Economics

How Market Competition Really Works

One of the best models of competitive markets in an economy is an evolutionary one.

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By Cameron K. Murray

One of the best models of competitive markets in an economy is an evolutionary one that embeds the ideas that cooperation and competition operating at different levels. The basic ingredients of the evolutionary approach are:

  • Variation – A process that varies inheritable traits at any reproducible unit (organism, tribe/colony, cell).
  • Selection – A process whereby the environmental conditions determine the reproductive success of a reproducible unit.
  • The result is a process of adaptation.
  • A firm (or any organisation) can be considered a reproducible unit.
  • The market and society as the environment which determines success and reproduction
  • Relative success matters for reproduction (firm growth and continued existence) rather than an absolute success.
  • Success depends on the local environment at each point time – there is no timeless correct way to do things, and there are environmental niches (sometimes temporary).
  • The success of markets in delivering efficient output is, therefore, the result of within-firm cooperation, and between-firm competition.
  • Without market level selection pressure, firms can become internally competitive, losing efficiency.

These ideas might make more sense with an example.

The core approach 
Imagine that within a firm every interaction amongst employees can be either cooperative, which results in improved production efficiency, or competitive, which helps one of the individual employees (conditional on the other being cooperative), but reduces the overall efficiency of the firm.

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It might be as simple as employees wasting resources blaming others for failures rather than working together to get an efficient outcome, or it could be as competitive and nasty as sabotaging the work of others in the firm to make yourself look good, which might be good for the individual, but bad for the company.

Perhaps the example of Amazon can help get your mind around this idea:

At Amazon, workers are encouraged to tear apart one another’s ideas in meetings, toil long and late (emails arrive past midnight, followed by text messages asking why they were not answered), and held to standards that the company boasts are “unreasonably high.”
The internal phone directory instructs colleagues on how to send secret feedback to one another’s bosses. Employees say it is frequently used to sabotage others. (Source)

The table below shows the stylised conflict between individual choices to cooperation or compete within a firm. For two people (A and B) who randomly meet within a firm, they can both cooperate and earn an individual payoff of 10 each (top left cell with A, B individual payoffs listed), giving the firm an overall payoff of 20. Or, one person can ‘defect’ while the other cooperates, giving that person a payoff of 15, but only a payoff of 0 for the cooperator, and an overall firm payoff of 15, which is lower than if people were cooperating. And the bottom right cell shows the payoffs if both people are competitive (the defect from cooperation), giving each a lower payoff of 5, and the firm a payoff of 10 (the sum of both people’s payoff).

Clearly, the best thing within a firm is for all interactions to be cooperative to get the highest total firm payoff, but there remains an incentive for each individual within the firm to occasionally defect and get a higher personal payoff.

Now, let’s think about market competition operating at a firm level. With more competition, would we expect the evolution of market to result in the success of more competitive individuals?

The diagram below shows a serious of three selection stages over rows from time one to time three. Each small table is an environmental or market niche, and each colour represents a single firm. So in the top row there are four firms (blue, green, yellow and orange).

Each small table shows in column N the number of cooperators or defectors within the firm. So in the top row blue table, there are 20 cooperators and no defectors in the firm. The next column, P, shows the average payoff to each person from random interactions amongst other firm staff. In the top row of the blue table the average personal payoff is 10 because all 20 staff are cooperators and every interaction with another cooperator in the firm gives a payoff of 10. The total firm (or group) payoff is in column G and is 200 in this instance (20 people getting a payoff of 10 each).

The next firm in the top row in green has within it 15 cooperating staff, and 5 defectors. The average personal payoff for the cooperators in that firm is 7.5 because they have a 1 in 4 chance of dealing with a defector, and a 3 in 4 chance of dealing with another cooperator. The defectors have a higher personal payoff of 12.5 for the same reason.

Moving across the top row, the yellow firm has 10 cooperators and 10 defectors. This firm is a nasty place to be, and half the time the firm is busy with staff blaming each other and not producing efficiently. The payoff (or total efficiency) for the firm is much lower, at a total of 150.

The last orange firm is mostly defectors, perhaps an extreme version of our Amazon example. The total payoff for this firm is just 125.

Outside these tables on the right side is a column N, which is the sum total of the number of people who are cooperators or defectors in each time period. In time one there are 50 cooperators amongst the firms (20 in blue, 15 in green, 10 in yellow, and 5 in orange), and 30 defectors.

Moving from time one to time two, or going down a row, is a selection stage in the competitive evolutionary game of market competition amongst firms. That is, only the most efficient firms survive, and the least efficient die off from lack of customers from their poor value products made inefficiently. In fact, in this example, the most efficient firm expands to take up the market niche left by the firm that dies off.

So when we move to the second row in time two, the least efficient orange firm has died off, and the most efficient blue firm has expanded to satisfy that market niche.

But notice this. When we add up the total cooperators and defectors working in all the firms in the market at time two, there are now 65 cooperators (15 extra), and 15 defectors (15 less), compared to time one. That is, competition at the firm level has led to the selection of the most internally cooperate firms to survive, not the most internally competitive. Going down one more row shows the new relatively least efficient yellow firm also dies off. Thus, what works at one point in time does not work at all points in time, and success in this game is only relative to others in the market environment.

The economic lesson from this simple example is that competition is good when it provides a selection mechanism that favours cooperative and efficient groups (or firms) that enable total production to expand. Variations that improve efficiency and cooperation within firms will, over time, be selected for by consumer choices in the market.

Within-firm competition with external costs
Let us now think about larger firms that have multiple departments making multiple products with a variety of different customers. We can also think of large bureaucracies in general, including government departments. Perhaps the above example has led you to think that competition within company departments might be a good way to select for the best ones. Unfortunately, this approach has a huge incentive problem, as the relative success of one department might be due to passing off costs to, or sabotaging, another. Thus, within-firm competition that results in an evolutionary selection process is very risky, and it is well known that ‘silos’ in firms can results in conflict between what is best for each silo, and what is best for the firm.

Unfortunately on most occasions, silos encourage behaviours that are beneficial to the occupants of the silo, but are often not in the best interest of the overall business or its customers. It also plays into the hands of corporate politics, since silos help to keep things private. And we all know that in office politics information is power.
 A recent survey from the American Management Association showed that 83% of executives said that silos existed in their companies and that 97% think they have a negative effect. (Source)

I capture the idea of sabotage, or passing on external costs to other departments, in the table below. Here the company has two departments (each small table), and within each department there is a choice to cooperate on either project A, which provides that department with a payoff of 20, or project B, which provides a payoff to that department of 10. However, project A comes with an external cost to the other department of 15.

For each department it is better to cooperate on A, giving them 20 each, but also inflicting an external cost of 15 each. The overall company payoff is just 10 in this situation. However, if the departments each cooperate internally on B, the overall firm payoff is double, at 20, as there are no other externalised costs.

Thus, for large organisations, the emergence of silos that are blind to the situation of other parts of the company may end up with a choice of projects and investments that are not overall optimal and efficient. Companies that find ways to ensure they maintain this inter-departmental efficiency as they grow are those that the market will select for.

Notice that this problem is a much more serious one in governments where there is no government-level selection pressure. At best there is an occasional change of government in a democracy, but rarely does this provide strong incentives to change operational processes all that much.

Indeed, the incentive to sabotage other groups and inflict costs on them also arise with market competition in general, and as such, provides a strong basis for competition laws and intervention where negative externalities from the activities of certain firms exist.

Muir’s chickens
The lesson here about market competition acting as a selection mechanism to favour firms that have high within-group cooperation is radically displayed in the experiments of William Muir, who bred chickens and either selected for a) the most productive individual egg-laying chicken, or b) the most productive cage of egg-laying chickens (in each cage were 9 chickens).

The results drive home the message of group selection is a process that increases the number of cooperators and total efficiency.

The first method favored the nastiest hens who achieved their productivity by suppressing the productivity of other hens. After six generations, Muir had produced a nation of psychopaths, who plucked and murdered each other in their incessant attacks. No wonder egg productivity plummeted! In the second approach, he selected the most productive groups and because they were already a group that worked well together, they included peaceful and cooperative hens. (Source)

Egg production by the cooperative cages increase 160% over just a few generations. More detail here.

Originally published here.

2017, November 30


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  • Lawrence Hamelin

    Your account of within-firm/between-employee behavior is plausible, but you seem to take the account of between-firm market selection for granted, without argument. Why should there not, for example, be a Prisoner’s Dilemma operating at the market level? This taking-for-granted is not unique to this essay; it seems pervasive on the site.

    As an economist (well, soon to be: MA in May, teaching in September), I think this sort of comparison seems to need mechanisms. It is not enough to posit just variations in the number of cooperators or defectors: what — if anything — about firms causes variations in the number of cooperators? Your invocation of Amazon (I’m not totally sure you deprecate them) seems to argue for an institutional foundation: employees cooperate or defect according to the policies, procedures, and culture intentionally fostered by upper management.

    Similarly, what mechanisms mediate between-firm market competition and selection? Who or what is doing the selection, and how does it mechanically take place? In biological evolution, the selective mechanisms are discernible: individual organisms starve, or are eaten, or are killed by pathogens, or fail to find a mate, etc. Economists tell stories in the classroom, but are these stories true? I don’t know any empirical work at this level. (The kind of applied econometrics I’ve been immersed in lately do not cover the sort of topics here.) If the between-firm selective mechanism were institutional, then attention to institutions seems warranted. What do the institutions select for and against? Which raises the normative question: to what degree should political intention — and whose intentions — play in those institutions?

    Finally, there seems to be some sort of unquestioned assumption that evolution is, if not the only or best mechanism of progress, but definitely powerful and good. I think this assumption is dangerous. If it were a deliberate choice by a moral agent, biological evolution seems horrifically evil; we tolerate biological evolution only because it is the working of unthinking physics incapable of morality. If economic evolution is different, then this difference in mechanisms and intentions would seem to deserve careful explication.

    • ckmurray

      All good questions Lawrence. Certainly there is a prisoner’s dilemma at a market level as well, which provides incentives fo collusion (either implicitly or explicitly).

      This post was just a summary of some discussion-starter ideas I teach in my classes to show that there are other ways of framing economic activity outside of the standard models. Of course there are many questions to be answered and many families of models will fit within this general framework.

      In terms of your ‘where are the mechanisms’ questions, these are exactly the type of questions I had of the standard economic theories of competition and markets! For example, what mechansim exists to create the assumed firms that compete in the first place? What mechanism gives the information to firms about how to act in anticipation of their competitors’ behaviour? And so on.

      • Lawrence Hamelin

        Indeed. I have the same questions of my own undergraduate and graduate economics education. Perhaps you or someone else — or maybe I myself — can begin to start investigating these questions.

        • ckmurray

          I think that’s what Evonomics is about – sharing some of the new insights into these questions. There are a few journals around dealing with them, but it’s a long journay to first start unravelling the jargon and approaches, then piecing together a consistent evolutionary view.

          • Lawrence Hamelin

            I’ve been following the site regularly, and I’ve seen a lot of conjecture. It’s promising enough, I think, to start to build an actual empirical research program.

            You claim here that market competition keeps firms cooperative, which is interesting. How can we measure cooperation within a firm? How can we measure market competition? How can we exploit variation in firm cooperation and market competition to at least get a correlation? Is there any way to do a natural experiment?

            My specialty is experimental behavioral economics. Perhaps an experiment could be designed to test these conjectures.

          • Lawrence Hamelin

            One other observation (related to my response to Stephen Morris above) is that the title seems like misnomer. I think you are trying to get to how market competition really works, but all we have is a model without clear guidance as to how to test it empirically.

  • Stephen Morris

    If we wish to promote evolution we need to remove the “barriers to variation”, the two most important of which are:

    a) purely elective government, which grants to politicians a monopoly on both initiation and ratification of legislation, thereby preventing much variation in legislation; and

    b) monopolistic sovereignty, which prohibits (often on pain of death) those who seek to incorporate their own states, thereby preventing variation in the scale, scope and internal organisation of states.

    The remedy for the first is some form of direct democracy which allows citizens (or perhaps a minority of politicians, or a number of states, or a number of municipalities) to initiate variant legislation which may be put to the people for ratification.

    The remedy for the second is a “polity market” based on the principle set out in Footnote 14 of Coase’s “Nature of the Firm”. The freedom to incorporate variant polities tends to evolve the optimal scale and scope of planning, as discussed here:

    https://www.macrobusiness.com.au/2013/09/thinking-like-coase-not-an-economist/#comment-276483

    • Lawrence Hamelin

      Three objections:

      First, it is unclear whether we wish to promote evolution; a biologist will tell you that evolution happens no matter what you do, so their task is to describe how evolution works. Economists tend to shy away, at least explicitly, from normative statements. The author seems to be talking about how market competition really works, not how he would prefer market competition should work.

      Second, it contentious that removing barriers to variation actually promotes evolution. Selection is important, and selection is by definition a barrier to variation, at least in the generation after selection takes effect. Any selection in economics must necessarily be social, so it is impossible to get society “out of the way” of “natural” selection.

      Third (related to the second), getting rid of purely elected government and/or monopolistic sovereignty are non-evolutionary (i.e. intentional social) impositions. Perhaps elected governments (none of which are, AFAIK, “purely” elected) and monopolistic sovereignty are the results of selection pressures. If this were the case, eliminating them would be contra-evolutionary. In much the same sense, in biological evolution, most niches are occupied (locally) by one species, a result of selection. The analogy between niche-dominance and monopolistic sovereignty seems direct and clear.

      • Stephen Morris

        All evolution takes place within an environment. If evolutionary theories are to have any practical application then the discussion must be one of which environment we wish to create for evolution to take place within.

        Otherwise we might as well stop discussing the matter here-and-now and confine ourselves to concluding: “It is what it is. Nothing can change. We live in the Best of All Possible Worlds. Let’s all go home.”

        If, however, we are prepared to address the issues of environment (the institutional “rules-of-the-game” within which evolution is to take place) then the issue becomes one of asymmetry between:

        a) moving AWAY FROM a status quo of purely elective government and/or monopolistic sovereignty; and

        b) moving TOWARDS purely elective government and/or monopolistic sovereignty.

        Each of elective government and monopolistic sovereignty exhibit Prisoners’ Dilemma effects which favour those who control existing institutions for collective action:

        a) existing political parties which can credibly offer future rewards to loyal members or campaign donors, and future punishment (i.e. dis-endorsement) to those who fail to toe the party line; or

        b) existing monopolistic states which can credibly threaten punishment to those who try to secede, and future rewards to those who fight secession.

        As collective action is more effective than individual action those who control existing institutions of collective action can readily maintain their status quo, whereas those who seek to overcome the status quo face the collective action problem of free-riders, each of whom may wish change but has a dominant strategy of sullen acquiescence.

        The result is a “meta-stable” state: not necessarily an equilibrium, but not able to move to equilibrium because of the transaction costs barrier. Prisoners’ Dilemma is an “anti-catalyst” which increases the size of transaction costs barriers.

        But there is nothing to suggest that that status quo is in any sense “superior” to other possible stable outcomes. Indeed, there is a forceful argument that it is “inferior” to a true equilibrium which would arise in an environment which eliminated unnecessary transaction cost barriers.

        The reason is the asymmetry referred to earlier. In an environment in which transaction cost barriers have been eliminated, there is nothing to prevent a move TOWARDS either purely elective government or monopolistic sovereignty:

        a) those who enjoy direct democracy may readily call a referendum to propose a variation back to purely elective government. In practice they never do, but there is no transaction cost barrier preventing it; and

        b) similarly, those who live is small states may readily negotiate to merge into a larger monopolistic state. Again in practice they almost never do (most systems of pooled sovereignty seek popular consent only for a very limited pooling and then grow it without further consent) but there is no transaction cost barrier preventing it.

        And so we come to the questions:

        a) In designing an environment within which evolution is to take place, what grounds are there for creating an environment of unnecessary transaction cost barriers which create a bias towards meta-stable outcomes?

        b) who is to make such decisions? and

        c) given that different people may have different preferences regarding environments (or on who is to make those decisions), how are those preferences to be aggregated?

  • Lawrence Hamelin

    I can see Stephen’s most recent comment in my email, but they have not yet appeared here. But because I presently have time, I will respond now. Since my response is lengthy, I will break it into parts. I hope the length of my comments will not offend our host.

    All evolution takes place within an environment. If evolutionary theories are to have any practical application then the discussion must be one of which environment we wish to create for evolution to take place within.

    I pretty much completely disagree with the second sentence. I think there is a lot of work to do before we get to creating an environment. We must begin, I think, with an investigation on what external constraints and processes are working on our societies, and what freedom of movement we have under those constraints. Naturally, our view of our external constraints will change over time, but we have to have some understanding first, and keep our eyes open for changes.

    More importantly, if we do have a choice as to whether to implement an evolutionary framework for social change, then we have to justify that choice; just because biological evolution is what actually happens does not by itself justify choosing that framework in a social context.

    Both of these considerations interact. If social evolution is an external constraint (as it is in biological evolution) then the morality of evolution is irrelevant; if it is a choice, the moral consideration becomes salient.

    I am not an evolutionary biologist, but I am reasonably well-educated for a lay person. As far as I can discern, evolution consists of the following premises:

    Whether we (or the organisms themselves) like it or not, there are heritable changes to organisms’ genotypes that sometimes correspond to individual organisms’ phenotypes (and sometimes don’t).

    Whether we like it or not, some phenotypes are better than others at reproducing for reasons of physics; the corresponding genotypes will (usually) have a change in frequency in the population.

    Whether we like it or not, there’s a lot of noise in the system: a lot of individual organisms differentially succeed or fail at reproduction for no better reason than chance.

    It is presently true that changes to genotypes are not correlated with changes to phenotype; for practical purposes, they are random. I do not believe that the evolutionary philosophical paradigm requires that all changes be entirely random; evolution would still hold if we made intentional changes, and the complexity of predicting the future would suggest that even the most careful intentions would still exhibit some random variation.

    I would speculate that at a social and economic level, evolution is both an external fact and a policy choice. At some level, whether we like it or not, ideas and institutions change, and ideas and institutions are differentially successful at reproducing themselves. Since this happens whether we like it or not, we can’t change this fact. We can, of course, keep this fact in mind as we create institutions.

    On another level, we do in fact intentionally create institutions, and we are free to adopt an evolutionary paradigm to design institutions. In this case, since we do have a choice, we have to justify both the efficacy and morality of whatever choice we do make.

  • If, however, we are prepared to address the issues of environment (the
    institutional “rules-of-the-game” within which evolution is to take
    place) then the issue becomes one of asymmetry between:

    a) moving AWAY FROM a status quo of purely elective government and/or monopolistic sovereignty; and

    b) moving TOWARDS purely elective government and/or monopolistic sovereignty.

    I’m a little confused. If purely elective governments and monopolistic sovereignty are the “status quo”, then how can we move towards them? You seem to claim we are already there, n’est ce pas? Still, your underlying meaning is clear enough.

    Your justification seems to be that “elective government and monopolistic sovereignty exhibit Prisoners’ Dilemma effects which favour those who control existing institutions for collective action.”

    Before we get to the mechanisms, I wish to make some general observations. Generally speaking, it is possible to move Prisoner’s Dilemma games around, but I would argue that they are fundamentally ineluctable at some level: you have to construct a PD game around another game to remove its PD-ness. So the objection that this or that game is susceptible to a PD interpretation is not by itself an objection.

    Your mechanisms:

    a) existing political parties which can credibly offer future rewards to loyal members or campaign donors, and future punishment (i.e. dis-endorsement) to those who fail to toe the party line; or

    b) existing monopolistic states which can credibly threaten punishment to those who try to secede, and future rewards to those who fight secession.

    do not seem to describe a PD game. A PD game requires that the Nash Equilibrium is not a Pareto optimum, and I can discern nothing in this passage nor the remainder of your post that describes a PD game. Perhaps I am missing something.

    Your argument seems to be that these institutions preserve the status quo. But so what? Evolution is and has always been a dialectic between stability and change. At the extremes, a completely static society is impossible, and even if possible would collapse when external conditions changed sufficiently. On the other hand, I do not want to wake up each morning to a completely different world, with completely different norms and institutions. Again, the metaphor of biological evolution seems salient: organisms have evolved mechanisms for DNA repair, which limit (but do not eliminate) opportunities to variation.

    I’m a communist, so I would definitely argue that there are desirable changes we can make to our present capitalist institutions. I would also argue that careful game-theoretic analysis can reveal important insights into our institutions regarding the justification for changes, tactics to achieve those changes, and limitations on the scope of their changes. However, I do not yet see that your specific game-theoretic analysis provides useful information.

  • As collective action is more effective than individual action those who
    control existing institutions of collective action can readily maintain
    their status quo, whereas those who seek to overcome the status quo face
    the collective action problem of free-riders, each of whom may wish
    change but has a dominant strategy of sullen acquiescence.

    As an economist, your terminology is a little confusing, but I think I can parse out your meaning.

    Your first statement seems to endorse Purely Elective Government and Monopolistic Sovereignty (PEG-MS). That PEG-MS (I assume from context that this is what you mean by “collective action”) is “more effective than individual action” then we have it just because social evolution has selected for it, and its evolutionary justification seems apparent.

    More importantly, that those who seek to change the status quo face obstacles and cannot easily implement their changes does not seem like an objection. At the extreme, I might want to be king of the world, but that I cannot easily implement that desire seems more like a feature than a bug. More realistically, as a communist, I do want to make changes to the status quo, but I do not hold just the difficulty of implementing those change per se against capitalist society. Capitalism’s resistance to change is not part of my objection.

    [T]here is nothing to suggest that that status quo is in any sense
    “superior” to other possible stable outcomes. Indeed, there is a
    forceful argument that it is “inferior” to a true equilibrium which
    would arise in an environment which eliminated unnecessary transaction
    cost barriers.

    Again, I fail to understand this objection from either an evolutionary or philosophical point of view. From the evolutionary perspective, no outcome is guaranteed or presumed to be better or worse. Indeed, advocating for evolutionary mechanisms seems to entail abandoning a priori judgements about potential outcomes.

    I do not know what “foreceful argument” you refer to. If you mean an argument in the Nietzsche-Hayek-Rand family, I think there are rebuttals that are at least equally forceful, and perhaps more so.