I. Competition and Economic Profit: the Traditional View

Competition is a major force in any economic system, but it takes a variety of different forms, some of which are productive and others destructive.  Successful economies tend to be those that channel competition into the creation of wealth and technical progress, since failing this, it easily becomes a force focused on redistribution that is wasteful and destructive of property or even of life itself.  In order to explore this issue, we first summarize some conventional economic analysis.

Suppose firms are earning economic profit in an industry that is perfectly competitive---meaning, in particular, that there is free entry and exit of firms into and from this industry.  The existence of econmic profit, which implies an above-normal return on investment, will cause expansion of supply, not only by existing producers, but also via entry of new competitors into the industry. Entry and supply expansion continue until all economic profits are competed away by the increase in supply, which brings down product prices and also pushes the opportunity costs of producers upward, if this is an increasing-cost industry. 

The appearance of economic profit thus plays a crucial role, acting as a magnet to draw forth supply increases.  Similarly, the appearance of economic losses would act as a magnet that repels supply from the industry.  In the long run, either economic profit or economic loss will disappear under perfect competition, but its appearance in the short run (or in long-run disequilibrium) is what makes the market work well, by adapting supply to shifts in demand and by motivating innovation and cost-effective production.  Over the long run, what happens out of equilibrium--or on the road to equilibrium--is critical in determining how efficient an economy will be. 

In the graph below, let demand and short-run supply be D₁ and S_S initially. The more elastic long-run supply curve is S_L--more elastic, because it allows for expansion of output via increases in capital as well as labour and gets around any decreasing returns to scale at the enterprise level via entry of new competitors. Equilibrium price and quantity are P₁ and Q₁. Then suppose that demand shifts upward to D₂, owing to a change in tastes. In the short run, the price rises to P_2S and quantity to Q_2S.  Entry of new competitors then drives price down to P_2L by raising quantity supplied further to Q_2L.  Of course, something similar would take place following an expansion of supply resulting from an innovation that lowers production costs. 
 

A positive economic profit means that a firm's revenues cover all its opportunity costs plus something extra left over for its owners and/or managers. If investments with a certain degree of risk yield 10% in other industries, then they would yield more than this--say, 15%--in an industry where excess or economic profit can be earned.  It is this something extra that attracts capital to the industry (and we note that economic profit, here 5% of the value of an investment, is customarily smaller than accounting profit).  An industry where investment with the same degree of risk yielded 8% would lose capital; its economic profit is ­2% of the value of the capital invested in the firm. 

II. Sources of Economic Profit

There are three sources of economic profit: 1.  The Rent to a Market Position when there are barriers to entry and/or exit; 2.  The Rent to a Product-Specialized Input when products are differentiated between firms and such inputs are not mobile between firms.  Such a resource is in vertical or upward-sloping supply to the firm using it, and no other firm uses exactly the same input or produces exactly the same product.  3.  The Return to Entrepreneurship.  Of these three, free entry and exit will compete away all the rent to a market position (see below), but not necessarily the rent to product-specialized resources. Moreover, while the first two may persist over the long-run, the return to entrepreneurship is economic profit or loss that arises in the short run, but disappears over the long run. It is considered a return to entrepreneurship, viewed as a productive input or factor of production. This suggests a reward for daring, skill, and risk bearing, although good fortune and good connections are often involved as well.  Moreover, even when it disappears over the long run, the appearance of economic profit or loss in the short run can enable someone to make or lose a fortune. 

III. Competition to Claim Economic Profit

If we ask why the rent to a market position disappears over the long run under free entry and exit, the answer in simplest terms is that supply expands as long as there is excess profit to be earned and contracts whenever there are economic losses. Economic profit or loss that appears in the short run, but disappears over the long run acts like a magnet, attracting resources into an industry and repelling resources from it. 

When it exists, however, economic profit in the form of rent to a market position does not play this role because it is protected by barriers to entry.  These barriers protect market power by protecting existing suppliers from entry of new competitors--generally, in industries that are monopolies or oligopolies--which implies that some firms have succeeded in establishing exclusive claims to excess profit. They have done this by by erecting the barriers in question, which prohibit or limit new competition. The resulting long-run profit is not a return to entrepreneurship, unless we are thinking of political entrepreneurship or of other efforts to restrict competition. The existence of rent to a market position is a sign of inefficiency, whose signature is often the "deadweight loss" triangle shown in many textbooks. 

Similarly, barriers to exit exist when firms unable to cover their costs are able (or forced) to remain in an industry, and when this can not be justified on efficiency grounds, owing to decreasing average cost (or increasing returns to scale). The "soft budget constraint" has been a highly effective barrier to exit in Sovet-Type and many transition economies, as well as in Japan and in several of the smaller Asian "tigers." Exit barriers also give rise to deadweight loss triangles.

But whether such a triangle gives a reasonable idea of the social cost of monopoly is open to question. To better grasp this and related issues, we draw on ideas from two seminal papers: Steven Cheung, "A Theory of Price Control", Journal of Law and Economics, April, 1974, and Richard Posner, "The Social Costs of Monopoly and Regulation", Journal of Political Economy, August, 1975.  The Posner article is sometimes said to be part of the "rent-seeking" literature, whose signal article is Anne Krueger, "The Political Economy of the Rent-Seeking Society," American Economic Review, June, 1974.  "Rent-Seeking" refers to competition to obtain "rents"--returns to inputs over and above their opportunity costs--through the political process. 

If we adapt the approach of Cheung in the article above to the present context, the existence of excess profit to which no one has an exclusive claim gives rise to two phenomena:

First, to the extent that no one can establish an exclusive claim, the profit will disappear. As we have seen, this happens through expansion of supply.

Second, firms will try to prevent it from vanishing by establishing exclusive claims to it. This would happen via erection of barriers that limit or eliminate competition. Sometimes these barriers are divided into two categories--"natural" and "artificial".

Suppose that one or more firms succeeds in gaining protection, in the form of barriers to entry that allow economic profit to persist over the long run, and suppose as well that some of these barriers are artificial.  (As markets have expanded in size with globalization, and production has become more flexible with computerization, natural barriers have tended to disappear or become weaker.)  Whereas profit arising purely from natural barriers is a reward for being first to market--and could also be considered a reward for entrepreneurship--profit protected by "artificial" entry barriers created by government is a reward for successful lobbying or for having the "right" political connections.  As noted above, any entrepreneurship involved occurs in the political arena, rather than the marketplace, and it sometimes happens that firms which grow large by innovating subsequently find it more profitable to shift to political entrepreneurship. (Small firms have also been known to band together to do this.)

Because it is valuable, a protected market position that yields long-run economic profit will be contested in some way. In order to gain and hold on to it, the firm may have to lobby, appear regularly before legislative hearings, hire extra legal counsel, and make political contributions, as well as direct appeals to the public. To maintain its monopoly, a criminal gang may have to be prepared to battle rival gangs in the streets. 

In short, if we compare two economies--one dominated by monopolies and the other by competitive markets--it would be wrong to say that the latter has competition while the former does not. Both will have competition, although in different forms.  In the economy with competitive markets, there is a better chance that competition will be wealth-creating, provided such an economy is also subject to the rule of law. In the economy with monopolies, competition is more likely to be wealth-destroying, and possibly, even destructive of life itself. 

This is not competition in the marketplace, which works by expanding supplies of goods buyers want more of and contracting supplies of goods buyers want less of, as well as by encouraging quality improvement, cost reduction, and development of new products and production methods. Rather it is competition to become the monopolist, or else the person who decides which firms may have monopolies, or the person who appoints that person, etc.  It is also rent seeking, as described above.

Recall that the presence of market power creates economic profit, which attracts competition to claim it, when no one has exclusive right to it.  Establishing exclusive right, moreover, may not be easy.  It is often possible to contest such a right through the political process, and, sometimes, even via theft or violence. The struggle between the Al Capone and Bugs Moran gangs to control the supply of alcoholic beverages to Chicago during Prohibition was not fought out primarily by offering better products at lower prices with better service.  Rather it was open warfare to decide who would be the monopolist and culminated in the St. Valentine's Day massacre.  By making alcoholic beverages illegal, the government helped to turn this market into a monopoly--since only criminal elements could supply it--but did not resolve the question of who the monopolist would be.

Thus the cost of monopoly will often exceed the area of the relevant deadweight loss triangle shown in economics textbooks. The costs of competing to become the monopolist--and to hold on to a monopoly position--could eat up all or part of the reward (the monopoly profit), with some of these costs being borne by firms that do not succeed in becoming the monopolist.  The costs in question are in addition to the standard deadweight loss.  As suggested above, such competition can be destructive indeed.  The deadweight loss triangle only gives the cost of restricting output below the level associated with all-around marginal cost pricing, on the assumption that the laid-off resources are re-employed elsewhere. 

As a general rule, moreover, competition, in the sense of low barriers to entry and exit, is a key ingredient in achieving satisfactory long-term growth, as noted above in website article #5 on Sustainable Growth.  This is because protection of monopoly power is often a barrier to entrepreneurship.  In particular, it often restricts the availability of finance for sunrise sectors with growth potential and thereby lowers intensive growth over the long run.

We can define government as the entity with power to create or destroy property rights that automatically apply to all residents of the territory under its jurisdiction.  Political decisions are those that determine what these rights will be, as well as the nature of the process that determines them.  In the present context, political competition, or rent-seeking, refers not only (or even primarily) to electoral competition, but also to competition between different organizations and individuals in society to influence government decisions. The latter competition exists in nearly all societies, but will be more open and represent a wider, more diverse range of views in societies that are "democratic," in the sense of allowing universal suffrage and electoral competition between independent political parties, which citizens are free to form.

By contrast, economic competition is competition within a given property rights framework.  In the above scenarios, economic competition is productive and wealth creating, whereas political competition is potentially destructive, and may be the largest part of the cost of market power to society. 

But economic competition can also be destructive and political competition in the form of rent seeking) can be productive. Suppose that, instead of competition to supply a product that is profitable to produce, we are dealing with competition to exploit a scarce resource to which there is free access.  From Market and State in Economic Systems, pp. 28-32, the value of this common-property resource will be destroyed through over-use and/or undermaintenance. The resource itself will often be depleted prematurely.  Once again, the two basic principles expounded above are at work. First, to the extent that no one can establish an exclusive claim to the return (here, the rent) from the resource, this return will vanish, in the sense of being offset by the cost of efforts (competition) to claim it.  If no exclusive claims can be established, the over-exploited resource will have no value. 

Fortunately, in many cases, the second basic principle also comes into play. That is, the parties involved will try to prevent the value of the resource from disappearing by establishing exclusive claims to it. Resources that are initially common property will then come into private and/or public ownership, with provision for restricting access to them, thereby preserving at least part of their value.  Many different configurations of property rights--each with different implications for distribution--may be able to do this, but the creation of such rights will be wealth increasing, provided the cost of creating them is less than the value that they preserve. 

Since lobbying and other activities of interest groups representing producers, consumers, environmentalists, etc. may be part of the process that shapes the new property rights, these activities can be productive, despite the presumption in the economic literature on rent seeking that they are always wasteful.  In particular, interest groups may play an important role in calling attention to the need for changes in property rights and in gathering and disseminating information, as part of the process that shapes them.  Potentially, the political competition to establish such rights is productive, whereas unbridled economic competition to exploit a scarce common property resource is destructive. 

What, then, is the difference between exploiting a market position and exploiting a scarce resource?  Why is economic competition productive in one case and destructive in the other?

A firm or group of firms supplying a given market would like this right of supply to be valuable, which is to say that they would like it to be protected by barriers to competition, which allow them to receive economic profit. These barriers limit access to the market by other suppliers, thereby restricting supply and keeping price above average cost.  A firm's market position then has a value to its owners or managers.  The problem is that this position has no value, as such, to society. That is, it yields no positive marginal product in production or marginal utility in consumption.  In an efficient world, it would therefore yield no income to its owners, which is to say that it would have no value to them.

By contrast, a scarce resource has a positive marginal product or marginal utility.  In an efficient world, it would have a positive value, which must be protected by restrictions on access to it.  (By "positive value" here, I mean that producers and/or consumers would be willing to pay for use rights to the resource, possibly including the right simply to view it.)  Just as the rent to a market position is vulnerable to increased competition among suppliers for access to that market, so the rent on a resource is vulnerable to increased competition for access to the resource.  The major difference is that the first type of competition creates a net welfare gain for society as a whole, whereas the second type destroys wealth and welfare.

As an example, consider the supply of taxi services to many North American cities vs. the systems of controlling some types of fishing in Australia and New Zealand.  These two systems are quite similar means of preserving rent, but one protects a monopoly, while the other protects a scarce and endangered resource.  In order to drive a taxi, an operator must own a licence or medallion in most metropolitan areas.  Only a limited number of these licences are issued, and new ones appear rarely, if ever.  The licences in question are a requirement over and above a chauffeur's licence and a safety certificate for the cab. They serve to restrict the supply of taxi services, which boosts the price of a ride and thus the economic profit that a cab can earn.  The licences are transferable and sell for the capitalized value of this expected future profit.  They allow drivers who sell their rights to collect all of this future profit and to take it out of the industry now.

By contrast, the same kind of transferable quota system for lobster fishermen has restricted fishing off Australia and New Zealand and successfully preserved stocks of this resource, which therefore have value.  Collectively, these licences are worth the capitalized value of the future rent on the resource, which is also the value of the resource.  Efforts to limit fishing off the Atlantic coast of North America have been far less successful, with the result that stocks of several species are rapidly depleting and earn no rent.  Australian fishermen also work less than their opposite numbers in Atlantic Canada and New England and earn higher incomes, which include the rent on the resource.  See John Tierney, "A Tale of Two Fisheries," New York Times Magazine, August 27, 2000. 

IV. Political Capture

A completely efficient set of property rights would maximize the total value of an economy's resources in production and consumption, net of the cost of establishing and enforcing these rights. It would assign a zero value to any potential "asset", such as a market position, without a positive marginal product or marginal utility.  An efficient society would therefore be one with a Constitution or Basic Law that succeeds in suppressing wealth-destroying competition, while promoting competition that is wealth creating. 

Because of distributional considerations, however, economists usually adopt a weaker notion of efficiency called Pareto Optimality.  In traditional welfare economics, an economy is Pareto Optimal when it is impossible to make one person better off (that is, with a higher utility or expected utility) without making someone else worse off at the same time.  A question then arises as to how an inefficient outcome--in the sense of an outcome at which a combination of taxes, subsidies, and other changes in property rights is possible that would make some people better off and no one worse off--could exist in a world of rational individuals.  Certainly, economists believe that they observe inefficiency--in the form of protection for market positions, price floors and ceilings, taxes and subsidies, and a variety of quotas and controls--all of which distort resource allocation or interfere with productive effort, in order to redistribute, income, wealth, and other benefits.

Such forms of redistribution may not always be less efficient than others, once all related costs, including information costs, are taken into account. Nevertheless, departures from Pareto Optimality can occur, because some outcomes are possible, but not politically feasible. In this context, Political Capture occurs when an interest group succeeds in using the public sector to inefficiently redistribute income, wealth, and/or other benefits to its advantage.  This redistribution must be inefficient in two ways.  First, The resulting outcome is not Pareto Optimal.  Second, the cost of this redistribution to the losers must exceed the gain to the winners.  The cost to the losers will equal the amount transferred plus any deadweight losses owing to resulting resource misallocation plus any costs associated with rent-seeking. 

Political capture therefore requires the sum of the latter two components to be positive, and this could happen for several reasons.  First, the costs involved may not transparent to those who bear them and who, in consequence, are unaware of these costs.  Alternatively, intimidation or use of force could bring such a result to pass.  A third possibility is that the benefits of redistribution are concentrated on a relatively small number of people, whereas the costs are widely scattered and therefore not salient in the minds of those who bear them when the latter make political choices.  Because elections are held only occasionally, even in a democracy, any candidate is evaluated on the basis of many choices, which are effectively bundled together.  Under dictatorship, political choice is even more restricted for most people.  Fourth, office holders facing periodic elections or evaluation may have short time horizons.   Finally, there is sometimes the tyranny of the majority when the majority voting rule prevails.  A group of 50% of voters plus one may be able to impose costs on the minority.  Under non-democratic forms of government, tyranny of the minority is possible. 

Why would an interest group seek an outcome which is not Pareto Optimal?  After all, might not some or all of its own members benefit if a Pareto Optimal solution were selected instead?  To explain this, we must say a word or two about the political process that generates property rights.  We borrow from a paper by Daron Acemoglu and James A. Robinson, "Inefficient Redistribution," MIT Working Papers on Political Economy, Cambridge, Mass., September, 1998. 

Political processes differ markedly from country to country, but we can think of all of them as ways of mediating or adjudicating between different interests in society, at least some of which are often represented by lobbies or political pressure groups. The method of balancing these interests, as well as the relative strength of each interest in the balance, will depend on the nature of the political system.  Within almost any system, however, an interest group will seek to acquire and maintain political power, in the sense of an ability to influence government decisions--laws, rules, and their application--to its advantage.  We could also say that it will seek a capacity to influence the shaping of property rights.

To this end, an interest group will seek not just any benefits for its members, but rather types of benefits that are more likely to preserve or increase its political strength in the future.  Future power and influence are important, because a government has, at best, a limited ability to commit now to future policy choices.  Suppose a government body grants certain firms the right to subsidies or to form and operate a monopoly cartel in perpetuity. Nevertheless, later on, this or another government body could find a way to weaken or even remove this cartel.  To preserve the value of its market position, the cartel must remain politically strong.  Thus the kinds of benefits an interest group will seek will be those which increase the size and assets of the group, as well as its attractiveness to the kinds of members (eg., relatively able, well-connected, or affluent individuals) that will augment its strength in the political arena.

Such a group will therefore try to use the political process as a means of attracting resources into its area of economic activity and/or of keeping resources it already has, even when these could be put to more productive use elsewhere.  For example, a declining industry may lobby to restrict competitive pressures on it or to gain subsidies that increase the demand for its product, reduce its production costs, allow non-competitive firms to stay open, etc.  This enables it to retain resources.  Successful lobbying may even allow the industry to survive rather than disappear altogether.   It won't be happy allowing its inputs to transfer to other sectors in return for compensation--the standard way of getting to a Pareto Optimal outcome--because the very effort to implement such a solution risks costing it future size, and therefore future power and influence. This has been a serious problem in transition economies, where sunrise industries often have relatively poor access to capital, which is squandered on politically powerful but inefficient sunset industries that waste it.

Similarly, a labour union may try to make it harder for employers to lay off workers who are its "insiders" or to use labour not covered by its collective agreements. Both union and employers may try to restrict competition from "low-wage" areas, especially when the latter are foreign.  While other types of subsidies (including lump-sum payments to its members, in exchange for removal of barriers) would probably be more efficient, they may also be inconsistent with the union's or the industry's ability to sustain its future lobbying strength, especially if we are talking about an industry in decline. 

The above suggests that the inefficiency associated with political capture will often be that of keeping/attracting too many resources in politically powerful sectors, when the inputs in question would be more productive elsewhere.  Note, however, that a firm or other entity with market power normally benefits from this by raising the prices of goods or services it supplies above competitive levels. The result is to restrict demand, but from what was said above, the same entities will try to offset this by using the political process to reduce their costs and/or to shift product demand outward.  Because of the offset, we can not be sure that too many resources will always be used in areas with relatively high degrees of political (and market) power. 

Indeed, the traditional view is that, in an economy with one monopoly and one competitive sector, too few resources are in the monopolized sector and too many in the competitive sector, because of barriers that prevent inputs from moving into the former.  This is the source of the standard "welfare loss from monopoly" mentioned above, which ignores political considerations altogether.  Because of its protection, a monopoly will set a higher price and a lower output than would a competitive industry, for any given demand and cost curves. 

But when greater size yields net benefits, in the form of higher future profit resulting from greater future political strength, the traditional MC = MR solution no longer governs monopoly price and output. Expansion of output now yields a marginal benefit, MB, in the form of higher future profit resulting from greater size and political influence.  This is in addition to conventional marginal revenue, MR.  If MB is calculated in current income equivalents, the monopolist will set output where MR + MB = MC, where MC is marginal cost.  Entry barriers of some sort are still necessary to preserve long-term gains from monopoly power, but output is now higher and price lower than in the traditional monopoly solution, for any given demand and cost curves.
 

Now it is unclear whether the monopoly will have a traditional triangle deadweight loss, but at least some of the resources that it uses in political competition are likely to be wasted from society's point of view.  On balance, it is unclear whether the monopoly sector will be larger or smaller relative to the competitive sector than it would be under all-around perfect competition with absence of political leverage by either sector.  In cases where declining industries are exercising this kind of power, however, the net result often appears to be to keep these industries inefficiently large, as well as to waste resources in rent-seeking and, possibly, in production as well. This waste, together with the denial of resources to potentially emerging sectors and to entrepreneurship, via subsidies and barriers that nourish the monopoly, may well be the biggest cost that a monopoly--or, more generally, a sector with political power--imposes on society. 

One such subsidy is superior access to capital. In this instance, the politically powerful sector gains relatively high access to bank loans and/or other types of finance at relatively low rates. This type of subsidy can often be given as well in ways that are not very transparent.  One result is to increase the size and capital intensity of the powerful sector, but the loans in question also finance outright graft and waste. 

By contrast, politically weak sectors face low access to capital at higher prices and may have to obtain investment funds or working capital on the black or "unofficial" economy--if they can obtain them at all--even though these inputs would be more productive here. Black market interest rates are generally far higher than those offered to favoured sectors. In many economies, powerful sunset industries and other inefficient enterprises appear to have relatively good access to loans, which they often don't repay, while sunrise industries with growth potential are starved of investment means.  This also stifles entrepreneurship, since venture capital is usually in especially short supply.  In addition, the obligation to subsidize weak sectors of the economy prevents the development of large or sophisticated financial markets. 

Finally, political capture is universal, but we might expect it to be a bigger problem in new democracies, as opposed to established ones. Building a successful democracy requires considerable know-how, much of which has to be gained via trial-and-error, and more generally, through experience.  Some experience is transferable, but new democracies are still likely to start further down the learning curve than those with a long history of democratic forms.

In addition, unless democracy results from a revolution that destroys the power of former elites, these elites may use their connections and insider knowledge to preserve their power in the new system.  They will seek to block the emergence of new, rival elites and may succeed in making the new system operate like the old in many ways.  Several transition countries appear to have fallen into this trap, which results in an inefficient quasi-democracy and quasi-market economy that stubbornly resists further political and economic reform.