Friday, February 19, 2016

The relationship between competition and welfare is not monotonic

Trying to relate welfare economics to public sector incentives in the course I teach on public economics, I make an effort to explain that competition is good for welfare... but not always. First there is the perfectly mainstream argument that there are market failures such as externalities, asymmetric information and public goods, which make perfectly competitive markets less than efficient. An interesting application of this reasoning is that competition for status creates a negative expernality, as explained by Robert Frank in a number of books and articles. For example, imitative consumption creates a scalation of expenditures that is wasteful and reduces savings or consumption in more productive activities. Also, relatedly, second best theory teaches that if we have market power and some other market imperfection, it is not necessarily welfare improving to increase competition, unless there is another policy instrument. Then competition does not do much in principle to reduce income inequality: if it reduces the power of monopolists, it may increase equality, but if competition creates unemployment or reduces wages, it increases inequality. Governments may want to reinforce the welfare safety net to make liberalization politically more acceptable.Then there are some subtle aspects related to incentives. The first is that at least the traditional textbook spot market is impersonal and ephemeral (Bowles), based on an extrinsic quid pro quo that makes selfish behavior more salient and undermines the role of intrinsic preferences. Competition in the workplace may undermine cooperative behavior, although competition for the job (competitive selection, not nepotism or patronage) or yardstick competition may be good for incentives without necessarily harming team spirit (ask Messi, Neymar and Suárez). Competition for status has negative externalities. Of course, it is easy to think about cases where competition is good for effort and therefore productivity (otherwise, your firm goes out of business), but the higher the competion the lower the profits and the marginal benefit of effort. Schumpeter would disagree that more competition is good for innovation, and that is why we have patents, but there is nothing like the quite life of the monopolist according to Hicks. Pros and cons, not a monotonic relationship between competition and welfare.

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