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EEI

INTRODUCTION

Recently Europe and the rest of the world have experienced the worst economic slump since the 1930s. There are some tentative signs that a recovery is under way, but the risk is high for setbacks in many parts of the world, particularly Europe and America.

As always happens during crisis situations, demagogues seize the opportunity to attack globalization. And while few outside extreme left wing and nationalist groups openly embrace the principle of restricted competition or protectionism, a disturbing number of leading politicians and pundits embrace positions which in effect are protectionist.

I will first here describe the benefits of free competition and globalization on a theoretical basis, illustrated with specific examples. I will also deal briefly with why some of the perceived benefits of restrictions of globalization is illusory, and the role that the euro and free financial markets play in promoting competition.

THE BENEFITS OF FREE COMPETITION

To understand the benefits of free competition, we should revisit the old neoclassical perfect competition model. That model have been critiqued by many because first of all it often overlooks how the existence of fixed or semi-fixed costs makes it irrational for marginal revenue to be equal to marginal cost, and secondly because it has many unrealistic assumptions that makes real world examples of it rare.

I largely agree with that criticism, but taking into account the existence of fixed or semi-fixed costs only means that an adjusted marginal cost is optimal. And while it is rarely seen in reality it remains the ideal state of affairs, all else being equal, a caveat you need to remember.

The reason for this is that if it is the case that a decision to increase production will lower the price not only of the extra goods but also the price of the goods that would have been sold anyway, then the marginal revenue (which is to say the additional net revenue caused by the increase in sales) of these goods will be lower than the price charged to consumers. And since the important things to firms is the marginal revenue, this means that they might abstain from additional production if the marginal revenue is lower than the marginal cost, even though the price charged to consumers is higher than the marginal cost. But since the difference between the price and the marginal revenue is only a loss for the firm, but not to society as that loss is a gain for consumers, this means that companies will choose a level of production which is too low to maximize overall utility.

This can be illustrated with a hypothetical example:

If for example a car company that produces a million cars at a marginal production cost of €8,000 per car and sells it for €10,000 decides to reduce its price to €9,000 because it reckons that they’ll still make an additional €1,000 per car when they sell to the 200,000 customers that are only willing to buy it if it costs €9,000 (plus a little extra in consumption taxes and car dealer margins). In this case, the previous million customers gains €1 billion from a lower price, the value of the new customers of the cars will be €200 million more than the cost of producing the cars. For the company however, its revenues will rise from €10 billion to €10.8 billion, while the cost of production will rise from €8 billion to €9.6 billion. As revenues because of the lower price for previous customers only rose €800 million thanks to the 200,000 extra cars, the marginal revenue was only €4,000 per car, lower than not only the price of €9,000 but also the cost of production of €8,000. As a result, the company actually lost €800 million from the price cut. Yet as that €800 million loss is lower than the total concumer gain of €1.2 billion, society as a whole would have seen its wealth rise €400 million.


This can also be illustrated in the following chart:



In a perfectly competitive market, the price would have been Pc and the quantity produced would have been Qc. But in a imperfectly competitive market, where marginal revenue is lower than prices, the price will instead land at the higher level of Pm while quantity will be at the lower level of Qm. For producers, the gains from the higher price consist in the ”A”-area while they lose the smaller potential gains in the ”B”-area. Consumers for their part will lose both the potential gains in the C-area and in the ”A”-area. The ”A”-area thus simply represents a redistribution from consumers to producers, while the ”C” and ”B”-areas represents economic efficiency-losses.

Generally speaking, the effect that increased output will have on price increases as the size of the company increases. This is because a given percentage increase in sales for a large company is bigger relative to the total market than the same percentage increase in sales for a small company, and all other things being equal a greater increase in supply will depress the price more.

Some economists have used this model to argue for draconian antitrust laws. But while it is conceivable that under certain circumstances antitrust laws could improve efficiency, in practice it will rarely do. One reason for this is as stated before that many overlook the importance for firms to cover semi-fixed or fixed costs. And a second reason is that creation of larger companies will usually create economies of scale, efficiency gains created by spreading out fixed and semi-fixed costs on a larger quantity of goods.

If legislators decided that only small businesses with two or three persons were allowed to produce cars, then cars would cost as much as hundreds of millions, or even billions, of euros per car to produce given the enormous amounts of money that it costs to build car factories, buy all the necessary equipment and raw materials and work on the actual construction of the cars. Not to mention of course, the amount of money it takes in research and development for new car models and features. But wth such high costs, almost no one would be able to afford cars and economic efficiency would clearly be far lower, not higher because of the forced break up of large companies. This example might have been a bit extreme, but the logic really applies to all sectors: namely the logic that benefits from economies of scale usually outweigh the negative effects of having marginal revenue below the price for many companies.

But while it is not certain whether the positive effects of increased competitive pressure from enforcing anti-trust laws outweighs the negative effects of reduced economies of scale, what can be certain is that free competition will have positive effects. With free competition, I mean removal of legal monopolies or other forms of legal restrictions to competition. This stands in contrast to anti-trust laws which constitute legally coerced competition.

But why should this be different from the issue of anti-trust laws? Couldn’t removal of barriers to competition similarly lead to losses in economies of scale that could to some extent cancel out the positive effect of increased competitive pressures?

No, and the reason for this is that here any reduction in company size will be the result of market processes rather than government fiat. The relevance of this is that smaller companies will only out-compete the larger ones if they have some kind of other advantage that compensates for the lack of economies of scale. For example, Swedish fast food chain Max was able to outcompete its much larger American adversary McDonald’s in Luleå and once also in three other northern Swedish cities: Umeå, Skellefteå and Piteå , despite the much larger marketing resources of McDonald’s and its bigger distibution chain. This was mostly because Max was much better in touch with the preferences of burger consumers in northern Sweden, something which compensated for the economies of scale advantage of McDonald’s.

Thus, while anti-trust laws provide at best only small benefits in terms of increasing competitive pressures and even these benefits are counteracted by decreased company efficiency. By contrast, free competition will not only increase competitive pressures, these effects will be reinforced (and not counteracted) by increased company efficiency.

Theoretically then, free competition is something that economic theory can unambiguously say is always beneficial.

The Link between Free Competition and Globalization

What then is the link between free competition and globalization? The answer is in short that globalization will at the same time enhance competitive pressure and economies of scale. Within a country, there is as was discussed before a trade-off between competitive pressure and economies of scale. But if domestic firms are able to sell abroad the products where they have a comparative advantage, and if foreign firms at the same time can

Imagine for example Swedish drug maker Astra being the only drug maker in Sweden and that foreign drug makers are shut out from the market. Obviously, they will not have a very competitive market. Nor will they be able to enjoy much economies of scale

What does this have to do with the issue of globalization? It is very much related to the issue of globalization as it expands the number of potential customers and so enables greater production volumes. If for example Swedish drug maker Astra (now merged with British drug maker Zeneca to form Astra Zeneca) could have only produced drugs for the Swedish market for a disease that affected 1% of the population then there would only be a potential market of only about 90,000. With such a small customer base, only very low research and development spending can be justified. If however Astra could sell in the European market, then the potential customer base would rise to about 5 million, potentially making research and development spending more than 50 times larger potentially profitable. And if it could be sold on the global market, then the potential customer base would rise to 67 million. Even if we exclude some countries that don’t respect patent rights or where people can’t afford it, we would still be talking about tens of millions of potential customers, compared to the 90,000 they would have if they had been limited to Sweden, enabling R& D spending several hundreds times larger to be profitable.

The potential gain in economies of scale for individual companies would be limited somewhat by the fact that they would face foreign competitors. But the increase in competition would be another factor that would improve economic efficiency.

Some Misleading Arguments against Free Competition

There are of course often counter-arguments raised against free competition and globalization. I will not here discuss all of the specific forms they come in, but they usually are variants of the two basic forms of fallacies that Fréderic Bastiat warned us about:

1) Looking only at the benefits of one group, while overlooking the harm done to others.
2) Looking only at the immediate effects, while overlooking the long term effects.

For example, it is easy to see how government subsidies or trade protection for one group, such as farmers or car workers will provide short-term benefits for members of those groups. They get money and jobs as a direct result of those interventions.

What is overlooked is however how first of all consumers and tax payers lose from these interventions. In the case of farm policy, consumers and tax payers have to pay more, and since competition is distorted and output limited, the losses for consumers and tax payers will exceed the gains reaped by farmers.

And to make matters worse, because such policies stifle innovation and productivity, it is not even certain that farmers benefit from these policies in the long term. One empirical example that indicates this is the case of New Zealand. When New Zealand abolished its farm subsidies, many New Zealand farmers feared a crisis for agriculture in New Zealand. And while there were initial problems, the increased competitive pressure have made the agricultural sector in New Zealand highly successful.

The Euro and Free Competition

EU both limits and promotes competition and globalization. Most of these examples are pretty obvious as in the case of external trade barriers and removal of internal trade barriers. For that reason, I will not in the limited time I have here focus on them. Instead, I will focus on something whose importance for free competition is often not well understood, namely the monetary union.

Many advocates of free competition in general, including for example the late Milton Friedman, advocates floating exchange rates, and argues that it is preferable to a monetary union. I obviously don’t have the time here to discuss all of the arguments for or against monetary unions that have been raised in the debate. Instead I will here simply points out why the monetary union promotes competition.

One reason for this is that when you have different national currencies, transaction costs inevitably arise. Thanks to today’s liquid currency markets, these costs aren’t great, but they are still a negative factor.

Another reason is the reduction in transparency as people don’t always understand just what the cost in their currency is. This is likely not a big problem either, but it is nevertheless a negative.

A third reason why the existence of national currencies inhibits competition is that they create exchange rate risks. Firms cannot be certain what future costs and revenues will be and might therefore abstain from projects that are likely but not certain to be profitable because they don’t want to take the risks.

The cost of this risk is reduced, but not eliminated by the existence of the financial instruments.

The fourth and arguably most important but often overlooked reason why the euro promotes competition is that it creates equal opportunities for companies regardless of where they are located, as companies cannot enjoy the benefits of an artificially cheap currency, or suffer from an artificially expensive, regardless of where they are located.

To understand why that is the case, assume that for example the Irish government had decided that they would slap imported goods and services with a 11.1% import tariff while at the same time providing a 10% subsidy to goods to exported goods and services. It should be obvious to everyone that this will distort competition. Yet this effect is identical to the effect of a 10% depreciation of the Irish pound if it had still existed.

Because it works in effect as combined import tariffs and export subsidies, having a weak currency is as much distortion of free competition as such tariffs and subsidies.

The Importance of Free Financial Markets for Globalization


Due to the economic crisis, the attacks on free financial markets have increased as they are blamed for the crisis. This accusation is not true as the crisis had its roots in monetary policy mistakes and various forms of regulations. I will not here elaborate more on that issue and will instead focus on the importance of free financial markets.

More specifically I will focus on the so-called Tobin tax that is proposed for currency markets. While as I just explained currency division inhibits and distorts international trade, that’s nothing compared to how bad it would be in the absence of currency trading, as that would force all countries to cease international trade and financial transactions, or limit it to pure barter. That would end all global competition and division of labor and cause a catastrophic decline in living standards. A practical example of how great damage that would create is North Korea.

Of course, few outside North Korea actually favor the end of all currency trading. Instead, they argue for things like the Tobin tax to curb speculative activity. If a Tobin tax was implemented, it is claimed that this would minimize speculative activity while having little effect on “legitimate” cross-border transactions and at the same bring in revenue.

No doubt it would bring in revenue and it would clearly also reduce speculative activities. Yet it would damage the people who engage in non-speculative transactions too. And this would not only be because they would have to pay the Tobin tax too. Indeed, even if there were some way to tax only speculators, the people who engaged in currency transactions for non-speculative reasons would still be hurt.

The reason for this is that without speculators, liquidity in the currency markets would be dramatically reduced. Lower liquidity would in turn mean that any large transaction would cause what is known as slippage. Slippage means that the price would fall because of the transaction and so people will always get a worse deal than the current quoted price, as any buyer would have to pay more and any seller would receive less. This will make people less willing to engage in these non-speculative transactions. This is a similar mechanism to the one described in the first chapter about how economic efficiency will be hurt if marginal revenue is lower than the price.

A Tobin tax would therefore limit globalization, which for reasons described in the second chapter will damage the economy.

Summary

Globalization is in effect a form of expansion of free competition across borders. Because it enables increased specialization, increased use of economies of scale and increases competitive pressures it is vital to ensure long term economic growth. Examples of obstacles to globalization that should be removed includes tariffs, quotas, subsidies, national currencies and regulation and taxation of capital movements.

Testing, testing

För att kunna granska.... Lite längre än så måste jag tydligen skriva i detta testande av hur det fungerar.