Lesson 3: Beneficiaries of Competition

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Concepts

market	entrepreneurship	competition
incentives	property rights	human capital

National Voluntary Content Standards in Economics

The background materials and student activities in lesson 3 address parts of the following national voluntary content standards and benchmarks in economics. Students will learn that:

Standard 4: People respond predictably to positive and negative incentives.

• Acting as consumers, producers, workers, savers, investors, and citizens, people respond to incentives in order to allocate their scarce resources in ways that provide the highest possible returns to them.

Standard 9: Competition among sellers lowers costs and prices, and encourages producers to produce more of what consumers are willing and able to buy. Competition among buyers increases prices and allocates goods and services to those people who are willing and able to pay the most for them.

• The level of competition in a market is influenced by the number of buyers and sellers.
• The pursuit of self-interest in competitive markets generally leads to choices and behavior that also promote the national level of economic well-being.
• The level of competition in an industry is affected by the ease with which new producers can enter the industry and by consumers’ information about the availability, price, and quantity of substitute goods and services.
• The introduction of new products and production methods by entrepreneurs is an important form of competition, and is a source of technological progress and economic growth.

Standard 14: Entrepreneurs are people who take the risks of organizing productive resources to make goods and services. Profit is an important incentive that leads entrepreneurs to accept the risks of business failure.

• Entrepreneurial decisions affect job opportunities for other workers.

Standard 15: Investment in factories, machinery, new technology, and the health, education, and training of people can raise future standards of living.

• Economic growth is a sustained rise in a nation’s production of goods and services. It results from investments in human and physical capital, research and development, technological change, and improved institutional arrangements and incentives.
• Historically, economic growth has been the primary vehicle for alleviating poverty and raising standards of living.
• The rate of productivity increase in an economy is strongly affected by the incentives that reward successful innovation and investments (in research and development, and in physical and human capital).

Key Points

1.  Overview: Lesson 1 identified the institutions common to capitalist economies and Lesson 2 argued that an institutional foundation of clearly defined and enforced property rights based on rule of law is essential to creating opportunities for people to escape from poverty. This third lesson continues the examination of institutions by focusing on competitive markets, the capitalist mechanism of exchange. The accompanying student activity, “The More, the Merrier,” simulates the greater availability of goods and services that occurs when competition is increased by opening markets to entry and exit.

2.  Key Terms and Concepts:

• Markets, and the rules that govern them, are institutions of voluntary exchange. A market exists wherever and whenever buyers and sellers interact to exchange goods, services, or resources.
• Market competition is the process by which the right to use resources is contested. It is the inevitable result of scarcity. Market competition is win-win rather than rivalrous (win-lose).
  • We often think of markets as places where buyers and sellers do battle, each trying to get the better of the other in the negotiation of price. In reality, competition in almost all markets takes place among buyers and among sellers, not between buyers and sellers.
    • Buyers compete with other buyers, trying to pay the least they can without losing to buyers who would pay more.
    • Sellers compete with other sellers, trying to charge the most they can without losing to sellers who attract buyers by offering a lower price.
  • Though we rarely think of it this way, a buyer-seller exchange is cooperative rather than rivalrous. In order for the transactions they both desire to take place, buyers and sellers must reach agreement – and they have strong incentives to do so.
  • Each is dependent upon the other in order to benefit; one does not benefit at the expense of the other.
    • Buyers depend on sellers to provide the products they want.
    • Far from wanting to “conquer” buyers, successful sellers come to understand that they are dependent on buyers for repeat sales and recommendations.
• Voluntary exchange: Market transactions are entered into freely, by both buyer and seller. Because exchange in markets is voluntary, every completed transaction indicates that, in the absence of fraud, deception or human error, both the seller and the buyer are better off. Their well-being has improved.
  • Each has given up something of lesser value to obtain something of greater value.
  • Repeated exchanges over time are particularly indicative of win-win outcomes.

3.  Markets are characterized by different degrees of competition.

• Capitalist economies are made up of many markets, with varying amounts of competition.
  • Some variation in competition is attributable to the characteristics of the product being marketed. Agricultural markets, for instance, tend to be much more competitive than markets for electricity or diamonds.
  • On a larger scale, differences in the institutional frameworks of property rights and regulation within a nation restrict market competition in some capitalist economies and enhance it in others.
• The degree of competition in any particular market is influenced by:
  1. the number of firms in the market;
  2. the relative ease of entry into and exit from the market;
  3. the degree to which the products of different producers are regarded by consumers to be substitutes for one another; and
  4. the relative availability and ease of access to information about the market.
• Competition may vary within an economy because of characteristics inherent in individual markets.
  • For example, grain markets are usually highly competitive because there are many sellers and buyers, and because one seller’s product easily substitutes for another.
  • The diamond market is less competitive because entry into the market is very costly, so there are only a few large producers and many buyers.
• The level of competition may also vary because laws and regulations within a nation may limit market entry and exit, the number of producers, and/or the availability of information.
  • For example, licensing of teachers, barbers, and taxi-drivers for quality and safety reasons also has the practical effect of reducing the number of competitors in those markets.
• The degree of competition in the economy as a whole is a function of the “rules of the game.” The institutional framework renders some capitalist economies open and highly competitive. Others claim to have market economies, but legal and regulatory restrictions close them to all but nominal competition.
  • Factors that determine the degree of competitiveness of a nation’s markets are:
  1. The rules of the game that affect market interaction, including:
     • the extent to which private property rights of both sellers and buyers are clearly defined;
     • the extent of the rule of law, and the expectation of consistent enforcement; and
     • the nature and extent of regulation of commerce.
  2. The extent of the free flow of information, including:
     • consumers’ access to information about the market, and
     • producers’ ability to disburse information about a product or service.
  3. The level of openness of entry into and exit from the market, including:
     • barriers to entry
       • legal barriers – licensing requirements, for example
       • extra-legal barriers – mafia-type intimidation would be an extreme example
     • the amount and quality of infrastructure (communication, transportation, banking, etc.).
     • (See the classroom activity, “The More, the Merrier”  for a simulation of the effects of opening markets. Linked below.)

4.  Throughout history and continuing to the present day, competitive market economies have the best record of reducing poverty and elevating overall standards of living by conferring benefits on the poor as consumers. (See Lesson 1 outline for data on countries that experienced significant reductions in absolute poverty by opening their markets in the last quarter of the 20th century.)

• A high level of competition among sellers leads to improvements in the well-being of the poor by making more goods and services available at lower prices.
  • Sellers compete with other sellers by offering lower prices, higher quality, or better service – whatever it takes to get buyers to purchase from them rather than from other sellers
  • Although sellers want to get the highest price they can get, competition from other sellers prevents them from selling at any price or “taking advantage” of the poor
  • As sellers search for lower-cost methods of production and increased productivity, competition forces prices down – meaning consumers must work less to pay for each purchase.
    • As Figure 1, below, indicates, a wide range of items in the open U.S. economy – from everyday food and clothing to cell phones and air travel – has become increasingly affordable.
      • This is especially clear when we look at the amazing reduction in the amount of labor time necessary to consume goods and services that, when they first appeared on the market, were luxuries of those at the upper end of the income scale.
      • Note, for example, that at the turn of the 20th century, a cell phone costs only 2% of the labor time needed to purchase one in 1984.

Figure 1

Source:   W. Michael Cox and Richard Alm, “Time Well Spent.” 1997 Annual Report of the Federal Reserve Bank of Dallas.   http://dallasfed.org/assets/documents/fed/annual/1999/ar97.pdf (accessed October, 2003)

• The competitive pursuit of lower production cost also leads to innovation, a process that makes affordable to the masses a range of goods once accessible only to the wealthy. (As mentioned in the Lesson 1 outline, even the poor in western market economies have household appliances like televisions, washing machines, dishwashers, stoves and ovens.)
  • As early as Adam Smith (in his 1776 Wealth of Nations), economists have argued that open markets increase division of labor and promote innovation. Data to support this contention are readily available in patent office records.
    • “. . . [A]s the Erie Canal progressed westward in the first half of the 19th century, patent registrations rose county by county as the canal reached them. This pattern suggests that ideas that were already in people’s heads became economically viable through access to a larger market” (World Bank 29, emphasis added).
    • See Lesson 4 Outline for a more detailed discussion of innovation.

5.  In addition to presenting poor consumers with more products at lower prices, competitive markets also create opportunities for the poor to increase their incomes as workers or entrepreneurs.

• The economic growth that is characteristic of competitive market economies creates jobs and leads to higher wage levels.
  • As growing economies compete for workers, wages rise. Higher levels of employment and sellers’ introduction of capital (in the competitive search for lower-cost production) lead to increases in worker productivity, which raises wages and incomes.
  • Higher wage levels allow workers to achieve higher levels of human capital, either through accumulated experience or through education.
    • Household surveys of developing nations with open markets indicate sharp declines in child labor as family incomes increase. Letting children go to school instead of working accelerates the accumulation of human capital and the productivity – and therefore the income-earning potential – of future generations of workers.
      • “In Vietnam, for example, the extent of work by children aged 6 to 15 had a clear relationship to household income in a 1993 survey. . . . [T]he income of the poorest 10 percent of the population increased more than 50 percent in real terms, which led to a sharp decline in child labor (and a corresponding increase in school enrollment rates)” (World Bank 117).
• Opening markets to competition also provides incentives that attract new entrepreneurs, at all income levels.
  • Even the minimal opening of markets in rural China has touched poor farmers. Instead of selling their produce to the state, they have become fledgling entrepreneurs, selling in agricultural markets.
  • “In China, much of the impetus for the rapid economic growth during the 1980s came from a tremendous expansion of rural township and village enterprise activities. . . . The inroads into rural poverty that were achieved in China during this period were nothing short of remarkable” (World Bank, 111). (See Case Study below.)

6.  Evidence of the efficacy of opening markets as a strategy for reducing poverty can be found even among nations that must be identified as “less capitalist” on our institutional continuum.

• The late 20th century provides instructive examples of countries, notably in Asia, that made significant standard-of-living gains by increasing both internal and external openness. (See Lesson 1, figure 3.)
• Privatization is one method of opening domestic markets in nations where the state has traditionally controlled production. In nations with private ownership of production, reduction of regulation may accomplish the same goal.
• Globalization, on the other hand, refers to opening a nation’s markets to competition from foreign producers.
• Lesson 1 identified the remarkable Chinese accomplishment since 1980 of reducing by 200 million the number of its poor citizens. Most of this success is attributable to the willingness of the Chinese government to tap the growth potential created by competitive markets.

Case 1: The Chinese Experiment:  Opening Markets Reduces Poverty

Introduction
In 1980, about 60% of those living on less than the equivalent of $1 U.S. /day lived in China and India, 600-700 million of those in China.   According to China’s own poverty line (equivalent to approximately $.70/day U.S.) 245 million people were extremely impoverished.  Most of the severely impoverished were rural peasants on communal farms.  The system of communal agriculture had produced consistently poor economic results characterized by periodic famines and the need for massive food aid from the United Nations.

Between 1977 and 1999 that number dropped to 33 million.  In December of 2003, the UN asked China to change its status from recipient to donor, in honor of ending its 25-year dependency on international food aid.

A March, 2012,  World Bank report, using the $1/day PPP standard echoes the Chinese findings:

1981	1984	1987	1990	1993	1996	1999	2003	2005	2008
730.4*	548.6	412.4	499.1	444.4	288.7	302.2	244.7	199.7	97.4

*millions living on less than $1/person/day, PPP

Source:  “World Bank:  New Data Show Historic Declines in Global Poverty.” March 27, 2012   http://business-ethics.com/2012/03/27/9309-world-bank-new-data-show-historic-declines-in-global-poverty/  World Bank update:  http://jrnetsolserver.shorensteincente.netdna-cdn.com/wp-content/uploads/2012/03/Global_Poverty_Update_2012_02-29-12.pdf

 The secret to China’s remarkable success:

“China has introduced truly revolutionary reforms . . . opening the economy to foreign trade and investment, and gradually making the legal regulatory changes that have permitted the domestic private sector to become the main engine of growth” (Dollar 16). 

 Opening Markets to Competition – Domestically and Internationally

Over the past 25 years, China has taken steps toward both privatization – opening internal markets to greater competition, and globalization – and opening its economic borders to increased international trade.

Although we would still place China toward the “less capitalist” end of the institutional spectrum we constructed in the Lesson 1 activities, it is instructive to note the reductions in poverty produced by even these beginning steps in conferring private property rights and opening markets to competition.

Timeline of 20^th Century Chinese Economic Reform

1950s	Agrarian Reform Law (1950) Abolished all private enterprise. Required that all Chinese agriculture be collectivized.  The Chinese commune system of agriculture was firmly established and all private farming abolished by 1958. Free trade in farm products was abolished and rural markets were banned. Output choices were made by government and commune teams were assigned output quotas. All output was delivered to the government procurement agency for distribution All foreign trade was conducted by the state. Major trading partners were Soviet bloc countries. Composition of exports and imports was determined by the state.
1960s	Continuation of closed, non-competitive system Characterized by low levels of economic growth and widespread extreme poverty
1970s	11th Chinese Party Congress (1978) Deng Xiaoping called for economic reforms, including the creation of Special Economic Zones (SEZ) to increase foreign trade
1980s	Reforms increased competition SEZs were established in villages in southeastern China Price controls were eliminated on many products “Household Responsibility System” replaced agricultural communes in 1982. Some opening of agricultural markets was allowed Foreign investors were given exemptions from all taxes and restrictive regulations IF they formed partnership enterprises with Chinese businesses (primarily export-oriented) Communes were broken up.  Families were assigned a piece of land and were allowed to decide what to grow and where and how to sell what they produced.  Individuals were no longer tied to particular pieces of land. People could leave farms if they wished and seek work in the cities. (Land “assignments” were not full property rights, but more like leases. Landholders could not sell land. Government allowed the emergence of rural township and village enterprises from the community-level structures that had been associated with the old commune system. Most of these were labor-intensive, export-oriented manufacturing firms This expansion of the non-farm sector provided alternative employment opportunities for rural peasants Housing was privatized. (Note, however, that home “owners” were not given full property rights.  Even today, the insecurity of house “ownership” means that homes are still not accepted as collateral for loans.  See lesson 2 for discussion of property rights and capital growth.)

Outcomes

• The right to enter the market with their produce drastically changed the incentives facing Chinese farmers.  Faced with the opportunity to affect their own well-being, the farmers responded as our model predicts; they produced much, much more than they had produced when they could not sell the fruits of their labor.
• This institutional reform led to a dramatic surge in grain production in China and fueled a spectacular poverty reduction between 1977 and 1987.
• Rural per capita income doubled.
• Agricultural and industrial output grew by about 10% per year.

For example:

“. . . [L]and-short Hong Kong industries were allowed to expand their operations into special zones.  As a part of this arrangement Chinese farmers were able to sell foodstuffs directly to them at whatever prices the peasants’ produce could command.  At the same time the state reduced the village rice quotas by 40% and eliminated other quotas all together.  Indeed within months the government’s procurement office for agricultural produce was closed down in the commune market town, and in its stead wholesalers from Hong Kong were allowed to set up buying stations.  They purchased fresh produce at prices several times higher than those previously available from the state.  This allowed Chen families to put most of their cultivation efforts into lucrative vegetable plots and they were also able to convert some rice paddies into commercial fish ponds for Hong Kong’s dinner tables.”  (Chan)

• The reforms also made an impact on non-agricultural sectors of the Chinese economy.
  • Foreign direct investment grew from $916 million in 1983 to more than $3.5 billion in 1990.

1990s

The success of 80s reforms served to highlight remaining problems: The coexistence of planned and market sectors of the economy gave rise to inflation and increased corruption. Competition was still highly constrained in most markets, which led to climbing prices for many products, especially urban prices for agricultural products.  (The Tiananmen Square Uprising was evidence of discontent with rising prices.) Deng Xiaoping was, however, convinced that China was headed in the right direction and he determined to continue reforms.  In 1992, he toured the SEZs in southern China to highlight the success of his liberalization policies and to launch a second wave of measures that further increased market competition: Foreign investors were allowed to create wholly-owned subsidiaries, and were no longer required to set up joint ventures with Chinese companies. In order to encourage imports of advanced technology and exports of manufactured products, 15 free trade zones, 32 state-level economic and technological development zones, and 53 new industrial development zones were established in large and medium-sized cities. Private enterprise was allowed to enter sectors of the economy that had previously been closed. (In 1991, the first McDonald’s opened in Beijing.) Eased price controls further. In rural areas, local township-village enterprises were allowed to privatize. In 1997, the 15th National Party Congress committed to reform and/or privatized SOEs (State-Owned Enterprises) in steel, coal, shipbuilding and other heavy industries.

Early Outcomes

• The Chinese economy quickly became noticeably more market-oriented:

Composition of National Industrial Output (%)
	1978	1999
State-owned	77.6	28.5
Collective-owned	22.2	38.5
Private	0.2	33.0

Composition of National Retail Sales (%)
	1978	1999
State-owned	54.6	24.3
Collective-owned	43.3	18.2
Private	2.1	51.5

 Source:  Statistical Yearbook of China; China Economic Information Network (www.cei.gov.cn), January 31, 2000.  from  “China’s Economic Reform:  Past, Present and Future,”  by the Overseas Young Chinese Forum.  http://www.oycf.org/Perspectives/5_043000/china.htm   (accessed March 4, 2004)

• In December of 2001, China formalized an agreement on conditions allowing it to enter the World Trade Organization (WTO):
• 1998 exports of agricultural products totaled $26.2 billion, a 150% increase over 1980.
• In 2002, China became the world’s top destination for foreign direct investment, with $53 billion in investment flows.
• 2003 GDP was 8 times as big as it was 25 years earlier, in 1978.
• 2003 share of global trade was 6 times as big as it was in 1978.
• China agreed to reduce its average tariff rates from 21.2% to 17% by 2004.
• China agreed to eliminate non-tariff trade restrictions on wheat, rice, corn, cotton, soybean oil, sugar, and wool.
• China agreed to open its financial service industry to foreign banks and investors by 2007.

Conclusion

While China has certainly not abandoned communism, the government taken steps to incorporate some forms of the property rights and market institutions characteristic of capitalism.  Most noticeable have been the opening of domestic markets through increased privatization, and the globalization of the Chinese economy through entry into international markets.  The fact that China has experienced such great poverty reduction as a result of having taken only small steps toward incorporating markets offers impressive evidence of the ability of capitalist institutions to generate wealth and raise standards of living.

Economic growth is the key to increasing standards of living, and clearly, China’s willingness to begin opening markets to competition has reaped the predicted benefits of lower prices, higher incomes, and rising standards of living.  Since 1980, fledgling market institutions in China have resulted in a soaring rate of economic growth that has outpaced not only developing countries but also the United States and other western nations.  The beneficiaries of that growth are the millions of nameless Chinese no longer included in the world’s “extremely impoverished.”

 Average Annual Percentage Growth in GDP

	GDP		Agriculture		Industry		Manu-facturing		Services
	1980- 1990	1990-2001	1980-1990	1990-2001	1980-1990	1990-2001	1980-1990	1990-2001	1980-1990	1990-2001
China	10.3	10.0	5.9	4.0	11.1	13.1	10.8	12.1	13.5	8.9
U.S.	3.5	3.4	3.2	3.5	3.0	3.7	3.1	4.1	3.4	3.7
High income countries	3.3	2.5	1.9	1.1	3.0	1.8	1.7	2.4	3.5	3.0
Middle income countries	2.9	3.4	3.4	2.1	3.2	2.7	3.7	5.7	3.2	3.7
Low income countries	4.5	3.4	3.0	2.6	5.5	2.9	7.7	3.0	5.5	5.1

Source:  http://www.worldbank.org/data/wdi2003/pdfs/table%204-1.pdf

Significant growth continues into the 21^st century:

Source:    http://asiapacificwatch.wordpress.com/2012/04/14/assessing-china-gdp/

7. Markets and competition do generate large productivity gains that increase the size of the economic “pie” that a nation’s population shares.  Opening markets to competition does not, however, guarantee that the wealth created by economic growth will be distributed evenly.  Depending on the configuration of a nation’s other social, political, and economic institutions, greater income inequality may accompany market expansion.

• However, the evidence is clear that where freedom of choice and market entry have been curtailed in the name of income equality, the size of the economic “pie” has grown very little and the poor and other segments of the population have advanced more slowly than in nations that tolerate some income inequality in the course of economic growth.
  • “A widespread anxiety is that growing integration [globalization] is leading to heightened inequalities within countries.  Usually, this is not the case.  Most . . . countries have seen only small changes in household inequality, and inequality has declined in such countries as the Philippines and Malaysia.  However, there are some important examples that go the other way. . . . Latin America, due to prior extreme inequalities in educational attainment . . . has further widened wage inequalities.  In China, inequality has also risen, but the rise in Chinese inequality is far less problematic.  Initially, China was both extremely equal and extremely poor. . . . Since the mid-1980s there has also been rapid growth in urban agglomerations; this has increased inequality as the gap between rural and urban areas has widened.  If this increase in inequality in China has been the price of growth, it has paid off in terms of a massive reduction in poverty.  The number of rural poor in the country declined from 250 million in 1978 to just 34 million in 1999” (Stern 5-6)
• In market economies, access to clean water, housing, heat and affordable food has moved millions out of absolute poverty, even in areas where significant relative poverty, or income inequality, remains.  (See Lesson 1 outline for definitions of absolute vs. relative poverty.)
• The most important outcome of markets for improving the wealth of the poor is the general, sustained increase in the standard of living brought about by producers and sellers constantly seeking ways to beat the competition through lower prices, improved quality, and greater variety of goods and services.  While managed, closed economies may experience isolated, one-time jumps, economies with open, competitive markets gain from gradual, long-term advances.

Conclusion

Thus, we may add “open, competitive markets” to the list of capitalist institutions that generate wealth and improve standards of living. It bears repeating that the evidence of the 20th century is in: Market economies with high levels of competition are those with the best record of reducing poverty and elevating overall standards of living.

In the Lesson 3 activity, “The More, The Merrier”,  students participate in a market that expands – from two (state-designated) sellers to many sellers. They experience the lower prices and greater availability of products that accompanies the opening of markets. The recent histories of nations as diverse as Russia, Uganda, Vietnam, India and China testify to how reliably the activity simulates reality.

Classroom Activities	Lectures (streaming flash video, ppt with voice-over, from Is Capitalism Good for the Poor? Online for Teachers)
The More the Merrier	Beneficiaries of Competition (19 minutes)