The assumption of ‘perfect competition’ is central to marginalist (neoclassical) economics. In classical economics, a strand of non-orthodox economics, a seemingly similar but fundamentally different assumption of ‘free competition’ is made. This blog post is about the differences between classical and marginalist economics with respect to their definitions of competition. A further comment relating to the method of economics is also made in connection with this matter in the concluding paragraph.
In marginalist economics, under conditions of ‘perfect competition’, the demand and supplies of commodities and all factors of production are in equilibrium. There is no unemployment of labour or any underutilization of capacity (‘capital’). What are these conditions of ‘perfect competition’? A large number of firms is assumed to exist, each too small to be able to set the price. That is, all firms are price takers and they attempt to maximize their profits. There are no barriers to entry or exit. Further, it is assumed that whatever the firms supply, there always exists sufficient demand. One wonders whether there is any real agency to these price-taking firms and entrepreneurs. When questions are posed in classrooms about their correspondence with reality, the response provided is that such conditions do not actually exist but are a first and a necessary abstraction so as to examine conditions of oligopoly or monopolistic competition. So, what is profit in marginalist economics under ‘perfect competition’? It is the marginal product of ‘capital’, which is zero entailing that profits just cover the interest costs; that is, are no returns to entrepreneurs undertaking risk and uncertainty? Ignoring the capital theoretic problems faced by marginalist economics, underlying this conception is the view that capitalists and workers are (‘justly’) rewarded for their contribution to production.
On the other hand, classical economists, from Adam Smith to Karl Marx, and contemporary economists following the classical tradition, after its revival by Piero Sraffa in 1960, assume ‘free competition’. There is free mobility of labour and ‘capital’. Firms and entrepreneurs are profit maximizers as in marginalist economics. No restrictions are imposed on the number of firms or their ability to set prices. The process of competition – profit-maximizing behaviour plus mobility of factors – tends to make the market prices gravitate towards long-period normal prices and a uniform rate of profit is obtained on the capital advanced. Note that the rate of profit is not zero as in marginalist economics. Alterations in demand and supply affect the market prices. If market prices fall below normal prices, production is not profitable and depending on their permanence the affected firms might exit the industry. Alternatively, production may be cut down because of the lack of adequate demand. Moreover, real wages are determined by wider social and political forces. If real wages are given (and given technology), the rate of profit and the configuration of normal prices are determined. Or, if the rate of profit is determined via the rate of interest set by monetary authorities, the real wage and the set of normal prices are determined. That is, distributive variables are capable of being determined exogenously. This is in stark contrast with the marginalist theory – the marginal productivity theory of distribution, as it is called. Classical economics in contrast to marginalist economics has a logically consistent theory of value and distribution embedded in a framework of competition with realistic conditions. Also, classical economics is able to accommodate institutions, be it collective bargaining or monetary policy, within its framework without any difficulties.
To conclude, besides other logical problems marginalist economics faces, it also possesses a rather restrictive notion of competition. But, does economic theorizing require such an assumption? My answer is in the affirmative. To identify casual chains, however short they might be, an environment of ‘free competition’ must be assumed. With free mobility of labour and ‘capital’ – a genuine conception of a competitive economy, a uniform rate of profit is obtained. But, note that a classical competitive equilibrium does not entail full employment. [Non-competitive elements will generate differential profit rates.] So, should we abandon the study of economic phenomena under ‘free competition’? No, because it conveys to us tendencies in a competitive economy and non-competitive processes are conceptualised as a departure from competitive ones.