You Play to Win the Game! And the Game is: Rent-Seeking
Matt makes an interesting argument:
This is an idea about the simple story you’ll find in your intro micro textbook about the behavior of a perfectly competitive market. The normal way people seem to react to this story is that people with right-wing views start talking about how bad government intervention is and people with left-wing views start talking about how unrealistic the assumptions underlying the model are. But another way is to think about it from the point of view of a businessman. This competitive market sure looks like a horrible place! You might make a living there, but you sure as hell aren’t going to get rich. Think of the immigrant family that owns the dry cleaning shop around the corner—long hours, hard work, modest income. That’s your capitalism and it pretty much sucks.
Obviously the whole reason to become a businessman in the first place is to get rich. Operating a business in a competitive marketplace is for suckers, or immigrants with limited English ability. The whole name of the game is to do something else. Get a license for something. Get into a line of work with network effects. Win government contracts. Get your hands on some intellectual property. Become a monopoly. Find some barriers to entry. If you think about Bill Gates, who’s about as successful a businessman as they’ve got, and he’s doing a whole bunch of those things simultaneously. That’s how you get rich.
To the list in the second paragraph, I’d add: genuine innovation. Admittedly, it’s hard to accomplish, and the gains to you personally are fleeting without the suite of anti-competitive moves in Matt’s second paragraph.
When I considered myself a libertarian, it pleased me to contemplate Adam Smith’s quote that “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices….” because it distinguished esteem for free markets from apologiae for businesspeople as a class. And I used to think that the challenge to libertarianism as an ideology that was implicit in the quote was essentially ethical: The libertarian had to take care that his advocacy was toward freer markets rather than merely greater corporate privilege.
But in light of what Matt writes, and I think somewhat further than he goes, I think the challenge is really intellectual. In light of the small returns available under perfect competition, “the profit motive” – the self-interested desire to achieve serious prosperity – isn’t just willing to make accomodations to official restraint of trade. It becomes, functionally, the desire to enter into and institutionalized webs of economic coercion and turn them to your advantage – licensing; subsidies explicit and tacit; patents and copyrights; government contracts; regulatory capture.
Progressive readers are about to chide me. “It took you this long to figure that out?” But that’s not the challenge I’m talking about; that’s the precursor to it. The challenge that grows out of that is, in a regime of Econ 101 perfect competition, how much incentive actually exists for innovation? The profit potential of innovation itself is fleeting because competitors take your new ideas up swiftly. The profit potential of restraint of trade doesn’t exist because we’ve defined it out of the scenario. That implies that only systems that feature anti-competitive practices can offer a “profit motive” worthy of the name.
Needless to say, not just any system of anti-competitive practices will do this. We’re talking about institutionalized systems of privilege, after all, which means they tend toward locking in gains for the existing club members and locking non-members out of the benefits. A lot of us see intellectual-property law tending in just this direction. Nor does it guarantee social welfare. Erik Prince is an extremely successful “entrepreneur” in the actual existing American political economy. I’m convinced his personal success is of negative net value to society as a whole. And the United States has probably been more successful at rigging its webs of privilege toward openness to innovation than many other societies. It’s a very easy trick to get “wrong,” since the webs are designed by and for the people who already benefit from them. And they’ll all tend to go wrong over time, for the same reason. But they might be the true fertilizer which feeds “self-interest.”
Comment by Mike Kozlowski —
March 21, 2010 @ 11:51 am
I agree a lot with these analyses, but there are two things that I think you’re missing here:
1. Both you and Matt are underestimating how much money there is to be made in commodity margin areas. Yes, the corner dry cleaner doesn’t make much money; but the owners of a large, multi-state dry-cleaning operation very well might. I worked at a grocery retailer a while back, and that’s a very thin margin business, but boy howdy do they make up for it in volume.
2. As for where innovation comes from, well, that’s the part where competition actually works, isn’t it? If you introduce a new method of doing something, your advantage might be fleeting; but if your competitors introduce it and you don’t follow suit, you’re out of business. You need to innovate just to keep with the Joneses, or to try to steal some part of their customer base.
Comment by matthew h —
March 21, 2010 @ 12:44 pm
Innovation, to occur, does not necessarily require great monopolized rewards. Many people innovate to improve their own local business or personal environment, or to impress the gal. Or for sheer ego and fun. Neither Leibniz nor Newton got a monopoly on calculus AFAIK.
Comment by Thoreau —
March 21, 2010 @ 1:20 pm
All of the money from calculus was made in the derivatives market.
Comment by Mona —
March 21, 2010 @ 2:04 pm
Jim, I’m genuinely puzzled. Yes, some self-identified libertarians have not been willing to do other than defend so-called “free markets” when the reality is that there exist, as you say, such things as: “licensing; subsidies explicit and tacit; patents and copyrights; government contracts; regulatory capture.”
However, many libertarians have long decried those barriers, corporate welfare & such. I know I always have! (Not that I’m against all IP laws, but I do oppose the most absurd, such as recent extensions of the temporal length of copyrights.)
So, these days I label myself a “left-libertarian,” but my views on the items you and Yglesias identify have always — whatever species of ‘tarian I’ve claimed — been of strong concern to me.
Comment by Russell L. Carter —
March 21, 2010 @ 4:39 pm
Yes sir, this post is correct. Very well said. No chiding required when no compensatory condescension is attached.
@3 Thoreau, doesn’t that just suck? Well to be fair a big chunk of the profits is assigned to bombs. (How to make ‘em, how to deliver ‘em). But I guess the derivatives market could be thought of as “bombs” of a different sort. It’s bombs all the way down!
Comment by Jim Henley —
March 21, 2010 @ 5:18 pm
Mona, this post isn’t about whether and which libertarian hearts are “in the right place.”
Comment by Thoreau —
March 21, 2010 @ 7:06 pm
Russell, it was a pun on the word “derivative” which is also the name of a concept in calculus concept that has little to do with the investment instruments of the same name.
Comment by DCA —
March 21, 2010 @ 8:18 pm
See, for a fuller analysis:
Entrepreneurship: Productive, Unproductive, and Destructive. William J. Baumol. The Journal of Political Economy, Vol. 98, No. 5, Part 1. (Oct., 1990)
(just google Baumol Entrepreneurship to get online versions of this and other relevant papers).
His basic point is that all societies have entrepreneurs, but the structure of the society will determine if they apply themselves to adding or subtracting social value.
Comment by Glaivester —
March 21, 2010 @ 8:35 pm
But another way is to think about it from the point of view of a businessman. This competitive market sure looks like a horrible place! You might make a living there, but you sure as hell aren’t going to get rich. Think of the immigrant family that owns the dry cleaning shop around the corner—long hours, hard work, modest income. That’s your capitalism and it pretty much sucks.
I would have to agree with some of Matt’s commenters – if you define “rich” as “mega-wealthy like a Rockefeller” this might be true, but I would doubt that everyone would be living on subsistence in this “perfect market,” which is what Matt is implying. I’m sure there would be plenty of people who would be far wealthier than their neighbors. If the Bill Gateses don’t exist, they probablty weren’t necessary.
Also, the idea that profits tend toward zero is based on the idea the people would be willing to work without getting any profit – a merchant’s profit is simply the value of his being a nexus for goods and services (which is, after all, the function of a merchant). People won’t do it for nothing, and the people who do it the very cheapest probably don’t do it so well. So there is always opportunity for money to be made.
Comment by Thoreau —
March 21, 2010 @ 9:40 pm
Keep in mind that in Econ 101, profits include opportunity cost, and every book I’ve ever read includes a fudge factor of personal satisfaction (not usually called that, often called “psychic income”) to account for the fact that some people will do something for cheap just because they really love doing it. There can be variability of earnings within a sector, but the theory is that everybody in that sector is making zero profit because whatever they’re making is what they could have made (including the extent to which they value the enjoyment of running that kind of business) doing something else.
If that theory is taken literally, it’s pretty much useless. Even in a competitive sector (note that competitive and free market are not generally the same thing) there can be significant variability in earnings. However, the theory can provide useful guidelines nonetheless.
Comment by Pyesetz the Dog —
March 21, 2010 @ 11:50 pm
Some of us like inventing things. The problem is converting innovation into profit, not profit into innovation.
Comment by Kevin Carson —
March 22, 2010 @ 2:32 am
Another point along the lines of Pyesetz’s comment:
One of the most important trends in technology is that the cost of innovation is becoming lower and lower. When the primary innovator is the owner of a garage factory, and his primary reason for innovation is his own immediate utility, the whole fixed cost of innovation vs. marginal cost pricing thing becomes a lot less relevant.
Comment by Mona —
March 22, 2010 @ 7:49 am
Jim, I agree w/ your most excellent post, but I wondered what one was to construe about your essentially juxtaposing(a) being a former libertarian with (b)the idea that progressives might chide you for purportedly only realizing the points you made. I would hazard to guess you have long understood the problems of anti-competitive practices that you cite.
Comment by Kolohe —
March 22, 2010 @ 9:22 am
Yglesias mentions right after the exerpted portion “From a formal point of view, you could consider this a libertarian analysis.” so there is some not-just-subtext of where ‘libertarian’ hearts lie, at least in Yglesias’s mind.
“Obviously the whole reason to become a businessman in the first place is to get rich.”
I just want to point out again that for most definitions of ‘businessman’ – that is the ones that aren’t just another way of saying ‘people who exploit other people’ – this is not obvious, and I doubt it’s even true.
In his update, Yglesias says ‘no my original idea is not just that people are rent seeking bastages, don’t be silly’. So then what *is* his ‘interesting argument’ if it is more than just that?
Comment by Nicholas Weininger —
March 22, 2010 @ 9:57 am
Isn’t this theory just a generalized version of the case for strong patents? And if so, isn’t the empirical case for it at most as strong as the empirical case for strong patents? Which case is, AFAICT, contested at best. Kevin of course could tell you more about the contesting than I.
Also, if this were true, you would expect those societies and sectors that had relatively high levels of opportunity for creating rent-seeking to also see relatively high levels of innovation. This is essentially the opposite of the historical record as I understand it. Now it may be that we’re all on one side of some sort of innovation-vs-rent-seeking-opportunity Laffer Curve, and if we lowered the level of rent-seeking opportunity to below what it’s ever been before, innovation would suffer. But this is (a) hard to demonstrate and (b) at bes t a case for making rent-seeking opportunities only as low as the lowest levels we’ve seen historically, which in practice is a case for a moderately-radical libertarianism.
I’m also skeptical because there are so many ways to get temporary but large advantages over your competitors even without government. Perfect competition requires a frictionless world, and even an anarchist real world would have lots of frictions. Matt Y even alludes to a couple of them– network effects, temporarily “natural” monopolies. In innovation-heavy fields in particular, if you can be the first and best at doing a new important thing, and if you can attract the other best people who want to work with you because you are the first and best, you can maintain a large and lucrative lead in expertise for quite awhile.
Comment by b. —
March 22, 2010 @ 10:41 am
If science was run as a market, we would still be in the caves. The issue is *credit*, not rent. In both senses of the word *credit*.
Comment by Jack —
March 22, 2010 @ 10:58 am
See Joan Robinson on imperfect competition.
Coase and Williamson on the firm.
Akerlof and Stiglitz on imperfect information.
Krugman on economies of scale and the effects on international trade.
In econ 101 they show you the supply curve goes northeasterly; the demand curve southeasterly and they meet in a perfect equilibrium.
In econ 301 they show you how the supply curve can go southeasterly (with economies of scale) and demand curves can go northeasterly (with luxury effects, for instance) – equilibrium can never be reached.
Of course reality is complex. Most of time “markets work”. “Capitalism is the worst of all systems except for the alternatives”. But this is a pragmatic case for capitalism, not an uncritical, hero-worshiping, religious case.
Comment by Jack —
March 22, 2010 @ 11:06 am
Of course, the typical business school student – even MBA – takes only econ 101-102. They then go on to take marketing, accounting or whatever. The little bit of analytic geometry required for econ 101 gets them thinking they are “scientists”. They go and read Rand and think they are “artists”. And imagine they are priests at the high temple of free markets.
Gotta get them to take econ 301 or at least integrate its conclusions into econ 101.
Or maybe they need a course in “its not all about you”.
Comment by Jesse Walker —
March 22, 2010 @ 4:06 pm
In addition to other points made above (particularly in comments #1, 2, and 11), I’d add that most innovation does not consist of great big breakthroughs. It consists of incremental improvements to earlier incremental improvements. I don’t think you need the carrot of monopoly profits to inspire that.
Comment by Joshua Holmes —
March 22, 2010 @ 7:39 pm
Essentially, Matt quoted the Good Book, which somewhat presciently said, “The love of money is the root of all evil.” Someone who wants to be rich at the expense of any moral or ethical rule will often find ways to do it. This is just a subset of the problem of human evil. As always, the two questions are: 1. What does it mean to be “good”, if anything? and 2. How do you make people be “good”?
I further disagree that the only reason people go into business is to be rich. There’s also the pride of ownership, the pride of being one’s own boss and making one’s own rules, the satisfaction of craftmanship of your product or service, etc.
Comment by Kevin Carson —
March 23, 2010 @ 12:05 pm
Nick: I think both M. Yglesias and Jim would see it as part of the case for patents from the standpoint of those who want to get rich off them, but as the case against them from the standpoints of libertarians who want the market to make stuff cheap.
Jesse: Good point. And a good many incremental improvements involve primarily changes in the way things are done, rather than significant expenditures of capital.
Comment by Gene Callahan —
March 25, 2010 @ 12:52 pm
“The challenge that grows out of that is, in a regime of Econ 101 perfect competition, how much incentive actually exists for innovation?”
None.
“The profit potential of innovation itself is fleeting because competitors take your new ideas up swiftly.”
No, in the model, immediately.
“That implies that only systems that feature anti-competitive practices can offer a “profit motive” worthy of the name.”
No, because perfect competition is just a model, and it’s a model of a market that can’t even really be thought through with total coherence. (For instance, you have the problem that in response to, say, a shift in the demand curve to the left, all competitors should, in the model, be simultaneously quitting and re-entering the market!)
Hayek’s texts here are key: “The Use of Knowledge in Scoeity” and “Competition as a Discovery Procedure.” In the real world of dispersed knowledge, perfect competition is only an abstract foil and profit can arise from knowing something someone else doesn’t. (E.g., Hayek’s example of a ship that would be travelling half-full except for the fact you know who has cargo to load on it.)
Comment by Gene Callahan —
March 25, 2010 @ 12:55 pm
By the way, none of the above should be read as implying that rent-seeking isn’t rampant in the real market — just that, once we admit dispersed information, it’s not the only way to make profits.
Comment by Gene Callahan —
March 25, 2010 @ 1:01 pm
“Also, the idea that profits tend toward zero is based on the idea the people would be willing to work without getting any profit…”
No, what you get for working is not called ‘profit’ but ‘wage’.