Dogma Premise # 5

 Markets prevent abuse of power or inefficiency among private producers.

Even people who are deeply skeptical of Capitalism are often surprised to learn that markets are intrinsically inefficient, and moreover do not even create pressure toward efficiency among competing producers.

The theory that markets force competing producers to become efficient is based on a familiar scenario.  Imagine a competitive market, in which a number of competitors produce, for example, a widget.  If one of the producers is less efficient (e.g., the workers are slower or their materials are more expensive), they will have to sell at a higher price, which will result in lower sales, which reduces investment, and eventually the firm will either become more efficient or go out of business.

For this to actually work in the real world, markets must be efficient and competitive, and producers must respond to competitive threats by becoming more efficient.  Typically, none of these conditions hold true.

First, markets are not intrinsically efficient.  Suppose that ten widget makers supply the market for widgets.  These ten firms have not only ten widget-making machines, but also ten sets of financial books, ten sales forces, ten marketing departments, ten legal counsel, ten customer service operations, ten brands to maintain, and ten tax returns to file.

This massive redundancy provides some benefits -- for example, if something bad happens to one of the firms, the others can still serve the market -- but efficiency is not among them.  Instead, the inherent redundancy of competitive markets is a massive inefficiency tax that defeats scale economies and increases the cost of all goods.

This is one of the reasons that mergers are so strongly favored by large companies -- the acquiring company typically fires half the staff of the acquired company, but keeps all the customers, and sees an immediate jump in per-unit profitability.  The instant savings is used to pay off the money borrowed to purchase the company in the first place.  If mergers are motivated by efficiency gains, it is because market competition is intrinsically inefficient.

However, even if market structures are not maximally efficient, it is supposed that competition within the markets nonetheless drives important efficiencies.  Most casual observers are surprised to learn that markets are considered either more competitive or less competitive, and that economists agree that perfectly competitive markets are rare to non-existent in the real world.  Instead, market participants are typically able to exert some influence over the price of goods, due too defects in the number of buyers or sellers, the amount of information available, transactions costs, entry and exit costs, and many other factors. Markets in the real world almost never deliver optimal efficiency in terms of pricing and production, but instead are riddled with structural flaws that ensure another layer of inefficiency is built into the sale of every product.

Yet it may be argued that even though markets have some intrinsically inefficient elements, and also some practically inefficient elements, they nonetheless are reliably effective at motivating good behavior from producers.

Would that it were so.

The good behavior that markets are supposed to incent is finding efficiency.  However, the actual behavior motivated by markets is seeking profits.

One way of increasing profitability is to become more efficient.  However, there are other ways, too, and unfortunately, finding efficiencies is not usually the most efficient way of finding profits.  A faster and more reliable route to profitability is to create market distortions.

So, for example, if a salt-seller is faced with diminishing profits due to a competitive market for salt, the producer might look for a more efficient method of creating or distributing salt, thus driving the market price even lower.  But this is hard work, and for most firms it is not their first response to a competitive threat.

Instead of becoming more efficient, imagine that the firm adds an extra nutrient to the salt, calls the nutrient “X21,” trademarks that name and markets it extensively, purchases the competitor that is selling at the lowest price, and creates an exclusive distribution agreement with WalMart ensuring that no other brand of salt will be offered alongside the producer’s salt in WalMart stores.

Adding the nutrient creates a differentiated product and makes price comparisons more difficult because the products are no longer identical.  Giving the nutrient an ambiguous name eliminates perfect information, because buyers may not be entirely sure whether the added nutrient is valuable or not.  Marketing the name shifts the locus of competition from product to brand and makes it more difficult for the generic competitor to sell against a recognizable name associated with vague but unfalsifiable product benefits (e.g., Morton Salt -- When it rains, it pours”).  Purchasing a low-priced competitor directly reduces competition.  If enough firms are taken out of the market, price-leading oligopolistic behavior may be attempted.  Finally, the exclusive distributorship agreement eliminates competition at the point of sale, blocking the success of a more efficient competitor.

And these are just a few of the basic moves from a long, long playbook taught to MBA students at every business school.  In most cases, more profitability can be achieved more quickly through market distortions than through efficiency gains.

Markets are not intrinsically efficient.  They are almost never perfectly competitive, and to the extent that they are competitive the market participants are likely to respond in ways that reduce the effect of competition rather than to increase their own efficiency.

This is why we cannot depend on markets to prevent inefficiency among producers.

Dogma Premise 6

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