower profitability.
Companies in oligopolistic markets have one interest in common. They want to maintain market conditions that allow them to profit. In other words, despite collusion in price or quantity agreements is prohibited by law, they have an interest to do so nonetheless. Businesses can signal their willingness to restrain their competitive attitude. The competitive process is then not only based on cost-structures, it is also based on their ability to influence market conditions. Market power in this regard is considered a form of market failing.
Market failing causes market prices to inflate and causes a lower propensity to consume. The customers end of the ‘oligopolistic bargain’ is that they trade their income at a too high a price compared with prices in competitive markets.
Suppliers in these kind of markets generate high levels of profitability. Market conditions allow firms to charge a profit premium at your expense. It is the only way for profits to come into existence.
The important insight derived from oligopolistic markets is thus that there are substantial profits. As a thumb-rule, one could argue these markets can be characterized with the “winner-takes-most“-rule.
In the idealized concept of a monopoly there is only one supplier. Because this supplier is the only source for consumers to choose from, it has complete influence on market conditions. A monopolist thereby can maximize its profits by limiting its supply. As a consequence of limiting supplies, it can ask a price much higher than the (marginal) costs of producing its product(s) or service(s).
A monopolist enjoys maximized market power. This market power allows a monopolist to set a price. However, prices are not infinitely high. Prices are restricted to the propensity of consumption of those interested in buying. This interest of consumers can be expressed in the price-elasticity of demand. A price-elasticity expresses the effect of a price change on the quantity of demand.
There is no way of knowing this elasticity other than to assess this through market research. This kind of market information provides monopolists (but also oligopolists) an understanding of its ability to maximize its profits.
Mathematically speaking, monopolists set their prices such that marginal revenue is equal to marginal costs. At this intersection, a monopolist maximizes its profits. These profits can be twice the production costs or even more. A monopolist is the ‘winner’ who ‘takes-all’.
Profits: A Result of Market Power
With these three idealized market typologies it can be pointed out that capitalism comes in different shapes and forms. It perhaps sounds contradictory if you have not gave it a thought, but profits are not a result of free markets. Contrary, profits are a result of a lack of competition. Therefore it must always be questioned when somebody uses the words “free markets”. Profits cause a lower propensity to consume. Because of that, profits effectively result in a disproportionate distribution of wealth.
But, are profits necessarily a wrong result? Some nuances are important. Profits allow a less proportionate distribution of wealth, but also allow new investments in businesses.
To be able to qualify profits as an unnecessary evil or as a welcome blessing, one needs to explore how profits emerge. The only way to do this, is by looking at the kind of market power that resulted in a profit.
If profits are to be qualified there is a need for a criterion or set of criteria that classifies different kinds of market power as either good or bad. My preferred criterion to label profits or market power as either good or bad is a function of the number of economic opportunities available. The lower the number of opportunities available the wronger profits are. The greater the number of opportunities the more profits are well-deserved.
Although barriers of entry limit the number of opportunities for potential competitors to enter a market, it is a prerogative to analyze to what extent these barriers can be lowered, without decreasing business opportunities. It must not be a rule of law to eliminate all forms of market power. Marketing, geographic locations, economies of scale, high quality products are all examples of sources of market power that are part of the competitive race.
These are business opportunities that are equally available to all. It makes businesses more competitive, and that is a good thing. These are necessary opportunities to ensure competitiveness. But, when businesses receive and/or use their market power to lower competition, problems arise. Competition is a fundamental precondition for free markets.
Capitalism is a reference to the mode of organization and comes in different forms and shapes. Perhaps it is an open door, but any organization needs management. Market capitalism is no different in this respect. Rules must aim at triggering the best results possible, not to limit these. Therefore, it must be clear to those who are making economic policies it is their prerogative to implement policies that make sure competitive markets emerge.
Pindyck, R.S. & D.L. Rubinfeld (1998), Microeconomics, Fourth Edition, Prentice Hall, New Jersey.