Mainstream competition theory is the theory of perfect competition (and also the theory of monopolistic-competition). Both of these theories result in an equilibrium position with no growth or economic change.

Mainstream growth theory explains how growth is caused by the advancement of technology. In New Growth Theory it is suggested that technology is created by investments in Research & Development (R&D). Growth theory has little (if anything) to say about competition.

Standard economics teaches of “perfect competition” as an equilibrium outcome where price equals marginal cost, economic profit is zero and efficiency is maximised. This is a static theory of competition. Competition is also a process and the theory of that process is the “theory of dynamic competition”.

This essay suggests that dynamic competition drives economic growth. Further, efforts aimed at achieving static competition (eg restricting mergers and market behvaiour) are likely to harm dynamic competition and therefore harm economic growth.

What is “dynamic competition”?

Dynamic competition is the process by which market players attempt to maximise their profits by competing in a marketplace that has other players who are also trying to maximise their own profits and welfare. 

Dynamic competition cannot be measured by the number of firms in a market or by how close the market is to “perfect competition”. Dynamic competition is measured by the barriers to entry and exit.

Dynamic competition is a constant process of innovation and immitation as firms attempt to organise their resources in such a way to maximise profits (by increasing revenue and/or decreasing costs). For an individual business, innovation and immitation are both new knowledge with costs to acquire.

The drive to acquire knew knowledge comes not only from the desire for more profit, but also from the more urgent desire to not lose current profits (or go out of business). Monopoly-pull incentive v competition-push incentive.

As knowledge requirements are constantly changing (changed preferences, resources, competitor behaviour etc) a firm must constantly be searching for new knowledge.

While immitation and innovation have the same impact on an individual business (as they are both new knowledge to the individual business) only innovation increases the total store of knowledge in an economy. Consequently, only innovation drives economic growth.

If the profit from innovation is “too high” then people will over-invest in new knowledge to the expense of investments in capital or consumption.

Investments in new knowledge have long-term benefits.

Investements in capital have medium-term benefits.

Consumption spending has immediate benefits.

The correct amount of spending in each will depend on the time value of money (ie discount rates). If we have a zero time value of money then we would value new knowledge more highly and reduce our spending on capital & consumption.

Immitation requires a Kirznerian entrepreneur and innovation requires a Schumpeterian entrereneur

Kirzner entrepreneur notices something that is costlessly knowable, but nobody else knew. Still needs to implement it (involves risk).

Risk drives innovation. In a competitive riskless environment there may still be an incentive towards efficiency, but little incentive towards innovation. That is, business will have a lower demand for new knowledge.

Risk is caused by lack of knowledge. Taking risks increases knowledge and increasing knowledge involves risk. Risks include changes in competition, technology, interest rates, exchange rates, preferences, policy etc. All business choices (including keeping the status quo in an equilibrium) involve risk.

One motivator for investing in knowledge is to achieve an economic gain. But an alternative motivator is to avoid an economic loss. Any action that removes the inherent risk of business from the businessman (ie government bail-outs) decreases the incentives of business to look for new knowledge.

The degree of risk aversion (willingness to accept risk) helps to determine the amount of investment and the expected return on investment. Less risk aversion = more investment = higher returns. The returns will be higher for two reasons: compensate for higher risk (therefore same expected return); and because no reason to avoid best return strategy (move to higher expected return).

Hayek understood the links between risk (uncertainty) and knowledge (discovery).

Hayek: “the results of a discovery procedure are necessarily unpredictable, and all we can expect by employing an appropriate discovery procedure is that it will increase the prospects of unspecified persons, but not the prospect of any particular outcome for any particular persons”

In other words — before the race, nobody knows who the winner will be. That is why they race.

Factors that determine the price of knowledge include:

* pre-existing knowledge in the economy (knowledge spillover decreases the cost of knowledge);
* transferability of the idea (some ideas are hard to transmit, eg old-age wisdom);
* knowledge of the knowledge (people may not know the idea is already known);

* natural intellegence;
* difficulty of the idea;
* complimentary knowledge (ideas can be self-perpetuating); and
* environmental factors.

The first three points show the impact of the knowledge spillover. The implication is that an investor in new knowledge with such spillovers wont receive a financial reward for the benefit of the spillover and there will be a consequent under-investment in such knowledge.

Sometimes there can be no knowledge spillover from previous knowledge as some knowledge has low transferability.

Demand for knowledge

There are various reasons why somebody might demand (ie be willing to pay for) knowledge:

* Financial reward;
* Fame;
* Curiosity; and
* Humanitarian reasons (e.g. cure for cancer).

When knowledge is pursued for fame, curiosity or humanitarian reasons then the knowledge spillover is not relevant.

For an individual, all knowledge has a cost to acquire (whether it is new or old knowledge). But unlike all other products, the price of knowledge is dependent on how many other people have the knowledge. The price of knowledge goes down when more people know it (decreasing marginal cost of knowledge). The cost of knowledge is especially high for the first person to acquire the knowledge because they had nobody to help them.

When one person’s knowledge decreases the cost of knowledge for other people this is a “knowledge spillover” (positive externality) and this is the most commonly cited market “failure” in the market for knowledge.

Common solution to the knowledge spillover: patents

Various solutions have been offered to offset the under-investment in new knowledge caused by the knowledge spillover. One solution is to give the innovator a short-term monopoly position over their idea so that they can make extra-normal monopoly profits.

This can be achieved by the government providing “patents” and therefore protecting their monopoly position. However, there are also costs of patents. These include:

* efficiency costs of monopoly;
* monopoly over ideas may reduce incentive to innovate;
* might encourage too much investment in new knowledge at the expense of capital & consumption; and
* rent-seeking, administration & compliance costs.

Non-government solutions to the knowledge spillover

* Keeping trade secrets
* First-mover advantage
* High cost of education (ie marginal cost of knowledge doesn’t decrease much)
* Driving up barriers to entry
* Different value of knowledge (ie knowledge not relevant to other people)

It is important to draw a distinction between “knowledge” and “human capital”. Knowledge is the total amount of ideas available to an economy, independent of how many people know the ideas. This is the relevant factor for considering the changes and growth in the total capacity of an economy.

Human capital (like all capital) is important — but ultimately it cannot cause economic growth.

Education does not increase the total amount of knowledge in society. Education provides more human capital (by mixing pre-existing base resources with pre-existing knowledge) but it does not increase the amount of knowledge. If knowledge were to be held constant then we would move to a steady state of human capital with education equal to human capital depreciation, and no economic growth.

Standard growth theory suggests that there are four basic factors of production:

* Land & resources
* Capital (including human capital)
* People
* Technology/knowledge

These are combined in the identity: y/n = A f (k, l)

Where y = income, n = population, y/n = per capita income, A = technology, k = capital, l = land/resources.

But capital is simply the combination of base resources (land, resources, people) combined with knowledge. So in essence there are only two factors of production — base resources (land, resources, people) and knowledge. Most things are a combination.

It is important to consider “knowledge” as broader than simply “technology”. There are two types of knowledge — technical knowledge & personal knowledge (Hayek). Both are necessary in production.

Assuming knowledge is constant then an economy will move to a steady state of per capita income using all available resources with all available knowledge. To consider economic change (including economic growth) it is necessary to consider changes in knowledge.

Conclusion: the study of economic growth & change is the study of changing knowledge

Understanding Real Business Cycles, by Charles I. Plosser (Journal of Economic Perspectives,Vol 3, No 3, 1989, pp51-77).

New Institutional Economics, by Peter Klein.

Austrian Monopoly Theory — A Critique (pdf), by Walter Block (Journal of Libertarian Studies, Vol 1, No 4, 1977, pp271-279). Reviewed on 24 August 2005.

The Austrian Theory of the Business Cycle in the Light of Modern Macroeconomics, by Roger W. Garrison (The Review of Austrian Economics, Vol 3, 1989, pp3-29)

The Use of Knowledge in Society, by Freidrich Hayek (American Economic Review, XXXV, No 4, 1945, pp519-530).

Hidden Order: The economics of everyday life, by David Friedman. Reviewed on 9 May 2005.

Carl Menger: The Founder of the Austrian School, by Joseph T. Salerno (published by the Ludwig von Mises Institute). Reviewed on 30 April 2005.