Perfect Competition and The Creativity of The Market (2001) Louis Makowski and Joseph M. Ostroy

American Economic Association
Perfect Competition and the Creativity of the Market

Author(s): Louis Makowski and Joseph M. Ostroy
Source: Journal of Economic Literature, Vol. 39, No. 2 (Jun., 2001), pp. 479-535
Published by: American Economic Association
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Journalof EconomicLiterature
Vol. XXXIX(June 2001) pp. 479-535
Perfect Competition and the

Creativity of the Market
LOUIS MAKOWSKIAND JOSEPHM. OSTROY1
Thecompletetheoryof competitioncannotbe knownbecauseit is an open-ended theory;it is

willbeposedinthisframework,
alwayspossiblethata newrangeofproblems andthen,nomatter
howwell-developed thetheorywaswithrespectto theearlierrangeofproblems,it mayrequire
elaboration
extensive inrespects it hadglossedoverorignored.(GeorgeStigler
whichpreviously
1957,p. 14)
1. Introduction associated. The historical part helps ex-

plain how perfect competition acquired
COMPETITION IS A central idea in its current formulation, with the im-
economics; its idealization as per- plicit presumption that it could have
fect competition underlies much of tra- been otherwise.
ditional analysis. But contemporary re- We take as our starting point the con-
search is largely directed elsewhere. Is tributions of William S. Jevons (1871),
perfect competition's time in the spot- Carl Menger (1871), and Leon Walras
light past? Should it now be moved to (1874), which marked the break between
the periphery to make room for new classical and neoclassical economics.
ideas? Our view is that anything that has When compared to David Ricardo, a
been so important and has survived for key figure in classical economics, the
so long is too valuable to be put aside. common marginalist elements in their
Every effort should be made to preserve work are an instance of simultaneous
its centrality, even if that means revising discovery. However, when viewed on
the way one thinks about the concept in their own, the styles and contents of
light of recent challenges. their contributions are quite different.
An important part of our story is an The dissimilarities between the Aus-
account of the development of perfect trian School, the neoclassical followers
competition and the general equilib- of Menger, and general equilibrium
rium theory with which it is intimately theorists, the developers of the stan-
I Makowski:University of California, Davis. Os- dard model of perfect competition for-
troy: University of California, Los Angeles. We mulated by Walras, are in some respects
thank Alberto Bennardo, Serguey Braguinsky, greater than those between neoclassical
Bruce Caldwell, Hongbin Cai, Bryan Ellickson,
Meir Kohn, Woojin Lee, John Whitaker, Oliver and classical economics. Into this mix,
Williamson, the paper's referees, and especially we add the emphasis on opportunistic
the editor, John McMillan, for helpful comments. behavior that is missing in both the
Some memorable conversations with Woojin Lee
several years ago were vital for clarifying the dis- Austrian and Walrasian traditions, but
tinction between privacy and delivery problems. dominates so much of contemporary
479
480 Journal of Economic Literature, Vol. XXXIX (June 2001)
economics. The Austrians and the Op- tive. Rather than dealing with an im-
portunists are both critical of the stan- personal market, perfect competitors
dard model. Although their criticisms interact with one another in an environ-
differ, they agree that the main reason ment involving intense rivalry. A per-
for its limited applicability is its ex- fect competitor will do whatever he can
treme informational requirements. We to increase his gain: bargaining vigor-
highlight these critiques as the origin of ously with others for a better deal, in-
contemporary diversity in neoclassical novating new products if he sees a
conceptions of "the creativity of the profit to doing so, strategically misrep-
market." In particular, we contrast the resenting his private information if this
rather low index of individual creativity is profitable.
in the standard model compared to Twvonotable features of the reformu-
Austrian and Opportunist conceptions. lation are that (1) prices are not exog-
We, too, find fault with the standard enously given, they emerge from bar-
model in ways that echo its critics. To gaining. Similarly, (2) the set of active
us, however, the problem of applicabil- markets is not exogenously given, it re-
ity stems not so much from its implicit sults from innovation. Hence, the per-
informational restrictions as from its fect competitor of the reformulation is
identification of perfect competition neither a passive price-taker nor a pas-
with price-taking. This identification sive market-taker. The competitive en-
hides the remarkable properties of per- vironment is also characterized by (3)
fect competition itself. The link be- widely dispersed private information.
tween perfect competition and price- Thus the discovery of market-clearing
taking had its origins in the early prices is not simply a process of prices
developments of neoclassical theory. mechanically adjusting to excess de-
Portraying the individual as a price- mands; they will not be discovered un-
taker was extremely useful for display- less opportunistic market participants
ing the new equi-marginal principle un- find it in their self interest to reveal
derlying individual choice. But it had their trade-relevant private information.
the unfortunate consequence of sup- At least since Adam Smith, the idea
pressing the entrepreneurial side of that competition could harmonize the
competition. In the end, price-taking pursuit of self interest with economic
and perfect competition became syn- efficiency has been an absorbing theme.
onymous, leading to the conclusion that The standard model has provided an in-
perfect competition is an inhospitable fluential formalization of that idea. The
environment for the exercise of market image of the perfect competitor as full
creativity. appropriator is intended as an alterna-
In the first part of this essay, we tive formalization. We view market fail-
document how advocates and critics ures as fundamentally due to failures of
alike have come to regard the passivity appropriation. Active competition is im-
of the perfect competitor as charac- portant because it facilitates appropria-
terological. In the second part, we give tion. This central point is suppressed,
the outlines of a reformulation that even lost, in the image of the perfect
moves away from the perfect competi- competitor as a passive market and
tor as a price-taker, to what we call the price-taker.
perfect competitor as a full appropria- In the reformulation, achieving effi-
tor. Our image of the perfect competi- ciency is both easier and harder than in
tor is someone who is active and innova- the standard model. It is easier because
Makowski and Ostroy: Perfect Competition and Creativity of the Market 481
entrepreneurial agents will innovate ior. In our view, the Austrians have too
new markets whenever they see a profit willingly accepted the low level of crea-
to doing so. Contrast this to modern tivity associated with the standard
general equilibrium theory with incom- model as synonymous with the limita-
plete markets; there individuals pas- tions of equilibrium analysis. We view a
sively accept whatever markets are perfectly competitive equilibrium as re-
missing. On the other hand, the possi- sulting from the entrepreneurial pursuit
bilities for opportunistic behavior make of profit potentials, i.e., as an expression
achieving efficiency more problematic: of market creativity.
entrepreneurial agents will try to game Unlike the Austrians, Opportunists
the system whenever it is privately prof- formulate their conclusions in the lan-
itable. The easier part is sympathetic to guage of equilibrium. Their point of de-
the Austrian viewpoint, while the harder parture is to contrast a richer world
part echoes Opportunists' concerns. view, based on asymmetric information,
The challenges presented by both parts, with stylized versions of the standard
when operating simultaneously, give the model. In contrast to marginalists' em-
efficiency question renewed life. phasis on the scarcity of resources, Op-
The transition from price-taking to its portunists focus on the scarcity of infor-
reformulation involves a change in the mation, in particular, the scarcity of
fundamental "margin of analysis." While information held in common. This is
traditional analysis emphasizes the also an Austrian theme, but from a very
equi-marginal principle with respect to different point of view: Opportunists
commodities, in the reformulation the emphasize the dark side of individual
individual becomes the basic unit of creativity.
analysis. He actively bargains with the There is a marked difference be-
rest of the economy to obtain the most tween the standard model and Oppor-
he can. In a perfectly competitive envi- tunists' concerns, but the gap is not as
ronment, there are perfect-substitute wide as is commonly thought, and it can
outside options: if a buyer or seller tries be bridged. To help establish this point,
to press his trading partner for more fa- we shall divide asymmetric information
vorable terms of trade, the latter has problems into two categories, called
recourse to a perfect-substitute, alter- privacy problems and delivery prob-
native buyer or seller. The perfect com- lems. Historically, the privacy of infor-
petitor takes advantage of this favorable mation (i.e., that each individual knows
environment to play off one potential his own tastes or production possibili-
buyer or seller against another, allowing ties better than anyone else) has been
him to fully appropriate his social an important theme in the standard
contribution. The emphasis on the indi- model, as illustrated by the attention
vidual margin accords with contempo- given to the decentralization role of
rary interests: strategic interactions are prices; but the tools to analyze privacy
between individuals, not between an problems were not as well developed as
individual and an impersonal price they are now. The path we shall follow
system. to connect perfect competition to Op-
Our reformulation does not accept portunists' concerns will go through pri-
the strong dichotomy emphasized in the vacy. In particular, the significance of
Austrian tradition between equilibrium perfect competition is based on the
and disequilibrium, where the latter is following result: full appropriation is
the exclusive locus of innovative behav- necessary for an incentive scheme to
efficiently channel the strategic behavior mists' central model for achieving effi-
resulting from the privacy of information. ciency. Section 8 contains some con-
While privacy is acknowledged as a cluding comments. Finally, in section 9,
source of asymmetric information, more references are given to the more formal
often than not Opportunists are con- work on which the reformulation is
cerned with delivery problems, that is, based.
trading in which one party is more in-
formed than the other about what is be- 2. The Standard Model
ing delivered (e.g., a high quality used
car or a low quality). In contrast to pri- 2.1 Economics as Tooled Knowledge
vacy, when there are delivery problems
perfectly competitive rivalry need not Joseph Schumpeter (1954) described
reveal the information necessary to science as "tooled knowledge." The
achieve first-best efficiency. To some, marginalist pioneers are grouped to-
this is evidence that the standard model gether precisely because they indepen-
should be put on the shelf, to be taken dently developed the same tool for
down only when informational scarcities understanding market valuations, mar-
can be ignored. We take a more inclu- ginal utility, in contrast to the cost of
sive view in which the overarching production/labor theories of value used
theme is the relation between competi- in classical economics. Beyond this the
tion and appropriation. From this per- common threads start to unravel.2
spective, delivery problems do not rep- One distinction among Jevons, Menger,
resent a break with the past. Rather, by and Walras is the form of their tools. In
introducing important limitations on Menger, marginal utility is presented
the appropriation properties of perfect verbally or by simple numerical exam-
competition, delivery problems enrich ples like those still used in texts for stu-
our appreciation of that theme. dents unfamiliar with calculus. He had
Sections 2 through 4 constitute the no interest in describing the principles
first part of the essay. In section 2 we of economics with mathematical certi-
sketch some basic features and inter- tude. It sufficed to explain carefully
pretations of the standard model. Cri- what constitutes an "economic good"
tiques, mostly Austrian, of the standard and to show that goods that are not
model are reviewed in section 3. In sec- themselves economic derive their value
tion 4 we add to the critical brew Op- as inputs in the production of economic
portunists' introduction of incentives goods: Just as the price of any economic
and strategic behavior. In section 5 we good will equal its marginal utility, the
outline our reformulation, illustrating price of any input will equal the value
that some of the supposed charac- of its marginal product, that is, the
terological deficiencies of the perfect marginal utility it can produce.
competitor can be remedied. Section 6 Unlike Menger, Jevons and Walras
describes the differences between the presented their utility analysis in terms
standard model and the reformulation of functions and their derivatives. Be-
with respect to why competition pro- tween the two users of mathematics,
motes efficiency. Section 7 shows how Jevons is regarded as playing second
the reformulation can accommodate fiddle, even though Jevons (1862) came
some Austrian and Opportunist cri- to his understanding of the importance
tiques of the standard model, while pre- 2 See William Jaffe (1976) for a similar point of
serving perfect competition as econo- view which also refers to tooled knowledge.
of marginal utility before Walras (1874). it to show how each individual would
The reason is that Walras not only respond to any possible vector of prices,
introduced marginal utility, he also hence to derive individual demand and
integrated individuals' choices into a supply functions. With these functions
formal multi-market framework, com- in place, the natural definition of a gen-
monly called general equilibrium, or eral equilibrium is prices such that
Walrasian equilibrium. Jevons was con- there is equality of aggregate demands
tent to sketch an analysis of equilibrium and supplies. In all of this, traditional
in an economy with two goods and two microeconomic analysis still follows
types of traders, whereas Walras spent Walras' footsteps. Notice that on this
his life assembling and expanding his path it is taken for granted that prices
system of equations to apply to the ex- precede maximization.
change of many commodities, to pro-
2.2.1 Tdtonnementand the Experience
duction,, to capital formation, and to
of Disequilibrium
monetary exchange. No one approached
his single-minded dedication, and he On his way to general market equilib-
has been rewarded for his efforts by the rium, Walras encountered a problem:
general acknowledgement that he pro- How are equilibrium prices discovered?
duced the most complete and precise His solution (a) built directly upon his
formulation, referred to here as the price-taking description of individual
standard model. According to Paul Sam- behavior and (b) could be interpreted,
uelson (1947, p. 8) ". . . in the general at least heuristically, as describing the
equilibrium system of, let us say, Wal- groping process of actual markets in
ras, the content of the historical disci- achieving equilibrium. His tatonne-
pline of theoretical economics is prac- ment (groping) was simply to assume
tically exhausted." The implication is that individuals act as price-takers not
that Walras' formulation is a logical only in equilibrium, but also away from
summary of marginalism. equilibrium.
Strict adherence to the rule that
2.2 Price-Taking as a Servant
prices precede maximization, both in
of Marginalism
and out of equilibrium, means that indi-
The behavioral postulate linking individuals are not responsible for equili-
vidual choice to marginalism is price- brating markets (it is not an optimizing
taking. The individual (household or decision). Rather, the detection and
firm) chooses quantities to maximize correction of disequilibrium is dele-
utility or profit, taking prices as given. gated to market forces, responding im-
In the hands of the early marginalists, personally to excess demands and sup-
price-taking proved a very convenient plies. Sometimes these forces are
simplifying assumption for displaying anthropomorphized in the form of an
the new equi-marginal principle under- exogeneous, benevolent "Walrasianauc-
lying optimal choice; in this respect, it tioneer," who adjusts prices until mar-
was a servant of marginalism. It had the kets clear. Samuelson's Correspondence
unfortunate consequence, however, of Principle takes the standard model for
suppressing the more entrepreneurial granted and elaborates on the implications
aspects of economic behavior. of tatonnement:
Among the three founders, price- In this study I attempt to show that there do
taking figures most prominently and exist meaningful theorems in diverse fields of
rigidly in Walras' formulation. He uses economic affairs. . They proceed almost
wholly from two types of general hypotheses. to the definition of economic behavior. Mar-
The first is that conditions of equilibrium are ket relations are impersonal, between persons
equivalent to the maximization (minimiza- and goods; and persuasion or "bargaining"is
tion) of some magnitude. . . . However, also excluded. (Frank Knight 1946, p. 102;
when we leave single economic units, the de- italics added)
termination of unknowns is found to be unre-
lated to an extremum position. . . . Instead, Critics of the standard model could
the dynamical properties of the system are justly point out that perfect competition
specified, and the hypothesis is made that the contains very little evidence of real
system is in "stable" equilibrium or motion. competition.
(Samuelson 1947, p. 5)
The Correspondence Principle was

2.3 Free Entry and Zero Profits
intended to show that the hypothesis
of a stable equilibrium-with respect Neoclassical economists borrowed
to an adjustment procedure predicated from their classical predecessors the
on the out-of-equilibrium behavior of view that, in a production economy,
price-takers-could be used to predict perfect competition is the simple, ines-
how equilibrium would change in capable conclusion of free entry. And
response to changes in parameters. with free entry comes zero profits. Al-
Walras' assumption of price-taking- most to the same extent as price-taking,
even out of equilibrium-was a bold the common identification of perfect
and not entirely satisfactory solution. competition with a free entry/zero
For example, Kenneth Arrow (1959, p. profit equilibrium eliminates the space
41) concludes "there exists a logical gap needed for the expression of market
in the usual formulations of the theory creativity.
of the perfectly competitive economy, For the early marginalists, the typical
namely that there is no place for a ra- commodities were homogeneous and
tional decision with respect to prices as standardized, and the typical setting for
there is with respect to quantities." This economic interactions was a stationary
is not the place to comment further on long-run equilibrium with many buyers
the logical or empirical difficulties asso- and sellers of each commodity. In such
ciated with tatonnement. For our pur- an environment, the identification of
pose, it is enough to observe that this equilibrium with free entry and zero
widely accepted description of how the profits fits like hand in glove. From a
competitive model works nailed down modern perspective, an economy with
the view that "perfectly competitive homogeneous commodities and free en-
behavior" and passive "price-taking try may not seem so different from a
behavior" are synonymous. classical world, but the early marginalists'
With price-taking firmly identified tools for analyzing value and distribution
with perfectly competitive behavior, ri- were brand new.
valry is not invoked, either as a part of the Walras' formulation was the most
adjustment process toward equilibrium clear-cut. He assumed constant returns;
or as a description of equilibrium: from this it immediately follows that
The "perfect" market, of theory at its highest profits cannot be positive in price-
level of generality, is conventionally de- taking equilibrium. In later versions he
scribed as perfectly or purely "competitive." generalized to the possibility of U-
But use of this word is one of our worst mis-
fortunes of terminology. There is no pre- shaped costs, but continued to assume
sumption of psychological competition, emu- that all technologies are freely repro-
lation, or rivalry, and this is rather contrary ducible (free entry), hence the same
zero profit conclusion. Given Walras' 3. Absence of Creativity in the

acute sense of symmetry, he might have Standard Model
appreciated the parallel between the
In this section we review the work of
gains to consumers from participat-
ing in the price system (consumers'
four writers that have as their point of
departure the limitations of the stan-
surplus) and the possible gains to
dard model. One is matter-of-fact in his
producers (producers' surplus); but in-
recognition of these limitations (Schum-
corporating this into his model would
peter), while the others are more criti-
have required departing from free en-
cal (Friedrich Hayek, Israel Kirzner,
try. That assumption was not made sim-
and Ronald Coase). Schumpeter and
ply for convenience, it reflected a defi-
Kirzner see the problem as confining
nite vision: All incomes should be
attention to equilibrium. Hayek raises
attributable to ownership of scarce re-
several issues intersecting equilibrium
sources; since ownership of technolo-
and disequilibrium, but we shall focus
gies was not scarce, the return should
on his remarks about the informational
be zero.
economies of the price mechanism as
Walras' insistence on zero profits is
in contrast to the Marshallian tradition
something that can be appreciated even
in equilibrium. Similarly, Coase calls at-
of producers' surplus as a symmetric
tention to the market system as a means
complement to consumers' surplus.
of economizing on the costs of transact-
Marshallian profits come from a source
ing. For different reasons, each of these
precluded by Walras, namely that firms'
writers agrees that the problems posed
technologies may not be freely repro-
and solved by the standard model are
ducible. Hence the owner of a firm may
earn a positive profit in equilibrium re-
only a part of what the market does. We
shall return to these issues in section 7.
flecting his firm's unique technological
abilities. There is a long tradition in 3.1 Schumpeter on Innovation
economics that identifies the unique-
Schumpeter did not dismiss the sig-
ness of a firm's technology with hidden
nificance of the standard model. In his
inputs that cannot be augmented. These
History of Economic Analysis (1954),
inputs reflect scarcities that are part of
he awards the prize for most significant
costs, hence Marshallian profits are in-
contribution in economic theory to Wal-
terpreted as rents to scarce hidden fac-
ras. However, while giving with one
tors. To illustrate, a proprietor whose
hand, he also takes away with the other.
exceptional managerial skills are re-
When it comes to the really important
sponsible for his firm's positive profits
problems, marginal analysis is only
converts this return into a factor pay-
ment to himself, just as if the owner
marginal:
were to hire someone with the same . . . The problemthat is usuallybeing visual-
skills from the outside. Walras' technol- ized is how capitalismadministersexisting
structures,whereas the relevantproblem is
ogy may be described as precluding how it creates and destroysthem. As long as
even profits as rents, whereas Marshall this is not recognized,the investigatordoes a
allowed for such profits. meaninglessjob. As soon as it is recognized,
By requiring profits to be zero, Wal- his outlookon capitalistpracticeandits social
ras shut the door to the market reward- resultschangesconsiderably.
The first thing to go is the traditionalcon-
ing entrepreneurial activity, while Mar- ception of the modus operandi of competi-
shall left it ajar. We will go through this tion. Economists are at long last emerging
door in section 5. from the stage in which price competition
was all they saw. . . . But in capitalist reality fore steady compared to what is innova-
as distinguished from its textbook picture, it tive and dynamic. The bursts of creative
is not that kind of competition which counts
but the competition from the new commod- energy unleashed by entrepreneurs
ity, the new technology, the new source of cause the circular flow to be temporar-
supply, the new type of organization (the ily destabilized until the standard
largest scale unit of control for instance)- model has time to adapt, only to be hit
competition which commands a decisive cost again by other innovations.
or quality advantage and which strikes not at
th,e margins of the profits and the outputs of The picture that emerges is of the
the existing firms but at their foundations and standard model as a punching bag that
at their very lives. This kind of competition is certain exceptional individuals take de-
as much more effective than the, other as a light in pummeling. The difference,
bombardment is in comparison with forcing a however, is that the pummeling is good
door, and so much more important that it be-
comes a matter of comparative indifference for the model because it is only through
whether competition in the ordinary sense such shocks that it can shake off the
functions more or less promptly; the powerful lethargy of its boring routine.
lever that in the long run expands output and
brings down prices is in any case made of 3.2 Kirzner on Entrepreneurship
other stuff. (1950, p. 84)
Kirzner's critique of the standard
The standard model is obviously not model, with its emphasis on the entre-
adequate to the task: preneur, bears a certain resemblance to
Perfect competition implies free entry into Schumpeter's view of business cycles,
every industry. . . . If our economic world but it is meant to be a more compre-
consisted of a number of established indus- hensive alternative vision which does
tries producing familiar commodities by es- not focus on the implications of en-
tablished and substantially invariant methods trepreneurial behavior on aggregate
and if nothing happened except that addi-
tional men and additional savings combine to economic activity. To Kirzner, the main
get up new firms of the existing type, then deficiency of the model is its exclusive
impediments to their entry into any industry emphasis on equilibrium.
they wish to enter would spell loss to the Kirzner (1973) juxtaposes the aim of
community. But perfectly free entry into a the standard model which is to explain
new field may make it impossible to enter at
all. The introduction of new methods of equilibrium prices and quantities with
production and new commodities is hardly the process by which the equilibrium
conceivable with perfect-and perfectly may be achieved. For Kirzner, as for
prompt-competition from the start. And this Schumpeter, entrepreneurial activity
means that the bulk of what we call economic and equilibrium are incompatible: "In
progress is incompatible with it. As a matter
of fact, perfect competition is and always has equilibrium there is no room for the en-
been temporarily suspended whenever any- trepreneur. When the decisions of all
thing new is being introduced-automatically market participants dovetail completely,
or by measures devised for the purpose- so that each plan correctly assumes the
even in otherwise perfectly competitive corresponding plans of the other par-
conditions. (pp. 104-105)
ticipants and no possibility exists for
Schumpeter erected a theory of busi- any altered plans that would be simulta-
ness cycles based on the actions of en- neously preferred by the relevant par-
trepreneurial innovators who peri- ticipants, there is nothing left for the
odically disrupt the smooth circular entrepreneur to do" (p. 26). En-
flow of the standard model. The stan- trepreneurial activity is predicated on
dard model is used to make a distinc- disequilibrium and on ignorance; it is
tion between what is routine and there- the alertness to information. It includes
not only Schumpeterian innovation of The debate represents a boiling over of

new things but "to perceive new oppor- the tension between marginalismand the
tunities which others have not yet no- creativity of the market that had been
ticed" (p. 81). Entrepreneurial profits brewing since Walras and Menger.
are not returns to ownership of things: The market socialists were among the
"It is not yielded by exchanging some- first to rigorously demonstrate the effi-
thing the entrepreneur values less for ciency properties of the standard
something he values more highly. It model. Their methods of proof made it
comes from discovering sellers and buy- clear that the crucial step in the argu-
ers of something for which the latter ment was that price-taking, optimizing
will pay more than the former demand. households and firms should face a
The discovery of a profit opportunity common set of market prices. The argu-
means the discovery of something ob- ment for market socialism proceeds
tainable for nothing at all. No invest- from a fairly literal extension of this
ment at all is required; the free ten-dollar demonstration. In the standard model,
bill is discovered to be already within all of society's wealth is owned by con-
one's grasp" (p. 48). sumers either in the form of payments
The essence of competition is en- for labor and capital directly owned by
trepreneurial activity. Since entrepre- households or in the form of ownership
neurs have no role to play in equilib- claims to the profits of firms. The effi-
rium, competition does not really exist ciency properties of the standard model
there. "This situation of market equilib- do not depend on how wealth is distrib-
rium is surely one in which competition uted, although the distribution of wealth
is no longer an active force. The cessa- certainly determines the distribution of
tion of the market process which we welfare. The market socialists reasoned
have already seen as characteristic of that since the distribution of the owner-
the equilibrium state is the cessation of ship claims to capital and profits, but
the competitive process" (p. 13). not labor, was more or less arbitrary,
The overall view is that what is equi- the efficiency properties of the standard
librium and what is interesting are model could be preserved by collectiv-
incompatible. izing nonhuman wealth and distributing
it in a more egalitarian way. Formally,
3.3 Hayek on Divided Knowledge
the argument is based on what is now
Hayek's contribution is set against a called the Second Theorem of Welfare
very influential application of the stan- Economics.
dard model-due to Oscar Lange
(1939), Abba Lerner (1944), and oth- working of the economic system as it existed, nor
was it primarily to portray the purely economic
ers-called market socialism. Given his relations within a network -of markets under the
attachment to private property, it is not assumption of a theoretically perfect regime of
clear whether Walras would have ap- free competition. It was, as Pareto perceived,
rather to demonstrate the possibility of formulat-
proved of this extension, but there is a ing axiomatically a rationally consistent economic
certain logical consistency to the mar- system that would satisfy the demands of social
ket socialists' interpretation of the stan- justice without overstepping the bounds imposed
by the natural exigencies of the real world. It is to
dard model that has been accepted by the great credit of Walras as an economic analyst
later general equilibrium theorists.3 that in formulating this system, he invented a
model that proved to be eminently serviceable to
3Jaffe (1977) says of Walras' Elements: "Wal- later economists who were more positivistic in
ras's latent purpose in contriving his general equi- their approach than Walras or were inspired by
librium model was not to describe or analyze the different social goals." r
Hayek did not criticize the Lange and view of price-taking as the origin of
Lerner interpretation of the standard minimal market creativity in the stan-
model as incorrect; rather he implicitly dard model, the market socialists inter-
accepted their interpretation. By grant- preted the parametric role of prices in a
ing the implications of the market so- way that made it seem more like a silk
cialists, Hayek could conclude that this purse. As a price-taker, anything except
was a clear demonstration that the stan- prices, e.g., the tastes, production pos-
dard model simply ignored vital features sibilities, and endowments of others, is
of the market. In Hayek's view, what was irrelevant information. The firm, for ex-
missing from market socialist proposals ample, only has to know prices to find a
was the tremendous informational profit-maximizing production plan.
economies of the market system: When markets clear, price-taking maxi-
mizers have achieved an allocation of
The peculiar character of the problem of a
rational economic order is determined pre-
resources satisfying all the equi-mar-
cisely by the fact that the knowledge of the ginal conditions required for efficiency.
circumstances of which we must make use While at first glance achieving effi-
never exists in concentrated or integrated ciency might be thought to require the
form but solely as the dispersed bits of in- detailed assembly of all divided knowl-
complete and frequently contradictory knowl-
edge which all the separate individuals pos-
edge, prices provide all the necessary
sess. The economic problem of society is thus information. This came to be known as
not merely a problem of how to allocate the decentralization role of prices, i.e.,
"given" resources-if "given" is taken to an optimal allocation for the economy
mean given to a single mind which deliber- consisting of many disparate units could
ately solves the problem set by these "data"
[marginal rates of substitution]. It is rather a
be obtained while each of the partici-
problem of how to secure the best use of re- pants knows only his own characteristics
sources known to any of the members of soci- (tastes, endowments, technology) and
ety, for ends whose relative importance only prices.
those individuals know. Or, to put it briefly, The decentralization role of prices
it is a problem of the utilization of knowledge
which is not given to anyone in totality.
became a centerpiece of modern gen-
(1945, pp. 77-78) eral equilibrium theory because it pro-
vided an appealing interpretation of the
Hayek's words, building on the ear- intimate mathematical connections be-
lier work of Ludwig von Mises (1935), tween pricing and efficiency. Underly-
were clear enough to make a deep im- ing an efficient allocation, there are
pression. His emphasis on divided prices; and without relying on any other
knowledge-in contrast to "disequili- form of communication, those prices
brium" or "uncertainty"-could be ap- can be used by price-taking maximizers
preciated as a subtle and significant ex- to obtain a socially efficient allocation.
tension of the meaning of scarcity. Here Of course, there still remained the
was something about which economists question of how to find such prices.
could say: "Now that you mention it, Here the market socialists invoked a lit-
that does seem basic." But Hayek eral application of tatonnement. This
offered no tools to build upon his ideas. search algorithm does not give individu-
The market socialists responded to als direct responsibility for finding
the Mises-Hayek challenge by claiming equilibrium prices; that is the job of the
that the standard model did contain market. The market socialists, instead
the ingredients to deal with divided of calling on market forces to raise
knowledge. In contrast to our sow's ear (lower) prices when there is excess
demand (supply), observed that a cen- Although externalities were not a part of
tral authority could record demands and the original version of the standard
supplies at various prices and adjust model, Pigou's ideas, like those of the
them until all markets clear. Hayek ap- market socialists, are very naturally
peared willing, perhaps for the sake of grafted onto it. Pigovian divergences
the argument, to go along with the ini- subvert the link between the equi-
tial stages of market socialists' claims. marginal consequences of choices made
But he vigorously objected to the as- by price-takers and market efficiency,
sumption that a central authority could thereby providing a logical inroad for
assemble all the information about indi- government intervention. While the va-
vidual demands and supplies needed to lidity of the Pigovian argument leading
make the proper price adjustments. to divergence between private and social
According to Hayek, market socialists cost is evident, its application in particu-
made the mistake of accepting the stan- lar circumstances is open to question.
dard model as the reason why competi- This is what Coase did. Moreover, his
tion works. "The argument in favor of questioning took the form of a basic cri-
competition does not rest on the condi- tique of the presuppositions that seemed
tions that would exist if it were perfect." to underlie many interpretations of the
(Hayek 1948, p. 104) standard model.
Coase's point of departure was to
3.4 Coase on Externalities recognize the reciprocal nature of ex-
In describing Coase's critique of the ternal effects: if A harms B, then by
treatment of externalities, we think of it preventing A from taking actions
as a continuation of the market socialist harming B, A may be harmed. The im-
controversy, writ smaller. Hayek was portant point, as far as efficiency is con-
concerned with the differences between cerned, is to weigh the value of the
fundamentally different systems of eco- harms. Further, if there is some way to
nomic organization, whereas Coase was trade these harms, the parties con-
concerned with our understanding of a cerned could weigh them and would
market economy. The similarity is that have an interest in pursuing the action
each author criticized the way the stan- involving the lesser harm, thereby
dard model was used to overstate the achieving efficiency.
claims for the economic role of the There is another way of looking at
government versus the market. Coase's critique that is more pointedly
Alfred Pigou's formulation of the dis- aimed at the standard model. The Walras-
crepancy between private and social net Pigou treatment of external effects is
product represents a basic qualification better at analyzing the consequences of
to the efficiency of markets: external effects than their causes. The
consequences follow from examining
The source of the general divergencesbe- equilibrium in the standard model rela-
tween the values of marginalsocial and mar-
ginal private net product that occur under tive to the operating markets. The im-
simple competitionis the fact that, in some portant point is that these operating
occupations,a partof the productof a unit of markets are exogenous rather than en-
resources consists of something,which, in- dogenous to the model. In this respect,
stead of coming in the first instance to the the participants in the economy are
person who invests the unit, comes instead,
in the first instance (i.e., prior to sale if the market-takers. Precedent for behaving
sale takes place), as a positive or negative passively with respect to one's environ-
item, to otherpeople. (1932,p. 174) ment is well-established in the Walrasian
tradition of price-taking, so market- instead of juxtaposing the firm and the

taking would seem to be part of the market as alternative ways of organizing
same mold. transactions, he juxtaposed the govern-
Coase's objection to market-taking is ment and the market (including firms).
a cousin of the Austrian critique of ab- Coase criticized the Pigovian tradition
sence of attention to entrepreneurial for operating under the tacit assump-
activity. One of the entrepreneur's roles tion that the entrepreneurial costs of
is to figure out what goods and services organizing market transactions to elimi-
are wanted and then arrange for their nate externalities were always prohibi-
supply. The entrepreneur is certainly tive, while the costs of government in-
not a market-taker; and, in fact, it is the ternalization were effectively zero. To
activities of entrepreneurs that lead to help make his point about the Pigovian
the set of marketed commodities as a bias, Coase introduced the idea of zero
crucial endogenous variable of the transactions costs. In this case he as-
economy, not an exogenous one as in serted, as long as property rights were
the Walras-Pigou tradition. From the completely defined, the market out-
entrepreneurialpoint of view, the Walras- come would efficiently internalize all
Pigou formulation of external effects as externalities, which came to be known
missing markets begs the question why as the Coase Theorem.
entrepreneurs are not jumping in to fill
the gaps. But before the entrepreneur 4. The Discovery of Strategic Behavior
can perform his function, certain pre-
conditions must be established. There A familiar quotation in economics is
must be objects to buy and sell or, in Adam Smith's statement that self-inter-
Coase's terminology, there must be est guides economic behavior. Hence,
well-defined property rights. one might conclude that analysis of
The term "property rights," rather strategic behavior and incentives pre-
than "commodities" or "goods and ser- dates the marginalist revolution. But in
vices," is a useful one because it en- terms of tooled knowledge, the discov-
courages the idea that what can be ery comes much later, about a century
bought and sold is more than just stan- after the marginalist revolution.
dardized commodities; e.g., the rights In the nineteenth century, strategic
to a parcel of land can be assembled or behavior was regarded as not really part
disassembled to fit the particular situ- of economics. To illustrate, consider the
ation. You might sell all of the rights, as following from Marshall, who mentions
in complete transfer of ownership, or it parenthetically as a subject not quite
you may sell a right-of-way through it, suitable for discussion in polite com-
or the rights to have the bees from a pany. In commenting on the advisabilityof
hive draw the nectar from the apple a system of taxes and bounties, Marshall
blossoms on it. This flexible definition (1890) says:
of just what constitutes the relevant But before deciding on such a course they
commodity goes along with the empha- would have to take account of considerations,
sis on the endogeneity of the set of which are not within the scope of the general
marketed commodities. theory now before us, but are yet of great
practical importance. They would have to
In comparing market versus govern- reckon up the direct and indirect costs of
mental methods for internalizing exter- collecting a tax and administering a bounty;
nalities, Coase drew upon his earlier the difficulty of securing that the burdens of
concerns with transactions costs. Now, the tax and the benefits of the bounty were
equitably distributed; the openings for fraud these issues. Until the 1970s, econo-
and corruption; and the danger that in the mists made more or less the same dis-
trade which had got a bounty and in the other
trades which had hoped to get one, people tinction as Marshall between economic
would divert their energies from managing and (un)ethical behavior.6
their own businesses to managing persons
who control the bounties. 4.1 Opportunists' Version of Divided
Besides these semi-ethical questions there Knowledge
will arise others of a strictly economic nature,
4 The commonly acknowledged key un-
locking the strategic/incentive toolkit is
Marshall's semi-ethical questions are now asymmetric information. Hayek's di-
part of mainstream economic investigations. vided knowledge is a clear precursor.
Moving ahead fifty years, the issue of Nevertheless, the Opportunists' version
opportunistic behavior made a fleeting of divided knowledge has a distinctly
appearance in the debate about market different feel. However Hayek and the
socialism. To Lange: market socialists might have actually
There is also the argument which might be
perceived the issues, their communica-
raised against socialism with regard to the ef- tion was limited by the tooled knowl-
ficiency of public officials as compared with edge then available; and this did not in-
private entrepreneurs as managers of produc- clude a full-scale apparatus analyzing
tion. Strictly speaking, these public officials another kind of creativity, the pursuit of
must be compared with corporation officials
"<self-interest with guile."7 This adds a
under capitalism, and not with private small-
scale entrepreneurs. The argument thus loses new dimension to the meaning of mar-
much of its force. The discussion of this argu- ket creativity. The older one empha-
ment belongs to the field of sociology rather sized by Austrian economists, such as
than of economic theory and must therefore Schumpeter's innovating monopolists
be dispensed with here. (1939, p. 109)
and Kirzner's alert entrepreneurs, pre-
sent opportunism's meritorious side.
More remarkable is the apparent willing-
Opportunists, on the contrary, have
ness of Hayek and other critics of market
drawn attention to the meretricious as-
socialism to accept these ground rules.5
pects of creative behavior, such as pur-
A decade later, two of the most well-
porting to offer a high-quality used car
known statements of economic theory,
known by the seller to be in bad condi-
John Hicks' Value and Capital (1939)
tion. They characterize the standard
and Samuelson's Foundations of Eco-
model as a world without information
nomic Analysis (1947), have no index
asymmetries where, for example, every
entry for "<strategicbehavior" or "incen-
buyer is assumed to be an expert auto
tives." More importantly, apart from the
mechanic able to assess the true condi-
optimizing implications of price-taking
tion of a used car, whereas Opportunists
behavior, there is no technical appara-
consider a market in which participants
tus in either work devoted to analyzing
are not so well-informed.
4 This is from the eighth edition (1929, p. 473). Differences between the Austrian and
5 Bruce Caldwell (1997) speculates that Hayek Opportunist approaches to asymmetric
may have grudgingly accepted these ground rules
because of the belief, which was widespread in the information can also be described in
1930s, that human behavior was malleable and terms of a contrasting emphasis on
institution-dependent. In such an environment, it
would not have sufficed to point out the opportu- 6 "Victorian gentlemen" is the term Samuel
nities for shirking since an alteration in the form Bowles and Herbert Gintis (1993) use to describe
of economic organization could alter attitudes to- the behavior of individuals prior to the 1970s.
ward shirking. 7 Oliver Williamson (1985, p. 65).
quantity versus quality of information. quality car will have to be the same as
Austrians focus on the immense amount the price for a high quality one. Unlike
of information implicitly utilized in the Jevons' version of the Law of One
allocation of resources. The genius of Price, which shows that competition
the market system is the way it trans- promotes mutually advantageous trades,
mits and channels a huge amount of in- this version can be used to demonstrate
formation. Opportunists focus primarily the opposite. Suppose buyers are will-
on the quality of information: How much ing to pay x for a car with no defects
of what is known will be accurately trans- and y for a car with defects. All sellers
mitted from one person to another? will claim their cars have no defects un-
Without exaggerating beyond recogni- less the expected reward from selling a
tion, each side may be said to ignore car with no defects is the same as with
the issue emphasized by the other. The defects. With equal numbers of each
Hayekian focus on complexity is quan- type of car offered for sale, if buyers
tity without explicit concern for quality, choose at random they would be willing
whereas the Opportunists, to highlight to pay at most (x + y)/2. Therefore, a
the quality issue, ignore quantity. seller of a car with no defects and reser-
Opportunists use an interesting ana- vation value z for his car, where x > z >
lytical device called the revelation prin- (x + y)/2, would not be able to strike a
ciple. (See, for example, Roger Myerson deal. All potential good deals would not
1979.) According to this principle, stra- get done.
tegic interactions in a market can be The crucial summary conclusion of
modeled as if individuals report the de- Opportunists' concern with quality
tails of who they are, what they know, rather than quantity of information is
and what they will do to a market mech- that incentive issues emerge from be-
anism, which processes that raw data to hind the curtain of topics unsuitable for
produce a market outcome. The stick- discussion to take a front and center
ing point is that equilibrium with re- position.
spect to the market mechanism will oc-
4.2 Leaving the Standard Model
cur only when each individual has no
out of the Loop
incentive to misrepresent his private in-
formation; in other words, when the With the development of Opportun-
quality of information reported to the ism, the standard model comes under
mechanism is perfect. Hence, the mar- attack from a different quarter. Now, its
ket must structure rewards-incen- limitations are seen not as the result of
tives-so that telling the truth does not over-emphasis on equilibrium. On the
lead to a payoff for any individual that contrary, the hypothesis of equilibrium
is lower than he would get by misrepre- is an essential part of the argument.
senting. Truth-telling must be incentive Rather the complaint is that by failing
compatible. to deal with informational asymmetries
Such a reward scheme may exhibit and the myriad of incentive problems
features not present in the standard that they create, the standard model has
model. For example, here is an Oppor- nothing to say about what are now re-
tunists' version of the Law of One garded as some of the most basic issues
Price: To encourage an owner of a low in economics.
quality car to acknowledge what he The contributions of the Austrians
knows when buyers cannot tell the dif- and the Opportunists are like an oppos-
ference, the market price for the low ing army attacking from two different
flanks. With respect to the creativity of goals is to argue that competition is a

the market, Austrians have consistently means of resolving many information
emphasized that the standard model problems, e.g., competition among buy-
overlooks the difficulties in achieving ers and among sellers often leads them
equilibrium in an uncertain environ- to reveal their trade-relevant private in-
ment. But because of entrepreneurial formation. This will occupy a significant
activity and innovations spurred by the part of the discussionbelow. In the present
profit motive, actual markets work well section, we want to prepare the way.
in realizing the practically achievable It will be important to address the
gains from trade. Their moral is: the older issue of divided knowledge in the
economic problem is inordinately more more contemporary language of asym-
complex and the actual resolution is metric information. In this way, the Op-
(therefore) much more remarkable than portunist emphasis on incentives will
is portrayed in the standard model. In play a more prominent role than it did
comparison, the Opportunists' reliance in earlier discussions, before incentives
on mathematical models and attention were a pare of our tooled knowledge. In
to equilibrium lead to different con- the Opportunists' lexicon, a distinction
trasts with the standard model. Their is made between (a) hidden action!
focus is primarily on how the presence moral hazard problems, that is, alloca-
of informational asymmetries among in- tion problems arising from some indi-
dividuals precludes standard model viduals' actions not being observable
conclusions; e.g., in a market for used by others, and (b) hidden information/
cars, a car may not be sold although adverse selection problems, that is, allo-
there is a buyer willing to pay more cation problems arising from some indi-
than the minimum price at which the viduals' (endowed or acquired) private
seller of that car would part with it. The information not being known by others.
explanation of this paradox is the exis- To illustrate, a hidden action problem
tence of another form of market creativ- may involve the care and effort an in-
ity, a negative kind, not recognized in sured driver takes in avoiding accidents,
the standard model. Their moral is: in- while a hidden information problem
formational asymmetries represent an may involve a buyer's private valuation
important form of scarcity, and the con- for a monopolist's good or a seller's
straints they impose often lead to con- knowledge about the quality of his used
clusions that are inconceivable in the car.
standard model. We will be interested in the question:
Combining the Austrian and Oppor- What does competition buy, in terms of
tunist critiques leads to the conclusion solving asymmetricinformationproblems?
that the standard model is doubly naive. For answering this question, it turns
out that a somewhat different taxonomy
4.3 Different Kinds of Asymmetric
is more useful. We shall categorize
Information
asymmetric information problems into
Austrians and Opportunists both (a') privacy problems and (b') delivery
criticize the standard model for its im- problems. Privacy problems refer to al-
plicitly narrow and unrealistic informa- location problems arising from each in-
tional assumptions. Each would agree, dividual knowing his own tastes or pro-
but not for the same reasons, that the duction possibilities better than anyone
standard model operates under the tacit else, while delivery problems refer to
aegis of perfect information. One of our allocation problems arising from some
individuals being more informed than system to cut through asymmetric

others about the qualities of some com- information problems, Hayek says:
modities to be delivered (e.g., whether
the seller of a used car will deliver a Assume that somewhere in the world a new
opportunity for the use of some raw material,
lemon or a peach, or whether a man- say, tin, has arisen, or that one of the sources
ager will deliver low or high effort). So of supply of tin has been eliminated. It does
privacy problems are a subset of hidden not matter for our purpose-and it is signifi-
information problems, focusing on hid- cant that it does not matter-which of the
den information about tastes and pro- two causes made the tin more scarce....
The mere fact that there is one price for any
duction possibilities; while delivery commodity-or rather that local prices are
problems include the remaining hidden connected in a manner determined by the
information problems and all hidden cost of transport, etc.-brings about the solu-
action problems. tion which (it is just conceptually possible)
might have been arrived at by one single
We adopt the term privacy from
mind possessing all the information which is
Leonid Hurwicz (1960). It covers what in fact dispersed among all the people
is often called the data of the economy, involved in the process. (1945, p. 526)
the characteristics of its households and
firms. That this data is private informa- How do we reconcile the Hayekian
tion has been a tacitly maintained as- view that the price system works de-
sumption throughout neoclassical eco- spite asymmetric information-and,
nomics. Emphasis on the subjectivity of more importantly, cannot be properly
tastes, for example, brings with it the understood without recognizing that
presumption that such information is there is asymmetric information-with
known only to the person concerned. the Opportunist view that we would
Privacy also has been a more explicitly be better off if all asymmetric informa-
maintained assumption. It helps to ex- tion disappeared? The answer, of
plain why a monopolist may have to course, is that there are different kinds
charge only one price per unit to all his of asymmetric information.
customers rather than attempt to en- An Opportunist might respond to the
gage in price discrimination, or why above quote by hypothesizing a less ho-
taxes on public goods cannot be based mogeneous commodity than tin pro-
on how much each recipient actually duced in several different grades of du-
desires them. In both of these examples rability, not readily detectable by
it is understood that, because of pri- buyers at the time of purchase. While
vacy, the information required would each of these different commodities
have to be supplied by the individuals might ideally command a different
themselves, with the obvious conclusion price, the Law of One Price might pre-
that it might not be accurately revealed. vail only because of an application of
It is not clear where Hayek's divided Gresham's Law, where less durable
knowledge fits into either taxonomy be- commodities drive out more durable.
cause it was not tooled. We view him as This kind of divided knowledge between
being concerned with privacy problems, buyer and seller-delivery problems-is
where households and firms' private in- not what Hayek had in mind.
formation is suitably indexed by time In terms of tooled knowledge, deliv-
and place.8 On the ability of the price ery problems may be viewed as new,
modern day externality problems. Ana-
8 This also seems to be Hurwicz's interpretation lytically, in delivery problems some in-
of Hayek. dividuals' private information or actions
can directly affect some other individu- perfect competition an economy can
als' final utility. In particular, in the de- efficiently solve its privacy problems
livery problems associated with hidden (incentive compatibility/revelation con-
actions, an individual i's utility or payoff straints are loosened by the force of com-
from an outcome x (say a contract) de- petition). By contrast, as Opportunists
pends not only on his own action ai (if emphasize, even under perfect competi-
any) but also on others' actions a_i: tion delivery problems impose binding
uO(,ai,a g). constraints on what markets can do.
The predominant view among Oppor-
For example, even given the employ-
tunists is that the failure to recognize
ment contract, a firm owner's profit ui
delivery problems is due to the fact that
will depend on the amount of unobserv-
informational asymmetries had been ig-
able effort the manager delivers on the
nored. Such a claim overlooks previous
firm's behalf. Similarly, in the delivery
appeals to privacy, untooled though
problems associated with hidden infor-
they were. Certainly, there is a gap be-
mation, i's utility from outcome x de-
tween the standard model and Oppor-
pends not only on his own type ti but
tunists' concern with hidden informa-
also on others' types t-j:
tion and actions. In fact, there are two
U0(, ti, Lis), gaps. First, there is the standard
where we identify an individual's type model's lack of appreciation of strategic/
with his private information. For exam- incentive issues arising from privacy.
ple, the final utility to a buyer of a used Second, delivery problems also are not
car will depend not only on his own valu- recognized. Failure to distinguish be-
ation for a car, but also on the type of tween the two can be explained by the fact
the seller, whether he is delivering a that without putting one foot down firmly-
lemon or a peach. From this it can be separating out the set of incentive is-
understood why the delivery problems sues arising from privacy-pioneering
associated with hidden information are contributions such as George Akerlof
sometimes also called common value (1970), Michael Spence (1973), and
problems (see section 6.6). By contrast, James Mirrlees (1999)9 skipped imme-
in privacy problems an individual's final diately to the second step, addressing
utility from any outcome only depends the implications of delivery problems.
on his own type, ui(x, ti); while privacy A goal of our reformulation of the
implies bargainingover the terms of a con- standard model will be to demonstrate
tract will be complicated by informational the logical integrity of the first step.
asymmetries, once a contract is agreed Fundamental lessons about incentives
upon, there are no potential delivery can be learned from the study of per-
problems to further complicate matters. fect competition in the presence of pri-
We view (a') privacy problems and vacy, without the added complication of
(b') delivery problems as leading to delivery problems. We shall emphasize
more or less distinct species of alloca- that Opportunist contributions are of a
tion problems. Even though the tools piece with a formulation of perfect
for dealing with both (a') and (b') over- competition in which the strategic/
lap and can therefore be regarded as incentive issues arising from privacy are
members of the same genus, each leads already present and accounted for.
to a very different answer to our ques-
tion, "What does competition buy?" 9Mirrlees' unpublished, but very influential,
Remarkably, it turns out that under 1975 paper was finally published in 1999!
Once that is established, the signifi- proach is informal, we prefer a more

cance of delivery problems as a distinct metaphorical comparison. Our reformu-
species of incentive problems can be lation shares some features with the
better understood. standard model, but it also has some
that are apparently opposite. They are
5. A Reformulationof the like two sides of the same coin: If you
Standard Model look at one side, you see certain things,
We accept the Austrian and Oppor- while if you look on the opposite side,
tunist critiques that the standard model the picture can be quite different. In-
has developed in ways that limit its stead of heads and tails, we refer to the
flexibility as a representation of market sides as "standard" and "opposite." We
behavior, but we do not agree that this think of the opposite side as including
comes from an excessive preoccupation features that are part of the heuristic
with equilibrium, or with the supposed lore of (perfect) competition and the re-
extreme informational requirements for formulation as an attempt to meld those
perfect competition. Rather, we regard heuristics into a coherent alternative to
the limits on the standard model's the standard model.
applicability as coming from quite a What is the relation between the two
different source, a failure to recognize sides? Think of the standard side as
the remarkable properties of perfect consisting of all economies for which
competition itself. there exist Walrasian price-taking equi-
This failure had its origin in the early libria (in a formal sense). For concrete-
developments of neoclassical theory. ness each such economy can be thought
The dominant role played by price- of as a point, and the set of all these
taking in general equilibrium led to points fill out the standard side. Only
perfect competition becoming identi- some of these economies make it to the
fied with it. The unfortunate conse- opposite side: the coin acts as a filter,
quence is that perfect competition is only allowing perfectly competitive
now considered an inhospitable envi- economies to pass through; on the op-
ronment for the exercise of market posite side, these economies expand to
creativity. The aim of our reformulation occupy the space left over by the ones
is to demonstrate that perfect competi- that did not make it across.
tion is deserving of separate and re- The economies on the opposite side
newed attention. When no longer iden- share three intertwined features: (a)
tified with price-taking, it has a lot to There is intense competition among
offer as an organizing framework for buyers and/or sellers, which determines
understanding strategic, innovative, or- equilibrium prices. This competition is
ganizational, as well as imperfectly "perfect" in the sense that each seller
competitive behavior. or buyer has recourse to a perfect sub-
In a formal presentation, a natural stitute outside option should any one of
way to introduce an alternative point of his trading partners insist on more fa-
view would be to demonstrate its logical vorable terms of trade. (b) Price-taking
consistency, say by showing that current in equilibrium is rational on the op-
practice is actually a special case of the posite side: the presence of perfect
proposed alternative.'0 Because our ap- substitute outside options implies no
10 For example, Opportunists often observe that
one individual can influence market-
in the absence of asymmetric information their clearing prices even if he tried to. Al-
conclusions agree with the standard model. ternatively expressed, each individual
price
p =?j
c02c I t
D D D
1 quantity 1 2 1 2 3
Figure 1. Three Economies on the StandardSide
on the opposite side really faces per- parties' abilities to persuade, threaten,
fectly elastic demands and supplies etc. For example, if the seller is an inef-
(PEDS). (c) The competition among fectual bargainer while the buyer is
perfect substitute buyers for any one tough, she will be able to appropriate
seller's goods allows the seller to fully all the gains from trade, forcing the
appropriate his social contribution, price down to c. In the economy in the
leaving his trading partners with no ad- middle panel, we have added an outside
ditional surplus relative to their outside option: the seller need not deal with
options. Similarly, competition among buyer 1, he could instead sell his unit to
sellers for any one buyer's patronage buyer 2 for w. By playing off one poten-
allows the buyer to fully appropriate. tial buyer against the other, e.g., by
To avoid confusion we will reserve having them bid for his unit, the seller
the term "perfectly competitive econ- can now assure himself of at least
omy" for an economy on the opposite w-even if the buyers are tough bar-
side; similarly, the term "perfectly com- gainers. Notice the force of competition
petitive equilibrium" is reserved for an (i.e., the presence of the outside op-
equilibrium of an economy on the tion) has reduced the size of the bilat-
opposite side. eral monopoly surplus for buyer 1 and
To give an elementary example, con- the seller to bargain over from v - c to
sider the three single-market economies v- w. The right panel, introduces a
in figure 1, all of which possess Wal- third buyer, with valuation equal to the
rasian equilibria, hence are included on first. Now, by playing off one highest-
the standard side. The specimen on the valuing buyer again the other, e.g., by
left involves bilateral monopoly: there is having them bid for his unit, the seller
only one buyer and one seller in the can obtain v-even if he is soft and the
market, the seller can supply up to one buyers are tough; he can relax and let
unit at a marginal cost of c, while the the force of competition work for him.
buyer wants at most one unit, with a Regard the third panel as illustrating in
marginal valuation of v. Any price in miniature the three interrelated features
the interval [c,v] is a potential Wal- of any perfectly competitive economy:
rasian equilibrium price. The amount First, the seller has a perfect substitute
v - c represents a bilateral monopoly outside option; second, competition be-
surplus to bargain over; the actual tween the two highest-valuing buyers
terms-of-trade will depend on the two assures that he faces a perfectly elastic
price 5.1 Comparisons of the Two Sides
S
5. 1.1 Another Margin of Analysis
On the standard side, the primary fo-
p --- - - - cus of attention is on commodities-as
in the derivation of commodity de-
mands and supplies. On the opposite
side, the individual becomes the basic
D margin of analysis.
1 2 3 4 5 quantity What makes an individual a perfect
competitor? The usual answer is that
Figure 2. An Economy with Two-Sided Perfect
the individual is one of many buyers or
Competition
sellers of the same commodity; but we
are looking for a synthetic definition,
demand for his good in the relevant re- not a possible sufficient condition. Our
gion (one or less units); third, he is able to answer is that a perfect competitor is a
fully appropriate the social value of his full appropriator: whatever quantities
good by playing off one highest-valuing the perfect competitor supplies, the
buyer against the other. amounts he extracts from the rest of the
The example shows that for perfect economy in exchange are such that oth-
competition, one does not always need ers are indifferent between trading with
two-sided competition. Sometimes in- the perfect competitor or not trading
tense one-sided competition (either on with him at all. We shall use appropria-
the buyers' side as above, or on the sell- tion terminology-referring to efforts to
ers' side) suffices to ensure PEDS and get the most that one can-throughout
the rest. A more conventional illustra- our discussion. The perfect competitor
tion of a perfectly competitive equilib- as full appropriator achieves the upper
rium with two-sided competition is bound on what he can hope to gain.
shown in figure 2. Again each individual From the standard side of the coin,
has either a unit demand or unit supply. the definition seems paradoxical. It ap-
Notice there is a marginal buyer with pears to identify a perfect competitor
valuation p and a marginal seller with with a perfectly discriminating monopo-
cost p who, respectively, serve as the list, the perfect competitor's apparent
outside options for the lower cost sell- antithesis. (The perfectly discriminating
ers and the higher valuing buyers monopolist is well-known to fully ap-
should their trading partners start to propriate the gains he contributes to
get tough and insist on paying less or the rest of the economy, in contrast to
receiving more, respectively, than p. the nondiscriminating monopolist who
The three aspects of any perfectly is unable to extract all the gains contrib-
competitive economy-perfect substi- uted to his customers, leaving them
tutes, PEDS, and full appropriation- with some surplus.) The paradox will be
describe the forces at play in a perfectly resolved when it is understood that we
competitive economy. It turns out that apply the definition in a general equi-
the three are equivalent, so any one of librium context where everyone is a
them could be the basis for a definition perfect competitor, i.e., after we see
a
of perfectly competitive equilibrium. the implications of each individual con-
Below we will emphasize full appropriation fronting a situation similar to the per-
since this feature is closest to our theme. fectly discriminating monopolist. The
unfamiliar pairing points in a direction marginalism. On the opposite side of

we want to pursue, toward the notion the coin, this margin is subordinated in
that perfect competition is compatible favor of the individual household or
with active behavior-even the ultimate firm as the marginal unit. When we re-
in greed-and away from the identifica- fer to "marginal"product on the oppo-
tion of perfect competition with passive site side, we mean the marginal product
price-taking. of an individual participant to the rest
The theory of land rents provides an- of the economy, with his resources and
other instance of full appropriation; and production possibilities regarded as an
this connection will be particularly indivisible unit.
helpful in making the case that our re- A third feature of the land example is
formulation of the standard model can that the parcel may be unique. In fact,
be regarded as a restatement of margi- landlords were frequently described by
nalism, but one that focuses on the indi- classical economists as monopolists be-
vidual margin rather than the commod- cause of land's non-reproducible, unique
ity margin. The owner of a parcel of character. Nevertheless, there is little
land on which a given dose of capital difficulty in understanding that "mo-
and labor yields fifteen bushels of corn nopoly" land rents may be determined
will receive a rent of five bushels if that under conditions of perfect competition.
same dose of capital and labor yields In comparison to the standard model
only ten bushels on the next best avail- which points to commodity homogene-
able parcel, i.e., the landlord fully ap- ity as a source of perfect competition,
propriates the value of his parcel to the on the opposite side the emphasis is on
rest of the economy. the (possible) compatibility of perfect
We call attention to some interesting competition with the heterogeneity of
features of the land rent example. First, individuals, which naturally leads to
the determination of land rent is a clear compatibility with the heterogeneity of
illustration that the landlord receives commodities.
the marginal product of the parcel. Sec- In our restatement of marginalism,
ond, as a non-infinitesimal, indivisible we replace the parcel of land in classi-
unit, the parcel of land exhibits analysis cal theory by the individual household
at the extensive margin. The owner of or firm as the unit on the extensive mar-
the parcel is dealing with the rest of the gin. The individual is a perfect competi-
economy, in this case the farmers bid- tor when he can fully appropriate his
ding for his parcel. Note that at the ex- contribution to others, i.e., the individ-
tensive margin, getting one's marginal ual can get his marginal product. We
product-the difference between what illustrate for an exchange economy.
others could get with and without the
5.1.2 Marginal Productivity Theory
parcel-is the same as full appropriation
in an Exchange Economy
with respect to the parcel.
On the standard side, marginal analy- One of the arguments neoclassical
sis highlights the intensive margin gov- economists used to demonstrate the de-
erning the choice between more and ficiencies of the classical approach was
less, e.g., the number of square feet the that it had little to say about value in a
landlord might choose to rent out given world without production, i.e., an ex-
the price per unit of land. Indeed, change economy. We adopt a similar
analysis at the commodity or intensive tactic of posing questions normally
margin is practically synonymous with associated with production, but in an
exchange economy. What does "full ap- buyer with valuation v > p is trading
propriation" or "getting one's marginal with a seller with opportunity cost
product" mean in an exchange econ- (hence valuation) c < p. Should the
omy? It could be replied that since mar- buyer leave the economy, his trading
ginal products and profits are intrinsi- partner could find a perfect substitute
cally about production, the question is outside option (trade with the buyer
meaningless. If, however, a sensible an- whose valuation is p) and be no worse
swer can be given for an exchange econ- off; only the departing buyer would be
omy, it might provide a template appli- worse off since he would lose his con-
cable to production, just as neoclassical sumer's surplus v - p. Thus buyer v
economists argued that posing the prob- fully appropriates his contribution to
lem of value in exchange helped to re- the total gains from trade; no one else
organize the determinants of value in a benefits from his presence.
production economy.
5.1.3 Another Definition of Competitive
Any marginal consumer in an ex-
Equilibrium
change economy can be thought of as
generating extra opportunities for pro- We will define a perfectly competi-
ducing "utility gains from trade" which, tive equilibrium as one in which every
after all, is the ultimate expression of individual fully appropriates his social
profits. An individual is rewarded with contribution, when viewed as the mar-
his marginal product if the utility gains ginal individual added to the economy.
he receives equals his marginal product. The experiment is analogous to stan-
But what is an individual's marginal dard marginal productivity theory
product in an exchange economy, when where, to calculate any worker's mar-
we face the ordinalist injunction not to ginal product, we view him as the mar-
make interpersonal utility comparisons? ginal worker added to the firm. A fun-
The theory of land rent provides the damental lesson comes from the
necessary clue. The landlord receives question "which worker is the marginal
the marginal product of his parcel ex- one?" The teacher smiles and says,
actly when the rest of the economy- "They all are!"
farmers renting the land, households Formally, a perfectly competitive
consuming the fruits of land, etc.-is as equilibrium can be defined in an en-
well off paying the compensation and tirely ordinal fashion (the discussion
having the parcel as it is keeping the above about indifference in a pure ex-
compensation while not having the change economy provides a hint). But
benefit of the parcel. Indifference is an here, because of its simplicity and intui-
ordinal notion. Therefore, it is ordinally tive appeal, we will confine ourselves to
meaningful to say that an individual re- a cardinal definition. Assume all con-
ceives his marginal product when the sumers have constant marginal utility of
compensation others give in exchange money income, so utility is effectively
for what they receive is such that if transferable from one individual to an-
those resources were retained and real- other. It is well known that, under this
located among themselves they would, assumption, any Pareto efficient alloca-
person by person, be no better or worse tion is equivalent to one which maxi-
off. In other words, the individual is ex- mizes the gains from trade. Let g de-
tracting as payment all the surplus he note the maximum potential gains from
contributes to others. trade in an economy, and let g-i denote
To illustrate using figure 2, suppose a the maximum potential gains without
any one individual i's participation in would contradict profit maximization,

the economy. Define individual i's mar- and if the payments were less than the
ginal product in an economy as the total product, the theory would be in-
amount i's participation adds to the to- complete because it would not explain
tal gains: MPi g - gi. (Think of g as a the profit residual."1 The difference is
production function and MPi as a discrete that the consistency condition on the
derivative reflecting the indivisibility of opposite side involves an adding up
individuals.) condition over individual households
Let t = (ni) denote a vector specify- and firms in the economy as a whole
ing the distribution of the total gains g rather than over inputs hired by a
among individuals, where ni denotes in- firm.
dividual i's slice of the pie (so, by con- Not all the economies on the stan-
struction, lini = g). Whether i is a pro- dard side will exhibit adding up. For ex-
ducer or consumer, view ni as his ample, in an exchange economy with
"profit" from participating in the econ- only two individuals, the marginal prod-
omy, broadly conceived as his utility ucts of the two people will not add up if
gains. The defining feature of a per- there are any gains from trade. To illus-
fectly competitive equilibrium is that trate with the left panel in figure 1, if
the total gains from trade g are distrib- the price were c, the buyer would fully
uted so that ni = MPi for each individ- appropriate, and if the price were v, the
ual i. That is, each individual is re- seller would fully appropriate, but evi-
warded with his full social contribution. dently both the buyer and seller cannot
Since Zinj=g, it follows that a perfectly simultaneously fully appropriate. The
competitive equilibrium exists if and problem here is the absence of outside
only if options: each needs the other to trade.
The two-person example suffices to
,MPi=g. (FA)
illustrate that a price-taking equilib-
rium need not be perfectly competitive.
If this condition holds, we will say that The converse, however, does hold: a
the gains from trade add up, or are fully perfectly competitive equilibrium (in
appropriable. our sense) is a price-taking equilibrium.
The existence of perfect competition
is related to the well-known adding-up Adding Up Theorem. For any alloca-
question that Philip Wicksteed (1894) tion of resources such that the gains
posed regarding the completeness of from trade are fully appropriable,
marginal productivity theory. Recall there exist prices such that if they
price-taking profit-maximization im- are taken as given and individuals
plies that each unit of input hired by a maximize accordingly, aggregate de-
firm receives the value of its marginal mand will equal aggregate supply in
product. Wicksteed observed that the this allocation.
marginal productivity theory of distri-
bution was a complete explanation for The prices mentioned above are just the
the distribution of the total product implicit terms of trade which allow each
only if the total payments to hired fac- 11 Modern general equilibriumtheory permits
tors exactly equaled the firm's total decreasing returns technologies; hence, factor pay-
revenue, that is, only if the firm earned ments can add up to less than total revenue. The
theory is incomplete in the sense that the resulting
zero profit. If the payments to factors profits are simply a residual not explained by mar-
exceeded the total product, the theory ginal productivity theory.
person to fully appropriate his social would deny that land rents are price-
contribution. determined, there would be no objection
If the Adding Up Theorem were not that Marshall's rents for individuals cer-
true, we would be hard put to maintain tainly are: the arguments of the func-
our one coin metaphor. The unilateral tions defining them, the indirect utility
consistency between the stronger full and profit functions, are exactly prices.
appropriation definition of perfect com- In agreement with Ricardo, Marshall's
petition and the weaker price-taking rents are simply the windfalls the indi-
definition is one way to express the re- vidual (as a gift of nature) receives from
markable properties of perfect competi- participating in the economy.
tion not visible on the standard side of On the standard side, rents are not
the coin. directly sought after; rather, they are
Full appropriation in an economy- the residuals resulting from maximiza-
with or without production-is a zero tion with respect to given prices. On
profits condition for individuals. It is the opposite side, households and firms
not that profits (= gains from trade) seek to maximize their rents (consumer
have been squeezed out of the econ- and producer surpluses) directly by bar-
omy; it is just that they have been trans- gaining over terms of trade, innovating
formed into rents, without any unex- commodities, and doing whatever else
plained residual. In fact, it would make that is not proscribed which increases
just as much sense to call full appro- their gains. Hence, viewed from the op-
priation a maximum profits condition posite side, it would seem natural to
since it permits each individual to ex- call individual maximizing behavior
tract his maximum possible payoff from "rent-seeking." His rent is what each
the rest of the economy. entrepreneurially creative maximizer is
able to extract from the rest of the
5.1.4 Perfect Competitors Are
economy 12
Rent-Seekers
The remarkable fact is that, since
Marshall was at pains to smooth over there is full appropriation, under per-
the breaks between classical and neo- fect competition each individual's rent
classical economics that, for example, exactly measures his social contribution.
Jevons hailed. Marshall's use of con- In particular, focusing on firms:
sumer's and producer's rent, or surplus,
is a nice illustration of his sense of con- a perfectly competitive firm's equi-
tinuity. The term rent in classical eco- librium profit will exactly equal its
nomics referred to the payments attrib- social contribution (xi = Wi),
utable to the "free gifts of nature" such 12 The term rent-seeking has been used (Gor-
as land ("the original and indestructible don Tullock 1967; Anne Krueger 1974) to describe
powers of the soil"). Think of individual a certain kind of behavior in which individuals
consumers and producers as already attempt to artificially manipulate their rewards;
e.g., in Ricardo's model, lobbying by landlords for
fixed in place like parcels of Ricardian government restrictions on the importation of
soil. Marshallian rents are the gains corn so as to increase home production and
measured in terms of profits or utilities therefore the price of British land. The suc-
cessful rent-seeker will therefore earn excess
from participating in the economy, just profits, i.e., rents over and above those that
as the payment the landlord receives for would accrue without artificial restrictions. Rent-
what is already there is his rent. In the seeking terminology is yet another example rein-
forcing the view that self-seeking behavior beyond
Ricardian model, rents are determined price-taking is incompatible with the standard
by prices. While the standard model model.
which of course gives it very good more strategically, to try to appropriate

incentives to create in the social at least some of its social contribution
interest. perhaps by undersupplying-acting as a
The conclusion depends on perfect entrepreneurially-alert rent seeker.
competition, not just on price-taking. Summarizing, unlike the opposite side,
The key contrast is: on the standard side a firm's profit re-
sidual may only dimly reflect its social
Inappropriability Property. In any
contribution.
price-taking equilibrium on the stan-
dard side, the rent each individual 5.1.5 Distribution, Not Valuation, Is the
receives (his producer or consumer Bottom Line
surplus) is no more than what he
The two sides of the coin present
could extract as a full appropriator:
contrasting descriptions of the relation
ni_<MPgfor all i. There is equality
between value and distribution. The
for all individuals if and only if the
standard side is geared to the valuation
economy is perfectly competitive.
of goods. In fact, the standard view of
The inequality highlighted in the In- distribution only has meaning as it
appropriability Property has a familiar relates to the prices of inputs. Thus
marginalist explanation. As a price- the concept of distribution as "how much
taker, a seller receives credit for each you get" is a byproduct of-a mere
unit he supplies at a rate corresponding footnote to-the determination of
to the value to the rest of the economy prices.14
of the last marginal unit supplied. On the opposite side, the roles of
Whenever the intramarginal units have value and distribution are reversed.
a higher value than the marginal unit, Here, since how much one gets is deter-
his credit understates the value of mined by full appropriation, the condi-
his entire contribution. A full appro- tions for equilibrium are stated directly
priator would, of course, receive full in terms of distribution, xt = (ni). The
credit.13 Adding Up Theorem says that when (0i)
So, if a price-taking firm's equilib- exhibits full appropriation, there are
rium profit is ni, the social contribution terms of trade p implicit in the distri-
of its production, namely MPi, equals at bution (it). Therefore, as a converse to
least ni, but typically more. For exam- the traditional line of causation, on the
ple, if a firm has a constant returns to opposite side the prices of commodities
scale technology, in any price-taking emerge as a byproduct of the theory
equilibrium 1ti = 0 whether or not there of distribution, via individuals' rivalry
is another firm with the same technol- (bargaining) over their respective shares
ogy. But if no other firm can match i's of the total gains from trade.
technology, MPi may be enormous even On the opposite side, there is a sim-
though ti = 0. In terms of the reformu- ple answer to the question "where do
lation, we would not expect the above prices come from?" They come from
firm to act as a price-taker, rather to act bargaining.
13An analogous statement applies when the in- 14This is how Knight regards the place of distri-
dividual is dehited for his purchases. The charge is bution: "Taking the theory of consumption and
at a rate that may overstate the true opportunity that of production, including capital production, as
cost to the rest of the economy. The undercredit the two main headings under which the bulk of
or overpayment feature of the standard model is analytical economics may be organized (distri-
revisited in section 6.4.2, "Incentives and the Two bution is not more than a footnote) . . .". (Preface
Marginsof Analysis." to the 1948 reprint of Knight 1921)
5.1.6 Disequilibrium Presents Profit lishing equilibrium by eliminating

Opportunities arbitrage opportunities).
In section 2.3, we remarked that 5.1.7 The Same Coin

strict adherence to price-taking and
The remarks above were directed to
tatonnement leaves the perfect competi-
the differences between the standard
tor with no direct responsibility for es-
model and our reformulation of it.
tablishing equilibrium. Instead, disequi-
These new perspectives can be pur-
librium is recorded at the level of
chased at a reasonable price: just take
aggregate excess demand, with market
perfect competition seriously. There is
forces adjusting prices accordingly. This
no need to throw out the standard
could be interpreted as a stylized ver-
model; indeed it is on the same coin.
sion of what goes on behind the scenes,
The Adding Up Theorem shows that
where individuals are changing prices
one can always go from the opposite
when they are unable to buy or sell
side to the standard side. Now we show
their desired quantities. Nevertheless,
when it is possible to go the other way.
formally, it is only the aggregate ex-
As we have defined it, the difference
cess demands that play a role in the
between (mere) price-taking and per-
tatonnement process.
fect competition is the absence or pres-
On the opposite, just as demand and
ence of full appropriation. Here is an
supply schedules do not define equilib-
alternative possible definition: Given
rium, they are not needed to give a
any price-taking equilibrium, an indi-
story of how equilibrium is established.
vidual is a perfect competitor if at the
Rather, we regard disequilibrium as a
equilibrium prices he really faces per-
source of profit opportunities. En-
fectly elastic demands and supplies for
trepreneurial perfect competitors seek
the goods he sells and buys, PEDS.15
to exploit these opportunities. For ex-
This means that the perfect elasticity
ample, if two groups of individuals have
conditions which the price-taker takes
different marginal rates of substitution
for granted, without testing the waters,
over two goods, by buying from a low-
are actually true for a perfect competi-
valuing individual and selling to a high-
tor, e.g., because there are many buyers
valuing individual, there are arbitrage
and sellers of a homogeneous commod-
profits to be made. If there are many
ity like corn. PEDS makes price-taking
individuals in each group, the operation
rational; e.g., since he cannot influence
can be repeated again and again, so an
the equilibrium price of corn, a corn
arbitrage opportunity becomes a profit
farmer will have to act as a price-taker.
pump. Although we cannot expand on
For most interpretations of the stan-
the details here (see Makowski and Os-
dard model, the price-taking hypothesis
troy 1998), the bottom line is that per-
is simply an abstraction for PEDS; it
fectly competitive equilibrium can be
is understood that the hypothesis is
thought of as resulting from individuals'
actively exploiting (hence eliminating) 15 Normally, perfect elasticity means that one
all arbitrage profit opportunities. can buy or sell in unlimited quantities at the going
price. For us it will suffice that there is perfect
The same market participants who elasticity within the range of quantities in which
must act as price-takers in equilibrium the individual is likely to trade, e.g., the supplier
(because of the availability of perfect of a house faces a perfectly elastic demand if there
is a tie among two competing buyers for the great-
substitute outside options), act as price- est willingness to pay (recall the right panel in
makers outside of equilibrium (estab- figure 1).
invalid when applied to a market with nated from the economy as they are
only a single buyer and seller like the when that individual is present. The in-
one illustrated in the left panel of fig- difference of others is due to the fact
ure 1. But it is exactly the difference that, as a full appropriator, the individ-
between price-takingand PEDS that leads ual extracts for himself any surplus he
to the opposite side of the coin: A price- contributes to others. When applied to
taking equilibrium in which everyone a single individual, this is a recipe for a
faces PEDS is a perfectly competitive perfectly discriminating monopolist.
equilibrium in our sense (everyone fully But, when applied to all individuals si-
appropriates). And conversely, what is multaneously, full appropriation implies
special about the equilibria on the op- that the prices prevailing when all par-
posite side is that everyone faces ticipants are present will be the same as
PEDS: the prices (including reservation prices)
when any single participant is absent,
price-taking equilibrium
which is the essential description of
+ PEDS X full appropriation.
PEDS.
So, at least when a price-taking equilib- It is satisfying to observe that PEDS
rium is already given, the definition is also behind the disequilibrium arbi-
of a perfect competitor as someone who trage opportunities in a perfectly com-
faces PEDS is equivalent to our defini- petitive market.'6 For example, the fact
tion of a perfect competitor as a full that if a trading opportunity is available,
appropriator. it can be repeated again and again re-
To give some intuition for the equiva- flects the perfect elasticity of the mar-
lence, it is easy to see that price-taking ket. An arbitrager takes particular ad-
+ PEDS implies full appropriation. Re- vantage of this elasticity away from
call that full appropriation means that equilibrium. That is what makes dis-
the individual is extracting the maxi- equilibrium such an unambiguous
mum possible payments from others for source of profit opportunities under
whatever he supplies (and paying the perfect competition.
minimum for whatever he demands). If
a seller faces a perfectly elastic demand 5.2 Thick and Thin Market Perfect
at some price p, he is certainly a full Competition
appropriator since his insistence on As in the corn market example, the
any higher price would be greeted usual illustration of PEDS involves a
with the complete loss of sales. Simi- large number of buyers and sellers of
larly, if a buyer faces a perfectly elastic homogeneous commodities. Call this a
supply at p, an offer to pay less would thick markets economy. There is an in-
be greeted by refusal to sell. Therefore, formal but influential tradition which
price-taking equilibrium + PEDS =X full says thick markets and perfect competi-
appropriation. tion are synonymous. That is, if the
Conversely, the Adding Up Theorem commodities supplied by individual
says that full appropriation implies producers are not identical, they
price-taking equilibrium. Full appro- will necessarily face downward-sloping
priation also implies PEDS: If an indi-
vidual is a full appropriator, then the 16The equivalence, above, between full appro-
rest of the economy would-after mak- priation and price-taking equilibrium + PEDS
holds for any number of individuals. But the re-
ing the necessary adjustments-be as marks for arbitrage assume a large number of mar-
well off if that individual were elimi- ket participants.
price MC
|AC'
p = $500,000
$450,000 AC
$400,000 D
0 q 100 200 houses

Figure 3. Full AppropriationLeads to Efficient Price-Makingand Market-Making
demand schedules for their goods.17 which the good would no longer be de-
When perfect competition is cast in this manded. This in turn implies that the
mold, its prospects for exhibiting crea- seller is fully appropriating the value of
tivity are minimized. Not surprisingly, his unique good, as the equivalence be-
therefore, we emphasize that it also is tween PEDS and full appropriation re-
important to think about perfect compe- quires. The economy in the right panel
tition in an economy with thin markets, of figure 1 illustrates this property of
involving sellers of heterogeneous thin market perfect competition.
commodities. In accord with our emphasis on the
Is thin market perfect competition creativity of the market, we also point
even possible? Recalling the equiva- out that perfectly competitive econo-
lence between PEDS and full appro- mies can include innovators of new
priation, the question can be recast as, commodities (market-making); a per-
how could a seller of a unique product fectly competitive innovator is not a
face a perfectly elastic demand curve, contradiction in terms. Here is an ex-
i.e., how could the price for his product ample. Consider an innovator of a
be the same with him or without him?- unique product, say custom-built
Phrasing it this way gives the answer: It homes. Suppose there are many poten-
is only possible if the seller can get the tial buyers. In particular, there are 100
economy's reservation price for each people willing to pay $500,000 for one
unit of his good, i.e., the lowest price at of his homes, 100 people willing to pay
$450,000, etc. The market demand and
17 See, for example, the quotations from Schum- the innovator's cost curves are illus-
peter in section 3.1. Or consider the following: trated in figure 3; we will consider two
"Goods must be perfectly homogeneous, or stan-
dardized, for if the product of any one seller is alternatives, a moderate fixed cost (AC)
slightly differentiated from those of others, he has and a high fixed cost (AC'). Notice,
a degree of control over the price of his own vari- since he is a relatively small producer,
ety, whereas under pure competition he can have
no control over the price of anything." (Edward in his effective range he faces a per-
Chamberlin 1962, p. 7) fectly elastic demand (PEDS): he will
price
MC MC
Cs
AC'
AC
Demand Demand
q quantity q O
MR
Figure 4. Imperfect Competition Leads to InappropriableBenefits, Hence to Inefficient Price-Makingand
Market-Maling
be able to sell as many units as he likes Even if he innovates his good, he will
at p = $500,000 each. (Think of this set price above marginal cost, so he un-
price as resulting from the highest- dersupplies (see left panel of figure 4).
valuing buyers bidding against one an- Worse yet, he may not even innovate
other for a home.) Further, since p is his good when it is socially efficient to
the economy's reservation price, the in- innovate, as illustrated in the right
novator fully appropriates his social panel. In both cases the market failure
contribution. His profit exactly equals can be traced to an appropriation fail-
the social benefit his production con- ure. Taking the producer's point of
tributes to others. He gives with one view, think of the consumers' surplus
hand, and takes with the other. triangle as representing the triangle of
Full appropriation gives the perfectly inappropriable benefits: the benefit to
competitive innovator good incentives, others from his production. In the left
both in his market-making and price- panel, for any output between q and q
making. In terms of market-making, he the size of this triangle is increasing
innovates his custom-designed homes faster than his profit is decreasing (so
(opening the market) if his fixed costs more production is socially efficient),
are moderate (AC), while he does not but since he cannot appropriate con-
innovate if his fixed costs are very high sumers' benefit, he does not take it into
(AC'); in either case, his market-making account in deciding on q (so he does
decision is socially efficient. Similarly, not produce enough). Similarly in the
in terms of his price-making, if he inno- right panel, since the producer's aver-
vates, he sets price equal to marginal age cost curve is everywhere above his
cost, hence the efficient quantity is sold demand, he sees no profit from innovat-
in equilibrium. ing his product. But innovating and
Contrast these conclusions to a mo- charging pMC per unit would increase
nopolist innovator who does not face social gain: consumers' surplus would
PEDS and cannot price discriminate. be A + B while his loss would only be
B + C. Again the source of the market which perfect competition cannot exist
failure is his inability to appropriate the because there is not adding up.
potential benefits to consumers. Typically, in accord with the Inappro-
The perfectly competitive innovator, priability Property, when there is im-
like the perfectly discriminating mo- perfect competition the inequality goes
nopolist but unlike the nondiscriminat- in one direction, individuals' marginal
ing monopolist, always fully appropri- contributions to the gains from trade
ates and hence innovates whenever it is are superadditive: XiMPi> g. The in-
in the social interest. Graphically, since terpretation of superadditivity at the
a perfect competitor faces PEDS, there margin is that there are strong comple-
is no triangle of inappropriable benefits. mentarities remaining among the indi-
viduals in the economy, which leads to
5.3 A Bridge to Imperfect Competition
the absence of perfect substitute out-
Advertising the importance of imper- side options. The bilateral monopoly ex-
fect competition, Joan Robinson wrote: ample in the left panel of Figure 1 is a
"In the older textbooks it was customary canonical illustration: Because each in-
to set upon the analysis of value from dividual needs the other to trade, with-
the point of view of perfect competi- out either individual i the gains from
tion. . . . But somewhere, in an iso- trade would be zero (g-i = 0); hence
lated chapter, the analysis of monopoly each individual's marginal product
had to be introduced. This presented a equals the entire potential gains from
hard, indigestible lump which the com- trade (MP-i - g - g-i= g = (v - c)). The
petitive analysis could never swallow. strong complementarity between the
. . . No sooner had Mr. Sraffa released two individuals leads to superadditivity
the analysis from its uncomfortable pen (XiMPi= 2g > g).
in a chapter in the middle of the book On the standard side, it is empha-
than it immediately swallowed up the sized that the nonexistence of price-
competitive analysis without the small- taking equilibrium is a signal of imper-
est effort" (Robinson 1933, p. 4). An fect competition. We readily concur. In
important benefit of the reformulation terms of our metaphor, such imper-
of perfect competition as full appropria- fectly competitive economies are off the
tion is the different bridge it constructs coin. A basic feature of economies lead-
to imperfect competition. While we ing to nonexistence of price-taking
would not suggest that perfect competi- equilibrium is increasing returns (non-
tion "swallows up" imperfect competi- convexities), say because of fixed costs.
tion, we do claim that when imperfect This is an important source of comple-
competition is viewed in terms of ap- mentarities at the individual margin: A
propriation problems, it no longer ap- larger economy can spread its fixed
pears as the whole meal, but as an costs over more people; so the marginal
appetizing next course. person added to the economy contrib-
utes not only to his own welfare, but
5.3.1 Complementarities as the Source
also to others'.
of Imperfect Competition
But imperfect competition does not
Just as we define a perfectly competi- require nonconvexities; many imper-
tive economy as one in which everyone fectly competitive economies have
fully appropriates hence there is adding price-taking equilibria, at least formally
up (XjMPj = g), we define an imper- (they are on the coin). These are the
fectly competitive economy as one in economies on the standard side for
0)
~~~~~~~~~g(n) g(n)
0 M N 0 n
number of people n
Figure 5. Imperfect Competition as a Failure of Adding Up
which price-taking is a dubious hy- rives, his relation with others will nec-
pothesis because of the absence of essarily be imperfectly competitive. For
PEDS; the bilateral monopoly economy example, if there are only M people in
of above is an example. The nonex- the population on the left, g'(M) M>
istence of price-taking equilibrium-as g(M), so there would be imperfect com-
a signal for imperfect competition- petition. Similarly, in the population on
fails to filter out these economies. In the right, g'(n) *n > g(n) for any popula-
contrast, perfectly competitive econo- tion size; so the economy will always be
mies can be thought of as ones passing imperfectly competitive.
through two filters: they possess a price- It is important to observe that the
taking equilibrium and there is PEDS origin of imperfect competition is not
or full appropriation in the equilibrium. necessarily nefarious. Quite the con-
There is a vital tension between the trary. Complementarities between indi-
superadditivity of the gains from trade viduals implies gains from trade.18 If
and the additivity property of perfectly the appropriation inequality XiMPi > g
competitive equilibrium which stipu- -signaling imperfect competition--
lates that the total gains can be imputed holds when the marginal individual ap-
to the marginal products of individuals. pears on the scene, a portion of the to-
This tension is resolved under perfect tal gains from trade remains "up for
competition, where the superadditivity grabs." This in turn gives rise to alloca-
of the gains from trade is exhausted be- tive inefficiencies, as we will discuss in
fore the "marginal individual" appears section 6.3.
on the scene; hence the marginal con- 5.3.2 Even Large Economies May Be
tributions add up to the total gains. The
Imperfectly Competitive
idea is illustrated in the left panel of
Figure 5: ignoring the indivisibility of In the traditional "list of conditions for
people, if there are at least N people in perfect competition" (e.g., Stigler 1957)
the population there is adding up since large numbers of buyers and sellers
g'(N) - N = g(N). But if the superadditiv- 18 Of course, artificially created complementari-
ity of the total gains is not yet ex- ties achieved by artificialmonopoliesremain a
hausted when the marginal person ar- sourceof imperfectcompetition.
figures prominently. Here we illustrate among individuals: (1) The presence of

that with sufficient complementarities, fixed costs implies not all potential com-
large numbers is not enough. modities can be innovated, hence there
As the number of market participants exists no price-taking equilibrium (e.g.,
increases, there obviously are more out- as in figure 4, right panel). Further, (2)
side options, which promotes competi- the large variety of complementary
tion. Indeed, if we restrict the set of products implies each producer will
commodities to a fixed, finite number face a downward sloping demand curve
of private goods, as we increase the for his good (as in figure 4, left panel).
numbers of buyers and sellers markets Here is an example of a monopo-
become thicker and thicker, so perfect listically competitive economy in the
competition is inevitable in the limiting sense of (2), but without (1). Suppose
economy. But there is another possibility. there is a continuum of heterogeneous
Monopolistic Competition. Chamber- commodities and a continuum of sell-
lin emphasized that as one increases the ers, both with unit mass. Each commod-
number of market participants, each ity k e [0,1] can only be produced by
new seller may find it profitable to dif- seller s = k. Seller k's total cost of pro-
ferentiate his product. So the variety of ducing xk units of commodity k is
marketed goods may increase hand in C(Xk)= (1/2)x2 measured in units of a nu-
hand with the size of the economy. meraire good m. Notice, unlike the
Chamberlin believed that commodity typical examples involving nonexistence
heterogeneity would inevitably lead to of price-taking equilibrium, in the cur-
individual monopoly power. Now we rent example there are no fixed costs (a
know that if goods are not "too differen- convex technology) and no free entry
tiated," perfect competition may still (technologies are proprietary). Also
arise. Andreu Mas-Colell (1975) and suppose there is a continuum of identi-
Oliver Hart (1979) exhibit formulations cal buyers with unit 1mass. Each buyer
of large economies with heterogeneous has utility function JO v(xk)dk+ m, where
commodities, where markets are thin =
V(Xk) 2Xk (1/2)x2.
- Hence consumers'
but perfectly competitive. demand for commodity k is D(pk) = 2 -
But once products are differentiated, pk. Note consumers' demand for k de-
perfect competition certainly is not in- pends only on its own price and not on the
evitable. The possibility of monopolistic prices of other commodities; this rather
competition can be illustrated both via special property is typical of examples
complementarities that are inconsistent illustrating (2). Since each seller's sup-
with price-taking equilibrium (econo- ply function is S(pk) = pk, in the price-
mies off the coin) and via complemen- taking equilibrium pk = 1 for each com-
tarities consistent with price-taking (on modity k (in terms of the numeraire),
the standard side). Avinash Dixit and with each seller k supplying 1 unit of
Joseph Stiglitz (1977), Paul Krugman his good and earning a profit of 1/2. But
(1979), and Wilfred Ethier (1982), for since no seller faces PEDS, each will
example, provide examples of monopo- find it more profitable to undersupply:
listic competition which combine (1) a price-taking equilibrium only exists in
fixed costs in production with (2) tastes a formal sense. In particular, in the mo-
or technology such that distinct com- nopolistically competitive equilibrium,
modities are always bounded away from each seller k charges the monopoly
being perfect substitutes. Here there price in his market pk = 4/3, supplies
are two sources of complementarity only 2/3 unit, and increases his profit to
2/3 by not price-taking. Since there are ability Property. To see the intuition
no fixed costs, in this equilibrium all notice that, once produced, the public
commodities are marketed; but as in good can be supplied to i at zero mar-
figure 4 (left panel), each commodity ginal cost; so he fully appropriates only
is undersupplied because of sellers' if he pays nothing. Relative to a Lindahl
inability to fully appropriate. equilibrium, rent seeking manifests it-
Public Goods. A second important self in buyers misrepresenting their pri-
setting in which large numbers of buy- vate valuations in an effort to appropriate
ers and sellers does not lead to perfect more of their marginal products.19
competition involves public goods, e.g.,
pay television programs (a public out- 6. Why Does Perfect Competition Lead
put) or technical information (a public to Efficiency?
input). Again the source of imperfect
competition is strong complementari- The desirability of competition is a
ties. Public goods are often described as dominant theme in economics. Overall
involving non-rivalrous consumption agreement that competition is good
since one person's consumption does hides substantial disagreement as to
not diminish another's. From the point why that is so, even when there is some
of view of a seller of a public good, this consensus on the definition of "good."
means that he has no perfect substitute For example, in their advocacy of com-
outside options since he can sell each petition as a discovery mechanism in a
unit of his good to everyone simultane- world of pervasive uncertainty, Austri-
ously. Hence perfect competition with ans have little in common with follow-
public goods is impossible. ers of the standard model. On the other
Unless there are fixed costs, econo- hand, Opportunists point out that even
mies with public goods can be included under perfect competition, unqualified
on the standard side. Modeling each efficiency may not be achievable. In
unit of any public good as n jointly sup- this section, we explore how the link
plied private goods (where n is the between competition and efficiency de-
number of potential buyers), the analog pends on the meaning of competition,
of price-taking equilibrium for public i.e., we compare the arguments for
goods is a Lindahl equilibrium. Because efficiency on the two sides of the coin.
the commodity space to describe Lin- 6.1 The Market Test Hypothesis
dahl equilibrium requires that each
buyer's consumption of the public good We begin with the opposite side. The
is a separate commodity, the price- desirable properties of full appropria-
taking hypothesis is evidently dubious tion can be illustrated with a simple
since each buyer is a monopsonist and 19 Samuelson uses large numbers to highlight
each seller has no outside options. Fur- the differences between public and private goods:
ther, it is well-known that the presence "In ordinarymarket economies as you increase the
number of sellers of a homogeneous commodity
of large numbers does not eliminate indefinitely, you pass from monopoly through in-
monopsony power in a Lindahl equilib- determinate oligopoly and can hope to reach a de-
rium. In particular, in any Lindahl equi- terminate competitive equilibrium in the limit. It
is sometimes thought that increasing the number
librium for a large economy, if any of citizens who are jointly supplied public goods
buyer i must pay anything for his public leads to a similar determinate result." (Samuelson
goods, his private benefit is less than 1955, p. 355)
See John Head (1962) for a remarkableessay on
the social contribution of his presence: the problems in allocating public goods, written
Xi < MPi, in accord with the Inappropri- from a thoroughgoing appropriationperspective.
example. Suppose a firm is considering By way of contrast, in the absence of full

two mutually exclusive production plans appropriation, "what makes less money
yielding profits ti or 72. The firm will, may be better, and what loses money
of course, choose the more profitable of may be best." Figure 4 illustrates: In the
the two. Suppose the social gains from left panel, starting from q, what is so-
the two choices are MPI and MP2, re- cially better (any output up to q) makes
spectively. If the firm is always able to less money; in the right panel, what is
fully appropriate the gains from its ac- socially best (q) loses money.
tivities, then tci= MPi and TC2=MP2, and The Market Efficiency Theorem ap-
therefore the choice that maximizes its plies in two rather different settings, in
private gain will also maximize social thick and thin market economies. In the
gain. Conversely, in the absence of full former, there are a fixed number of stan-
appropriation, we may have private- dardized commodities such as generic
social profit reversals where, for exam- food, clothing, and shelter; there are no
ple, >X2, but MP2>MPi. The prob- opportunities for commodity innovation.
lem is the inappropriable benefits, that More interestingly, in the latter the com-
7t2<MP2. Such profit reversals are al- modities are heterogeneous and idiosyn-
most inevitable in the absence of cratic such as sourdough bread, hand-
perfect competition.20 painted T-shirts, and custom-built homes.
Call the market test hypothesis the In either setting, perfect competition
idea that the size of each firm's profit implies full appropriation. But because of
accurately measures the size of its social the possibility of innovation, how these
contribution. As a slogan it says, "What rents are obtained is a more challenging
makes money is good, what makes more problem in a thin market setting.
money is better, while what loses
6.1.1 The Market Test Hypothesis
money is not worth doing." The market
with Innovation
test hypothesis is the key to market effi-
ciency on the opposite side of the coin. Local Price Information Is Enough.
As illustrated above, under perfect com- In a thick markets/standardized com-
petition profit opportunities provide the modities world, all prices are common
right incentives for entrepreneurs to knowledge. By contrast, with thin mar-
exercise their creativity in ways that kets we take it for granted that the actu-
maximize the total gains from trade. ally marketed commodities will only be
The same idea was illustrated in fig- a small subset of all the potentially-
ure 3: because he faces PEDS, the marketable ones. (After all, the set of
perfectly competitive innovator always all conceivable commodities is un-
fully appropriates the social value of bounded.) This raises an important is-
his output, no matter what quantity he sue. Since most commodities are not
produces; so he chooses the efficient marketed, knowledge of prices, to use
output. Hayek's words, "would not be available
to one mind." Taken literally, his de-
Market Efficiency Theorem (Oppo-
scription of the informational econo-
site Side). The market test hypo-
mies of the price system is deficient.
thesis is valid when there is full
The creativity of the market requires
appropriation.
the aggregation of information about
20 To illustrate, profit reversals always occur
commodities that are not marketed.
when a monopolist cannot price discriminate, but Recalling the discussion in section
never to a perfect discriminator. 5.2, if a supplier of a unique commodity
(an innovation) is to fully appropriate, alone is worth r per unit and Y alone
then he must receive the economy's res- is worth s per unit, but because of
ervation price per unit for any number complementarities between them, the
of units he may feasibly offer. Because bundle of X and Y is worth more than
the set of potentially marketed com- r+ s. For example, X might be a spe-
modities is so numerous, it would be cialized hardware, and Y might be a
unreasonable to assume that each pro- complementary software.
ducer knows all reservation prices. For- This possible non-additivity among
tunately, such complete information is innovations imposes a basic limitation
unnecessary. on the theme of decentralization. If the
As an extension of divided knowl- innovator decentralizes its operations so
edge, suppose each producer only has that decisions about X and Y are made
information about the economy's reser- in separate departments, the superaddi-
vation prices for the goods he can sup- tivity in the profitability of supplying
ply. As a summary statistic about others' X + Y may not be noticed. (By contrast,
characteristics, this goes beyond pri- without complementarities, the decen-
vacy; but it does not extend to the other tralized conclusion that neither X nor Y
extreme usually accorded to complete should be produced would be the right
information about prices. Collectively, one.) This complication will be ignored
reservation prices are known, but like at the individual level by assuming that
divided knowledge, this information is whatever the possible interdependen-
not held in common. We refer to this as cies among bundled innovations, the or-
"local price information." ganizational structure of the firm is
With this background, the market such that they are correctly perceived
test hypothesis can be applied to inno- (separate departments cooperate, perhaps
vation with incomplete markets. Using forming joint ventures).
his (accurate) local price information, Going beyond a single entity, how-
any single innovator considering alter- ever, such interdependenicies may be
native innovations yielding profits t1i more difficult to recognize. Consider
and t2 will choose the socially more ef- the following statement by Pigou:
ficient one because he will fully appro-
It is idle to expect a well-planned town to
priate in either case. His local price in- result from the independent activities of iso-
formation tells him all he has to know lated speculators as it would be to expect a
to choose efficiently. To illustrate with satisfactory picture to result if each separate
figure 3, whether the innovator pro- square inch were painted by an independent
duces thirty homes or sixty, his profit artist. No "invisible hand" can be relied upon
to produce a good arrangement of the whole
will equal the whole social gain. from a combination of separate treatment of
Product innovation when there is the parts. (1932, p. 195)
(only) local price information is the
source of an important qualification to For the purposes of the discussion be-
the Market Efficiency Theorem. Con- low, ignore any real externalities from in-
sider an innovator facing a bundling completely defined property rights, say
problem: offering either the innovation with respect to air pollution.
X or Y results in losses, whereas offer- A good arrangement of the whole can
ing X and Y together yields a profit. As- be relied upon from a separate treat-
sume that this is not due to cost savings ment of the parts when those parts enter
within the firm, but to a non-additivity additively. In that case, the market test
in the economy's reservation values: X hypothesis applied to each speculator
provides the correct indicators as to more familiar market price externalities

which should be undertaken. When due to monopoly power that precludes
they do not enter additively, we shall full appropriation. It also includes (3)
say that there are reservation price ex- real, or ownership, externalities; indeed,
ternalities: the reservation value of one that is where the significance of appro-
supplier's innovation depends on the in- priability was first recognized. The princi-
novations undertaken by others. Pigou's ple also extends to (4) Opportunist con-
statement could be interpreted as say- cerns with delivery problems (see
ing that while there may be no innova- section 6.6).
tions to the status quo which are profit-
6.1.2 The Standard Argumentfor
able for any perfectly competitive
Efficiency of Perfect Competition
speculator, taken one at a time, this
need not preclude a jointly profitable The market test hypothesis has little
bundling of speculations. The unrecog- to do with the demonstration of effi-
nized joint profitability is due to reser- ciency in the standard model. Instead,
vation price externalities associated the argument is based on price-taking.
with the location of economic activities:
Market Efficiency Theorem (Stan-
a given relocation may not be profit-
dard Version). A price-taking equi-
able unless many other activities are
librium leads to an efficient alloca-
relocated.
tion of resources, assuming there are
We have already seen that full appro-
prices for all commodities (complete
priation is about "adding up." Innova-
markets).
tion with (only) local price information
introduces another layer. There can be The assumptions for market effi-
adding up with respect to an existing ciency on the two sides of the coin are
collection of marketed commodities. not directly comparable. In the stan-
However, unless the distribution of dard version, markets are assumed to be
ownership rights is such that the inno- complete, market-making is never con-
vations of separate owners are additive, sidered; in this respect, the standard
the gains from complementary innova- version is much less general. On the
tions might not be individually appro- other hand, price-taking is a weaker hy-
priable by their initiators. Even though pothesis than full appropriation (it does
it may be valid with respect to already not require PEDS); in this respect, the
marketed commodities, the market test standard version applies more gener-
hypothesis need not exhaust all the ally. It only depends on the alignment
potential gains from innovation. of prices and opportunity costs at the
To take account of this qualification, intensive margin, whereas the market
we restate the above Market Efficiency test hypothesis requires alignment of
Theorem in the negative. payments with opportunity costs not
only at the intensive margin, but for
Appropriability Theorem. Limita-
intramarginal units as well.
tions on the efficacy of market crea-
The market test hypothesis is not in-
tivity originate in limitations on
voked on the standard side of the coin
appropriability.
because it is not generally true there. In
In this form, the principle is widely ap- the standard model, profits are simply a
plicable. It covers not only (1) innovation residual, an unearned rent without any
and the complications caused by reserva- special interpretation. Recall from the
tion price externalities, but also (2) the Inappropriability Property in section
5.1.4 that on the standard side a firm's 6.2 Efficiency tvith Privacy
profit typically understates the social
value of its production by an amoujnt Recall both the perfect competitor
that varies from case to case. and the perfectly discriminating monop-
One might therefore conclude: "Be- olist act as full appropriators. But when
cause the efficiency properties of the we take the privacy of information into
Standard Version do not demand full account, the perfect competitor is in a
appropriation, the market test hypothe- much better position to achieve this up-
sis is an inessential part of the logic of per bound than the would-be perfect
competitive market efficiency. All that discriminator.
is required for market efficiency is the The monopolist selling a homogene-
usual equalities at the commodity mar- ous commodity may be forced to charge
gin between prices, marginal products, a single price per unit to all customers
and marginal utilities (or their separat- because that may be the only way to es-
ing hyperplane counterparts)." Our re- tablish the incentive compatibility con-
sponse is definitely not. Rather, what ditions encouraging each buyer, in ef-
the Standard Version shows is that the fect, to reveal his tastes. The would-be
twin hypotheses of price-taking and perfect discriminator faces a bargaining
complete markets can be used to elimi- problem: "Unless you give me x, I will
nate the need for profits to accurately not sell to you." To that, the buyer can
signal the social valuations of alterna- reply: "It is not worth that much to
tive production plans. For us, this indi- me." The perfectly competitive seller
cates that there is something fundamen- has no such problem; he simply lets
tal missing. In fact, there are two buyers bid as much or as little as they
things. First, price-taking makes perfect wish. He does not need to know what x
competition unnecessary in the sense is; as long as there are several would-be
that the Standard Version of the Market buyers with the same valuation, it is
Efficiency Theorem holds even when enough to have them compete to dis-
firms really face downward sloping cover x. The seller plays off one buyer
demands, hence have (unexploited) against another, forcing them to reveal
monopoly power: as long as firms their private information.
play at price-taking (i.e., pretend to Perfect competition does not pre-
face PEDS), the outcome will be effi- sume that individuals know prices be-
cient. But will they really play this forehand (prices precede maximiza-
game? tion). It only presumes that people seek
Second, and for our current theme to make deals to realize the best they
more importantly, in the standard can (maximization precedes prices). For
model individuals not only act as pas- the perfect competitor, full appropria-
sive price-takers, they also act as pas- tion is not undermined by privacy. To
sive market-takers: If markets are not frame this point, recall the frequently
complete (and realistically they never expressed contrary view that perfect
are), that is the end of the story as far competition requires perfect information.
as the standard model is concerned. 6.2.1 Perfect Competition Yields a
Complete markets or, more generally, Vickrey Outcome for Everyone
market-taking precludes the possibility
of perfectly competitive innovation, Renewed emphasis on appropriability
which reinforces the passivity of the has emerged from the work of William
perfect competitor. Vickrey (1960), Edward Clarke (1973),
and Theodore Groves (1973) in their longer necessarily be efficient: the ob-
concern with the implications of strate- ject may remain unsold. The problem is
gic behavior in mechanism design. The that a second-price auction gives the
following is a simple variant of the pre- buyer his marginal product, but not the
vious example. Suppose a landlord with seller. The seller's marginal product is
a single parcel for sale; also suppose, v, the highest-valuing buyer's valuation,
just to simplify the exposition, he has since that is the amount the seller is
zero private value for the parcel. There contributing (without him there would
are several potential buyers, the highest- be no object to buy). To extend Vick-
valuing buyer has a valuation of v and rey's scheme to include the seller, one
the second highest a valuation of w < v. must give him v (to give the seller good
But the landlord does not know any incentives/his marginal product) and
buyer's valuation, it is private information. have the winning bidder only pay w
Is there a way to sell the parcel that (to also give the buyer good incentives/
will eliminate strategic (untruthful) bid- his marginal product). This illustrates
ding, to ensure that the parcel will be in miniature the well-known budget-
sold to the buyer with the highest valu- balancing problem in Vickrey-Clarke-
ation? Vickrey's solution is: Offer the Groves schemes: there must be outside
parcel to the highest bidder, but make funds equal to v - w to make the
him pay only the second highest bid; scheme work. In terms of the Inappro-
this will eliminate any potential buyer's priability Property, v - w equals the gap
incentive to strategically misrepresent between liMPi and the gains from trade
his true valuation. To see the full ap- g in the example.
propriation connection, notice Vickrey's The exception occurs when there is
scheme rewards the winning bidder perfect competition. If the landlord is
with his marginal product: If the parcel confident that there will be at least two
is worth v to the highest bidder and w highest valuing bidders, there is no
to the next highest, then v - w equals need for him to place a reservation
the marginal product of the winning price since the first and second-price
bidder, i.e., the extra gains from trade will coincide, so he will be able to ap-
given his presence in the market. So, propriate his marginal product. In this
since the buyer only pays w in a second- case the marginal product of the win-
price auction, he appropriates his ning bidder is zero, so not only the
marginal product. seller but all the market participants
Will the landlord use this efficient have fully appropriated. This case is
scheme to sell his parcel? Typically not: illustrated in the right panel of figure 1.
The theory of optimal auctions tells us If the landlord had k > 1 unique par-
that the best scheme for the landlord is cels for sale, not just one, the same rea-
a Vickrey auction plus a reservation soning applies: He would face a per-
price p calculated using his best guess fectly elastic demand and be able to
about the distribution of buyers' valu- fully appropriate as long as there are at
ations. The idea is that if the landlord least k + 1 highest-valuing buyers in the
thinks the highest bidder may value the market. Again he can play off each buyer
parcel much more than the second against the others and obtain v for each
highest, his expected revenue will in- parcel. This case is similar to figure 3.
crease by requiring any bidder to bid at The principle behind the second
least p. Since all buyers' valuations may price auction is the same as the one
be below the floor, the outcome will no underlying full appropriation. Perfectly
competitive equilibrium is a giant Vick- Privacy Theorem. When information

rey auction, for sellers as well as buyers, about individual characteristics is
and for divisible as well as indivisible private, efficiency and incentive
commodities. Such a conclusion ap- compatibility are jointly achievable
pears divorced from the standard model when there is full appropriation.
because the indivisibility of the object
For the economies on the opposite side,
precludes traditional marginalist rea-
therefore, we can conclude that another
soning, emphasizing equality of com-
remarkable feature of perfect competi-
modity marginal rates of substitution.
tion is that it overcomes the hurdles
By contrast, focusing on the individual
imposed by the privacy elements of
margin, appropriating one's marginal
asymmetric information.
product is meaningful whether goods
In fact, we can say more. Mechanism
are divisible or indivisible.
design studies the implications of all
It is convenient to divide the discus-
possible reward schemes, whether or not
sion into two special cases, one for buy-
they have an interpretation as a market.
ers and one for sellers. For full appro-
Therefore, it addresses the possible
priation (as well as good incentives),
tradeoff between efficiency and incen-
whether the good is divisible or not,
tive compatibility in a more comprehen-
each buyer should only pay the "oppor-
sive way in which the market mecha-
tunity cost of his purchase," i.e., the
nism can be compared with any other
minimum that others require for giving
mechanism. In that contest, perfect
up what they supply to the buyer. For a
competition comes out well:
single, indivisible object, the opportu-
nity cost of giving the object to the Uniqueness Theorem. When infor-
highest valuing buyer is giving it to the mation about individual charac-
second highest valuing buyer. Similarly, teristics is private, efficiency and in-
each seller should receive the "reserva- centive compatibility are jointly
tion value of the sale," i.e., the maxi- achievable only when there is full
mum that others would be willing to appropriation.
pay to obtain what they receive from
the seller. For a single, indivisible ob- Uniqueness arises from the fact that,
ject, the reservation value is the maxi- outside of perfectly competitive econo-
mum price to the highest valuing user. mies, it typically is not possible for
The way to achieve full appropriation is everyone to fully appropriate without
for each buyer to make payments ac- violating the economy's resource con-
cording to others' opportunity cost and straints. The example in which the seller
for each seller to receive payments ac- had to receive v while the buyer had to
cording to others' reservation value. pay only w illustrated the point.
More synthetically, the principle says 6.2.2 Incentives and the Two Margins
that-whether buyer or seller, or of Analysis
both-exchanges should take place such
that rest of the economy is as well off Considering that it is so closely related
after dealing with the individual as they to perfect competition, it is remarkable
would be if they did not. that the opportunity cost/second-price
Summarizing, full appropriation is method of payment was a mechanism
the principle behind the efficiency design discovery rather than something
and incentive compatibility properties mechanism designers simply borrowed from
uncovered by mechanism designers: perfect competition. The explanation,
of course, is that this aspect of perfect nopoly surpluses to fight over. But in
competition is not clearly visible on the the absence of perfect competition, the
standard side of the coin. It provides strong complementarities between indi-
another illustration of the change that viduals leads to the impossibility of full
comes from shifting the margin of appropriation: liMPi > g. Since the eco-
analysis from the commodity to the nomic pie cannot be divided "naturally"
individual. according to each individual's social
In the standard model, there is a contribution, the total gains from trade
well-known parallel to the above notion becomes a common property resource;
of opportunity cost. It is based on the contentious bargaining over slices of
commodity marginal rates of substitu- the pie typically shrinks its overall
tion or marginal rates of transformation. size.
Opportunity cost calculations of com- We illustrate when there is both
modity X in terms of Y based on dx/dy symmetric and asymmetric information.
are emphasized in the standard model
6.3.1 Bargaining over the Pie When
because they are relevant for efficiency,
There Is Complete Information
for maximization by a price-taker, and
for the demonstration that a price-taking Consider the following example. A
equilibrium leads to efficiency.21 While monopolist has zero costs of produc-
this is the right margin for price-taking, tion, and faces some tough bargaining
it is the wrong one for emphasizing in- buyers. Compared to any potential
centives. When acting strategically, the buyer, the seller is ineffectual: when-
individual cares about his total profit, ever there is a bilateral monopoly sur-
not only about the marginal profit from plus to bargain over, the buyer gets it
trading a marginal unit. all. So, if there were only one potential
buyer with valuation 20, the price
6.3 Imperfect Competition Leads would be zero, and all the gains from
to Inefficiency trade would go to the buyer as con-
sumer's surplus. But rather than just
Gainsfrom Trade as a Common Prop- one buyer, suppose there are three
erty Resource. Traditionally, perfect tough-bargaining buyers with valuations
competition has served as economists' 20, 15, and 10 respectively, as illus-
central model for achieving efficiency. trated in figure 6 below. If the seller
The reformulation strengthens this role produces only one unit, he can play off
by pointing directly to what goes wrong the two higher valuing buyers (e.g.,
when competition is imperfect. have them bid for the unit) and obtain a
Think of the total potential gains price pi = 15; notice the presence of the
from trade in an economy as a pie to be second highest valuing potential buyer
divided. Bargaining determines the di- reduces the size of the bilateral monop-
vision. When there is perfect competi- oly surplus between the seller and the
tion, the availability of perfect substi- highest-valuing buyer from 20 to 5.
tute outside options makes bargaining Similarly if he produces two units, the
determinate; there are no bilateral mo- producer can assure himself of p2 = 10
21 Lerner had it right when he summarized the for each unit by playing off the two
essentials of profit-maximization in the standard higher-valuing buyers against the third.
model by what he called the Rule: "If the value of Indeed this is the most the monopolist
the marginal (physical) product of any factor is
greater than the price of the factor, increase out- can appropriate given our assumption
put. If it is less, . . . " (Lerner 1944, p. 64) that the buyers obtain any bilateral
valuations By design, Nintendo did not fill all of the re-

tailers' orders . . . In 1988, for instance, it
20 sold 33 million cartridges, but market surveys
showed it could have sold 45 million . . .
15
[Nintendo's] largest customers got a healthy
10 share of the games, but the company refused
to cave in to their demands; no company had
all of its orders filled all the time. By then,
the toy and electronics as well as department
0 1 2 3 quantity stores were dependent on Nintendo, not the
Figure 6. Bargainingwith Three PotentialCustomers other way around. (David Sheff 1993, pp.
194-95)
The point emphasized by Branden-

monopoly surplus. (This assumption is burger and Stuart is that Nintendo was
one way of rationalizing why a monopo- engaged in a game not only with con-
list might not be able to price discrimi- sumers, but also with large, powerful
nate. Privacy provides another reason.) retailers of video games who, unlike
Finally, if he produced three units, bar- consumers, were active tough bargain-
gaining would lead to a price per unit of ers. By limiting its supply to any re-
p3= 0: there would be no outside op- tailer, Nintendo could play off one
tions left, just three bilateral monopoly against another.
bargaining problems. The ineffectual The industrial organization literature
seller would be driven to the wall. contains many examples in which the
Clearly, to maximize his profit, the potential gains from trade are up for
producer will undersupply, producing grabs. As another example, consider the
only two units rather than the socially case of Judo Economics (Judith Gelman
efficient three: his slice of the pie is and Steven Salop 1983). Suppose a non-
bigger in equilibrium, but the total pie discriminating monopolist is selling q
is smaller than it could be; ten units of units at p each. A clever entrant can
potential surplus are lost in the strug- steal some of the monopolist's custom-
gle. A nice interpretation of the out- ers by offering a low price p' but only a
come, consistent with our emphasis on limited quantity q'. If p' and q' are art-
the importance of outside options, is fully chosen, the monopolist will not re-
that the seller buys a better outside op- taliate because he would have to lower
tion by making his good artificially his price to all his customers to match
scarce. Compare this to the perfect the entrant's price; the small entrant
competitor: he does not have to artifi- uses the large monopolist's size against
cially manufacture a better outside op- him, hence "judo economics." The story
tion, perfect substitute outside options gets even more interesting when the en-
are already available to him in the trant begins to sell coupons entitling
market. the holders to buy units from the en-
The above story is due to Adam Bran- trant at p'. The monopolist finds it prof-
denburger and Gus Stuart (1994), with itable to honor the coupons sold by the
the following application. In the 1980's entrant, so the entrant makes money
Nintendo established a dominant posi- producing nothing! What is the entrant
tion in the home video game market by really doing? The entrant is providing
a variety of astute moves, including de- some of the monopolists' customers
liberately limiting the supply of its with an outside option. That is, similar
game cartridges: to Nintendo, he is manufacturing
outside options. From the point of view that is, v - c < 1/4. That this game has
of consumers, he is allowing the monopo- no Bayesian equilibrium such that trade
lists' customers to appropriate some occurs whenever v > c is due to Myerson
more of the benefit they provide to the and Mark Satterthwaite (1983).22
monopolist. That is, they are getting
more of their marginal products. 6.3.3 Tension between Efficiency and
Bargaining When There Is
6.3.2 Bargaining over the Pie When Imperfect Competition
Valuations and Costs Are Private
Information Nintendo, Judo Economics, and the
above revelation game illustrate the
Under privacy, a new possibility
treacherous webs that may be woven in
emerges for increasing the size of one's
the absence of (natural) perfect substi-
slice: strategically misrepresenting
tute outside options. They illustrate the
one's valuations or costs. We illustrate
tension between the superadditivity of
with a well-known example.
the gains from trade-tending to make
Consider bilateral monopoly bargain-
them a common property resource, up
ing over a single indivisible object. Sup-
for grabs-and the additivity needed
pose it is commonly known that both
for perfect competition/perfect substi-
the buyer's valuation and the seller's op-
tute outside options. In the absence of
portunity cost for the object have been
perfect competition, there simply is not
drawn from a uniform distribution on
enough surplus available in the econ-
[0,1], but only each individual knows
omy to reward everyone with his full so-
his own type. In the bargaining game,
cial contribution (his marginal product).
both the buyer and seller make a claim
So there is an inevitable struggle over
about his true type, v and c in the inter-
the division of the gains from trade.
val [0,1], resulting in the object being
By contrast, under perfect competi-
traded at the split-the-difference price
tion, the outcome of bargaining be-
p=Q(c+iv)/2 as long as v 2 c;if v<c, the comes determinate. The availability of
seller keeps the object and no money
perfect substitute outside options re-
changes hands.
solves any potential tension between ef-
The split-the-difference rule pro-
ficiency and bargaining. In terms of our
motes strategic misrepresentation: the
complete information examples, there is
buyer will understate his true v ("I no need to artificially manufacture out-
don't really want it that much") and the
side options; perfect outside options are
seller will overstate his true cost c ("I
already present in the market. In terms
would lose money at that price"), in or-
of our incomplete information example,
der to manipulate the price to his ad-
there is no need for an individual to
vantage (rent seeking). Since neither
misrepresent his type in an effort to get
party knows the other's valuation, such
more of his marginal product; competi-
misrepresentation sometimes leads to tion ensures each individual is already
no trade even when v > c. Chatterjee
getting his full marginal product.
and Samuelson (1983) showed that this
Does the omnipresence of imperfect
game has a Bayesian equilibriumin which
competition imply perfect competition is
the seller announces c= max {2c/3 + 1/4, c}
(exaggerating his true cost) while the 22 Compared to the split-the-difference rule, the
buyer announces v = min {2v/3+ 1/12, v} Vickrey/marginal product rule which gives the
seller v and makes the buyer pay only c leads to no
(downplaying her true valuation); so no misrepresentation. But it is not budget balancing,
trade occurs if 2c/3 + 1/4 > 2v/3 + 1/12, unless there is perfect competition.
an empty ideal? We think not. Rather, ect succeeds than if it fails. Assuming
the image of the perfect competitor as success is only a noisy signal of effort
full appropriator provides a beacon illu- (i.e., the project may fail even if the
minating what can go wrong under manager works), the incentive contract
imperfect competition: the problem forces the risk averse manager to bear
involves appropriation. some risk. From a first best perspective,
the contract involves inefficient risk
6.4 Delivery Problems
sharing: the risk neutral principal
Delivery problems add another stra- should bear all the risk. In terms of our
tegic possibility for increasing the size theft analogy, any potential manager's
of one's slice. A thief, unsatisfied with promise that he will work hard if he
his share, may try to steal some of his gets the job cannot be enforced. To
neighbor's property. There is an ele- protect himself against theft (shirking),
ment of theft in delivery problems. Like the principal buys a burglar-proof
the bait-and-switch con, when what is alarm (the incentive compatible con-
delivered is not easy to recognize, an in- tract), but this entails a social dead-
dividual may promise to deliver X but weight loss (the risk premium paid to
deliver an inferior Y instead. The differ- the manager).
ence is that, in delivery problems, the Notice that the ex ante competition
potential victim is well aware of the among the identical potential managers
possibility of being cheated; he makes did not eliminate the need for the bur-
every effort to avoid it, buying a theft- glar alarm. Why? First, observe that
proof burglar alarm whenever they are perfect competition did do its job: it
not prohibitively costly. But there are made the outcome of bargaining be-
resource costs in purchasing alarms; tween the principal and potential man-
hence, deadweight losses are entailed agers determinate, eliminating any bi-
and first-best efficiency must be sacri- lateral monopoly surpluses. As would
ficed. A remarkable feature of delivery happen with complete information, the
problems, that distinguishes them from principal gets all the gains from trade
privacy problems, is that perfect com- from "innovating" his managerial posi-
petition often fails to resolve them. The tion. But the presence of many perfect-
theft analogy is helpful for under- substitute potential managers does not
standing why: we do not expect perfect eliminate the delivery problem: regard-
competition to solve the problem of less of how many perfect-substitute
theft either. people are in the pool, once one of
To illustrate, consider a simple moral them is chosen (so the thief is now in
hazard example. A risk neutral principal the house), the size of the pool no
wishes to hire one manager from a pool longer matters: he will shirk unless his
of identical, risk averse potential man- ex post incentives are appropriately
agers. The manager may work or shirk, structured.
but this is unobservable by the princi- More formally stated, the incentive
pal; he can only observe whether the compatibility constraint, to structure in-
project the manager is in charge of is centives so the manager will deliver
successful or not. Since shirking is less work, is binding in this example; effi-
costly to the manager than working, to cient risk sharing must be given up to
implement work, the principal must of- satisfy it. By contrast, when there are
fer any manager it hires an incentive only privacy problems, the presence
contract that pays him more if the proj- of perfect substitute outside options
ensures that the incentive compatibility 6.4.1 Common Value Auctions23

constraints, to structure incentives so
that individuals will reveal their true Analytically, a common value auction
valuations and costs, are not binding; (e.g., bidding for the right to draw oil
they do not undercut achieving first- from a common pool) may be regarded
best efficiency. As we saw in section as a hidden information delivery prob-
6.4, perfect competition assures that lem. To see why, recall the defining fea-
everyone will be rewarded with his full ture of such a delivery problem is that
marginal product; this effective incen- any individual i's final utility or payoff
tive scheme results automatically (cost- from any outcome x depends not only
lessly) from perfect competition, and it on his own type ti (own information),
leads everyone to reveal all their trade- but also on others' types t-i: ui(x, ti, t-i).
relevant private information about To see the fit, interpret ti as bidder i's
valuations and costs. signal (private information) about the
The delivery problems associated amount of oil under the ground; and
with adverse selection, as opposed to notice that each bidder's payoff from
moral hazard, work a little differently, winning the auction will depend not
but the main outlines are the same. To only on his own signal, but also on oth-
give an example, recall the case of a ers'. The winner's curse illustrates: in a
seller of a used car that happens to be a sealed bid, common value auction the
peach. Buyers are unable to determine winner concludes that others' private
whether a lemon or peach is being de- information about the amount of oil in
livered. To protect themselves, they the pool was less favorable than his
only pay their valuation for an average own.
used car, which may be considerably Like delivery problems more gener-
less than their valuation for a peach. ally, common value problems typically
Here the potential bait-and-switch hap- cannot be resolved efficiently. In such
pens at the door (not after the thief has models, each individual's type includes
entered the house). Intense competi- both a private value component reflect-
tion among potential buyers again does ing his personal situation and a common
its job, eliminating any bilateral monop- value component, e.g., a signal about
oly surpluses: any used car seller is able the amount of oil in the pool. Partha
to appropriate the full value to any Dasgupta and Eric Maskin (1998) pro-
buyer of an average used car. But no vide simple examples showing, in gen-
more. Our potential peach seller may eral, there do not exist efficient mecha-
decide to (inefficiently) keep his car. nisms for allocating object(s) in this
The burglar alarm (that peaches fetch two-dimensional case. Philippe Jehiel
no more than lemons) has prevented and Benny Moldovanu (1998) prove a
even an honest man from entering the generic impossibility result.
house. To illustrate the issue, consider a
Unlike privacy problems, perfect straightforward generalization of a Vick-
competition typically does not solve de- rey auction involving a single object:
livery problems. Nevertheless, using the Each individual is asked to report his
benchmark of the perfect competitor as type (both his private value and com-
full appropriator does throw light on mon value component). The mechanism/
these problems. As with imperfect auctioneer calculates each individual's
competition, the problem is one of 23 John McMillan suggested we look at this sub-
appropriation. ject as an instance of delivery problems.
expected benefit from winning the ob- falsify. He gets his marginal product,
ject given everyone's reported informa- whether he tells the truth or not.
tion. The object, say the drilling rights, One way in which the tension be-
are given to the individual with the tween efficiency and bargaining can be
highest expected value, but he only resolved in common value auctions oc-
pays the second-highest expected value. curs when the other has nothing to lose
Unlike the private value case, there is from telling the truth (although nothing
now a strategic reason to misrepresent, to gain either). To illustrate, Richard
in particular, to claim there is less oil in McLean and Andrew Postlewaite (2000)
the pool than one believes: such a re- have observed that if any one individ-
port will decrease the expected benefit ual's signal (private information) is re-
to others and hence decrease the dundant in the sense that his signal
amount the individual will have to pay adds no extra information to the aggre-
if he wins the auction. The incentive gate of all other agents' signals, then
problem can be phrased in appropria- the above modified Vickrey scheme
tion terms: the individual's private gain would work: Because an individual's
from misrepresenting exceeds the social private information will not change oth-
gain. ers' expected value for the object, he
To see the "delivery problem," sup- has nothing to lose by telling the truth.
pose an individual offers another a pay- In a related vein, Wolfgang Pesendorfer
ment if the other will truthfully tell him and Jeroen Swinkels (1998) have ob-
the common-value component of his served that if individuals' signals are in-
private information. Assuming there is dependently drawn from a common dis-
no way for the individual to verify tribution, the law of large numbers
whether or not the other has told him implies that the marginal individual's
the truth, after taking his money, the signal will be effectively redundant.
other still may not deliver the goods. This is one of the keys that allows them
The issue is how to make the other ac- to show that if there are sufficiently
countable if he tells a lie, that is, if he many bidders for sufficiently many ob-
does not deliver what he promises. The jects (multiple plots on the same pool),
size of the payment does nothing to the outcome of bidding will be asymp-
promote accountability. totically efficient and informationally
By way of contrast, notice that in pri- revealing in spite of common values.
vate value auctions, the Vickrey/marginal Notice how competition helps resolve
product scheme works because it brings the common value problem in these
each person's private gain from the in- special cases: Each individual has no
formation he provides-whether true or "monopoly power" from his information
false-exactly in line with social gain. because others' aggregate information
To illustrate, suppose in a second-price, provides a perfect substitute outside
single object auction the highest-valuing option. But these examples are special;
bidder has valuation v and the second- in most realistic settings the tension be-
highest has w. If the w buyer claimed to tween efficiency and bargaining will not
have valuation wv- > v, he would win the be resolvable. To illustrate, if one
object and have to pay society's oppor- makes the realistic assumption that ob-
tunity cost of him getting it, namely the taining private information (a signal) is
valuation of buyer v. Because he bears costly, again there will be a private-
the full social cost of even his false in- social profit reversal: If no one buys a
formation, he has good incentives not to signal, the price of a plot would reflect
individuals' ignorance about the amount side, Schumpeter saw no room for crea-
of oil under the ground; some individu- tivity. Ironically, he singled out appro-
als would see a profit to buying a signal priation of the gains from innovation as
since having more information than oth- the hurdle that the perfect competitor
ers about the amount of oil under the was uniquely unsuited to surmount. For
ground may allow them to purchase a Schumpeter, a perfect competitor is
bargain (a peach at the price of a necessarily one among a number of sup-
lemon). But allocative efficiency re- pliers of the same product using the
quires the object(s) to be allocated ac- same technology. If one of them were
cording to individuals' private values, to invest in the development of a profit-
from the highest valuing down, not ac- able new product or new cost-saving
cording to their superior knowledge technology, it would appropriate the
about the common value component; so gains only for a moment-too short to
the outcome would again not be alloca- recover its investment; soon after it be-
tively efficient: the private value of a gan to market its product or use its new
signal would exceed the social value technique, competitors would imitate the
(Jackson 1999). This information aggre- innovation. In comparison, a Schumpe-
gation dilemma is related to Sanford terian monopolist is big enough and
Grossman and Stiglitz (1980). unique enough to keep imitators out, at
least for a sufficiently long period of
7. Appropriation and the Market time. From a contemporary perspective,
Process the argument seems a confusing mix-
ture of theory and practicality in which
In the following subsections, we re- it is assumed that the firms in the stan-
turn to previous criticisms of the standard model are necessarily unable to
dard model, but viewed from the per- establish property rights to their in-
spective of the reformulation. In the novations (e.g., patent protection).
first, we comment on entrepreneurial Schumpeter shares with Chamberlin
behavior and innovation; in the second, and many others the view that novelty
we review the connection between com- is contrary to perfect competition, that
petition and market socialism; in the a perfectly competitive innovator is
third, we look at the apparent contrast logically impossible.
between the market and what goes on Contrary to Schumpeter's depiction
inside a firm; and in the fourth, we of innovation as an extraordinary hap-
highlight the importance of property pening disrupting the routine circular
rights. Rather than simply agreeing with flow, we view innovative activity as an
the critics that these four topics are everyday event reflecting the desire for
symptoms of the standard model's defi- profits/rents. We readily grant that in-
ciencies, we shall argue that each is a novation in the real world is fraught
spoke connected to the organizing hub with appropriability problems (not per-
of perfect competition. fect competition). But perfect competi-
7.1 Perfectly Competitive Innovation tion as full appropriation helps illumi-
nate the issues, showing what is
Schumpeter's views on innovation required for market creativity to work
provide a nice illustration of the role at its best.
perfect competition plays in one's In the literature on endogenous growth,
thinking, depending on which side of two appropriability problems are em-
the coin is up. Looking at the standard phasized. In addition to Schumpeter's
concern with (a) non-excludability, John Bates Clark (1899), a pioneer of

there is the issue of (b) non-rivalry. The marginal productivity theory, antici-
latter occurs because innovation is pated some of Schumpeter's concerns,
often driven by advances in knowledge but was less pessimistic about competi-
and know-how, public goods (see Paul tion. Like Walras, he agreed that imita-
Romer 1994). tive free entry leads to a long run static
Non-rivalry refers here not so much equilibrium with zero profits. However,
to collective consumption of outputs as besides the long run, Clark's vision in-
of inputs. In particular, technological cluded a short-run dynamic equilibrium
knowledge, once produced by one firm, during which entrepreneurs may reap
can potentially be utilized by all firms. temporary rents: "Dynamic science
This gives rise to strong potential com- deals with profits in their original state,
plementarities among firms. Recall as normally created by improvements in
from the discussion in section 5.3 that industry, in the proceeds of which the
such complementarities create appro- entrepreneurs have a share; while static
priation problems-even if there is per- science deals with them in their later
fect exclusion: When complementarities and permanent state, as they are trans-
among firms dominate, the sum of the muted into increments of wages and in-
parts (individual marginal products) is terest" (p. 420). To Clark, "friction"
necessarily greater than the whole (total created the space necessary for profits:
gains from trade). Some firms will
The interval between actual wages and the
necessarily be under-compensated for static standard is the result of friction; for, if
their innovations relative to the full competition worked without let or hindrance,
appropriation ideal. pure business profit would be annihilated as
The upshot is that, even if perfect ex- fast as it could be created-entrepreneurs
clusion were possible, efficient innova- could not get or keep any income. ... Were
it not for that interval, entrepreneurs, as
tion would be problematic. Imagine such, would get nothing, however much they
that each new technology is completely might add to the world's productive power.
proprietary: no firm can use another's . . .Dynamic theory has to show how great is
technology unless granted a (single-user the interval that insures the maximum rate of
only) license by the technology's owner. progress-how much entrepreneurs need, in
the way of profit, in order to make them do
Also imagine there are many bits of all that they can do to keep wages moving
technological know-how that may bene- upward."(pp. 410-11)
fit a firm. As complementary inputs, the
terms of trade for licenses to use these In Marshallian terms, frictions give rise
bits of know-how would be up for grabs. to quasi-rents.
Strategic maneuvering to gain an advan- While we would not dichotomize eco-
tage in these myriad bargaining prob- nomic analysis into statics and dynam-
lems could lead to considerable losses. ics, we share Clark's emphasis on inap-
As an obvious parallel with collective propriable benefits as the source of
consumption, buyers of such licenses inefficiencies. As a pioneer of marginal
would have little incentive to reveal productivity theory, he knew well that
their willingness to pay. In addition, perfect competition allows each factor
buyers would have reason to manufac- to fully appropriate: the price of each
ture their own alternative, though infe- input will equal the value of its mar-
rior, technologies as outside options to ginal product, that is, the final utility it
put a lower bound on the surplus which contributes. We believe he would ap-
could be extracted from them. preciate our extension of this formula to
the individual margin: under perfect sum transfers.24 For market socialists,
competition, the reward of each firm this meant that the final distribution
will equal the final utility it contributes. of welfare could be separated from the
We also believe he would appreciate initial ownership of resources without
our bridge to imperfect competition, sacrificing efficiency.
that in the absence of adding up there This view is now a casualty of our
are inevitable inappropriable benefits. tooled knowledge about incentives. The
(See the remarks in Clark 1887 on "in- broad outline of the argument is simple;
appropriable benefits," in his chapter ti- it depends on the privacy of informa-
tled "Non-competitive Economics.") tion. Opportunistic behavior introduces
Such benefits raise difficult questions a set of previously ignored incentive
for public policy, "dynamic theory" in compatibility constraints that effec-
Clark's terms. For example it is inter- tively rule out efficiency preserving re-
esting that complete (unlimited) patent distribution schemes. To illustrate, sup-
protection is typically inefficient, lead- pose zi is the (vector of) purchases and
ing to undersupply of knowledge and sales of individual 1, p is the vector of
know-how, because the market test hy- equilibrium prices, and p *zi = ri > 0 so
pothesis is invalid for allocating public that this individual receives a positive
goods. That private property rights are transfer ri. Because transfers must sum
not a universal elixir will be a theme in to zero, there is another individual, 2,
section 7.4, when we discuss the Coase for whom p *Z2 = r2 < 0. From an Oppor-
Theorem. tunist or modern mechanism designer
Analyzing the efficiency of innovation point of view, imposition of lump sum
in the real world is highly complex; transfers creates new profit opportuni-
the appropriation problems are multi- ties. If individual 2 were able to imper-
dimensional. The discussion above sonate 1 by offering to trade zi, and if
hopefully suggests that having full 2's utility from zi were higher than
appropriation as a benchmark helps from Z2, the above redistribution would
illuminate one's path, even if it takes not be incentive compatible. Once we
one into rough, imperfectly competitive admit this conclusion, others quickly
terrains. follow. An individual need not be lim-
ited to impersonating some existing
7.2 What's Wrong with Market
type, but might claim to be someone
Socialism?
"new" to see what he can get. The end
While Schumpeter exhibited pessi- result is that the tax scheme must be
mism about the relation between com- limited to those transfers such that each
petition and the ability to appropriate, individual could not do better by pre-
the market socialists simply ignored the tending to have characteristics that
issue. For market socialists, perfect differ from his own.
competition is not at all about appro- When incentive compatibility con-
priation; in particular, its efficient pric- straints are added, efficiency evidently is
ing properties can be separated from its harder to achieve. In fact, it precludes
distributional implications. The logical redistributive transfers:
bridge connecting the standard model
Corollary of the Uniqueness Theo-
to market socialism is the Second Theo-
rem. For efficiency to be compatible
rem of Welfare Economics, that any ef-
ficient allocation can be converted into 24The First Theorem is what we referred to as
an equilibrium using appropriate lump the StandardVersion in section 6.1.
with the creative behavior that leads Theorem: In the absence of perfect
to incentive constraints, full appro- competition, individuals will not act as
priation is required; therefore, lump price-takers either.
sum transfers are precluded. Our remarks connecting the logic of
market socialism to the First and Sec-
Of course, as a formal proposition, ond Theorems of Welfare Economics
the Second Theorem of Welfare Eco- appear to reach the same conclusion as
nomics remains valid; the difference is the Opportunist critique by Stiglitz
in how it is interpreted. Today, we see (1993):
the implications of divided knowledge In this essay I arguethat the idea of market
as limiting the feasible set of incentive socialism is fundamentallyflawed-and for
compatible transfer schemes rather many of the same reasons that the Arrow-
than as an opportunity to exploit the Debreu model on which it is based is flawed
decentralization role of price-taking. as a descriptionof the market economy. I
contendthat if that model (or its precursors)
Consequently, the Second Theorem is had provided a correct description of the
more of a technical corollary than an economy, then market socialism would in-
economically substantive conclusion. deed have had a runningchance of success.
On the essential similarity between Thusthe failureof marketsocialismservesas
the First and Second Theorems, De- much as a refutationof the Arrow-Debreu
model of marketeconomyas it does of the
breu says: "To sum up briefly, an attain- market-socialist ideal. (p. 21)
able state is an optimum if and only if
there is a price system to which all the To see that the quotation above is
agents are adapted in the way described grounded differently, it is elsewhere re-
above [as price-taking maximizers]. marked that "the genius of Arrow and
These two essential theorems of the Debreu was to find the almost singular
theory of value thus explain the role of example of an economy-involving
prices in an economy" (1959, p. 90). complete markets and perfect informa-
The Second Theorem involves an equi- tion-for which the market is efficient"
librium concept that includes not only (Arnott, Greenwald, and Stiglitz 1994).
price-taking but also transfer-taking: The implication is that the First Theo-
People are supposed to regard their al- rem is alright as far as it goes, but it
located transfers as parametric. Because happens to be empirically beside the
of this similarity, interpretive demur- point because it excludes the sine qua
rers with respect to the Second Theo- non of Opportunism, asymmetric infor-
rem carry over to the First Theorem, mation. This is at once a criticism of the
i.e., to the reasons why price-taking standard model and an acceptance of its
leads to efficiency. This leads back to validity as the correct demonstration of
our discussion in sections 6.1 and 6.2 on the relation between competition and
the market test hypothesis and its ir- efficiency. "Since this is what the First
relevance to the proof of the Standard Theorem says is needed," the criticism
Version of Market Efficiency. The va- goes, "I cannot accept it."
lidity of the market test hypothesis is The standard model has for some
based on full appropriation, the key fea- time now called attention to the privacy
ture of a reward system making effi- of information about tastes and produc-
ciency compatible with the incentive tion possibilities, in its emphasis on the
compatibility constraints implied by pri- decentralization role of prices. In this
vacy. Failure to recognize incentives is sense, contrary to the above quote, the
also a feature of the standard First standard model does not assume perfect
information. It is not the assumptions due to incomplete contracting. This

behind the "singular example" that are modern perspective puts firm formation
unsatisfactory, but the argument itself; and perfect competition on the same
namely, the failure to appreciate the page.
link between competition and appro- Appropriation at the individual mar-
priation, in particular, the crucial role gin is virtually synonymous with incen-
of full appropriation for resolving pri- tives, whether inside the firm, outside
vacy problems. That deficiency was of it, or on the border determining the
built into the standard model from the boundary of the firm. An example of a
beginning, with its overemphasis on principal agent problem outside the
commodity valuation as the central is- firm is the landlord-tenant relation de-
sue of economics, while downplaying scribed in Pigou (1932). The example
the distribution of gains to individuals concerns dealings between separate
and its implications for incentives. market participants, but it is readily
About the Opportunist critique, seen to overlap relations within a firm.
above, our summary is that after A landlord rents a parcel of land, in-
grounding objections to market social- cluding a barn, to a tenant-farmer. In
ism in the principles of appropriation the pursuit of his objectives, the farmer
under privacy, one may then go on to invests some time and effort to make
examine the further consequences for improvements in the barn. As a conse-
appropriability of delivery problems. In quence, the landlord raises the rent,
failing to distinguish between privacy knowing that with these improvements,
and delivery problems-failing to put the property is worth more. If the
one foot down firmly before taking the farmer were the owner, he would cap-
next step-the above critique skips over ture all the increase in productivity
a basic point. from improvements to the barn. But as
a tenant, the farmer's improvements
7.3 The Firm and the Market
confer a benefit on the landlord. Of
The standard model treats the firm as course, knowing that he would not be
a "black box," focusing on the relations able to appropriate all of the benefits of
across economic units rather than at- the improvements, the farmer will be
tempting to look within. Hence it offers less conscientious.
little to those interested in the econom- The issue is: Who appropriates the
ics of organization. Knight (1921) in- gains or losses from the change in the
sisted on the importance of opening the condition of the barn? The problem
box. For him, true profits were the arises because of the separation of own-
product of a contractual arrangement in ership from control: the landlord owns
which the firm's owner is the residual the barn, but the farmer is responsible
claimant, while workers receive a fixed for its condition. A possible, creative so-
wage; the owner-entrepreneur's confi- lution is to pinpoint the problem at its
dence in his ability to make decisions source by writing a contract estab-
under uncertainty was used to explain lishing that the farmer fully appropri-
this kind of contract. Unlike Knight, in ates the efforts, or lack thereof, he
contemporary theory the structure of makes on improvements. Now, because
the firm is understood in terms of the landlord has transferred the rele-
coping with the opportunistic behavior vant part of his property rights in the
arising from principal agent delivery barn to the farmer, ownership and con-
problems or from hold-up problems trol (of any change in the condition of
the barn) are effectively united while cope with races on poorly maintained
permitting division of labor. cinder tracks where pushing and shov-
Of course, such a contract may not ing (delivery problems) are part of the
be feasible. Without monitoring daily race.
usage, the landlord might be unable to
7.4 The Importance of Property Rights
observe the true condition of the barn
until well after the farmer has ended Economists are sensitive to the im-
his tenancy. In that case, the landlord portance of private versus common
might consider going into farming by property rights. When a cattle owner
hiring others, including a barn-manager grazes his herd on a common pasture,
whose duties include the carrying out of he over-utilizes the commons because
specific instructions as to its mainte- he fails to take into account the reduc-
nance. But this creates related principal tion in pasturage to others. By contrast,
agent problems. Now, the concern if the pasture becomes private property
might be that instead of the barn being (enforced by fences), cattle might still
overutilized by the tenant farmer, shirk- vie with each other for blades of grass,
ing on the part of the manager might but the consequences of any possible
lead to underutilization. overgrazing would fall entirely on the
Principal agent problems are exam- land's owner.
ples of transactions costs. Transaction What is perhaps less appreciated is
cost economists often make the follow- that, even if all property rights over
ing invitation: "Now that you have physical goods are well defined, estab-
studied the standard model where lishing property rights over the gains
transactions costs are zero, let's see from trade may still entail a costly
what happens when transactions costs struggle. Indeed, under imperfect com-
are positive." With the standard model petition, this is unavoidable: If indi-
as the point of departure, the simplicity viduals' marginal products do not "add
of price-taking behavior leaves the per- up," who should get what share of the gains
fect competitor unprepared for the en- remains up for grabs. This is the ten-
tirely new strategic considerations he sion between efficiency and bargaining
confronts when transactions costs are discussed and illustrated in section 6.3.
positive. One purpose of the reformula- The tension may be described using
tion is to show that the change is actu- the language of externalities. The graz-
ally more a matter of degree than a dif- ing example above is an example of a
ference of kind; and, moreover, it is one real externality, an action by one indi-
the perfect competitor is well-prepared vidual that directly affects some other
to confront because, when one gets individuals' utility or production possi-
down to the analytical cutting edge of bilities. Even if all property rights over
transactions costs problems, more often benefits are private (no real externali-
than not they refer to appropriation ties), the process of bargaining over the
problems. division of the gains from trade can lead
Think of the perfect competitor of to pecuniary externalities, actions by
the reformulation as a world-class miler one individual that indirectly affect oth-
accustomed to running on the smooth- ers' welfare by influencing their trading
est and fastest artificial surfaces under possibilities, hence their final gains
the scrutiny of judges enforcing rules from trade.
against fouling. It is not difficult to To illustrate, suppose the pasture is
imagine that such a runner could also made into private property, but it is
held by a single owner who faces a less marized as a theorem. From Coase's
than perfectly elastic demand schedule original article, it was difficult to tell
and who is unable to price discriminate where he himself stood, but in a later
because of buyers' resistance (informa- essay he came down squarely in favor of
tional or otherwise). The landowner is (11).25 We shall argue that by eliminating
in a symmetrically opposite position to perfect competition as a key condition,
the cattleman grazing his herd on a the Coase Theorem weakens the links in
commons: Because the landowner less the chain from property rights -e ap-
than fully appropriates the gains from propriation -e efficiency, and there-
supplying more pastureland-thereby fore undercuts the case for property
creating a beneficial (pecuniary) exter- rights.
nality-he supplies too little, whereas Version I is similar to our emphasis
because the cattleman more than fully on the market test hypothesis. From re-
appropriates the gains from putting ad- marks throughout this essay, it should
ditional cattle on a common pasture- be evident that our goals overlap with
thereby imposing a harmful (real) the main thrust of Coase's contribution,
externality-he supplies too much. to redress the absence of market crea-
Attempts to sort out the conse- tivity associated with the standard
quences of pecuniary versus real exter- model. Where Coase took as his point
nalities go back to Marshall and Pigou, of departure the Pigovian tradition of
and continue today. On this issue, the (what we have called) market-taking
conclusion of the reformulation is: with respect to externalities, our posi-
There is a fundamental similarity be- tion can be described as an effort to re-
tween imperfectly defined property capitulate that theme in a more generic
rights (real externalities) and imperfect way. Moreover, our conclusions over-
competition (pecuniary externalities). lap. Where Coase singled out the con-
One leads to appropriation problems no cept of property rights-rather than
less than the other. standardized commodities-as the means
The similarity between these two to deal creatively with problems at hand,
kinds of appropriation failures is not al- we have emphasized full appropriation
ways recognized. To elaborate, we shall as the salient feature enabling property
contrast the following two versions of rights to be most effectively used.
the Coase Theorem: In our view, the logic of property
rights is bound up with the meaning of
(I) With perfect competition, well-
perfect competition. Version II of the
defined property rights and zero
Coase Theorem obscures that connec-
transactions costs, markets are
tion. For efficiency, property rights
efficient.
should be well defined, e.g., common
(II) With well-defined property rights
property resources should be elimi-
and zero transactions costs, markets
nated. In addition, however, the distri-
are efficient.
bution of the gains from the use of
Unlike version I, version II suggests a those rights should add up according to
trade-off between competition and zero the principles of full appropriation. As
transactions costs, with greater reliance illustrated in the cattle-grazing exam-
on one requiring less on the other. (I) is ple, both common property resources
the original version due to Stigler (1966)
in which Coase's observations in "The 25 See his "Notes on the Problem of Social Cost"
Problem of Social Cost" were first sum- (1988).
(ownership externalities) and common tion shrinks when discussing its ideali-
property elements in the gains from zation as perfect competition. Dissatis-
trade (pecuniary externalities) lead to faction is often summarized by saying
inefficiencies. "perfect competition is such a special
The ambiguity of Coase's "zero trans- case." Any model is, of course, limited.
actions costs" points to a lacuna that The real objection is that its limitations
was only partially glimpsed because his cut it off from larger concerns. Never-
essay pre-dated the tooled knowledge theless, even the most grudging would
of incentives. It is a residual term admit that much of our tooled knowl-
whose definition is left to post-theorem edge is exhibited in the form of state-
interpretation. The more frictions it ments about perfect competition. This
eliminates, the less meaningful the con- creates an obvious dissonance between
clusions derived from it. The definition acknowledgement of its significance
of zero transactions costs required for and disparagement of its formalization.
(II) eliminates bargaining costs so that In large part, the dissonance can be
there are no misallocations due to im- attributed to a mismatch between the
perfect competition; e.g., the monopo- questions the standard model has been
list and his customers are always able to called upon to answer compared to its
reach an efficient division of the gains original purpose, which was to demon-
from trade. We have seen in section 6.3 strate the principles of price deter-
that when there is privacy plus imper- mination, with the understanding that
fect competition, there will often be those principles applied to markets with
lost gains from trade. So zero transac- many buyers and sellers of standardized
tions costs includes the assumption that commodities. With respect to its origi-
information about others' charateristics nal purpose, the standard model is a
is common knowledge. Privacy may be well-designed machine.
an admission of positive potential trans- But it also has served as the default
actions costs, but we regard it as having framework for addressing many signifi-
nearly the same acceptance as scarcity, cantly different problems, and for these
i.e., an assumption that should be made. purposes its sleek design is too smooth
Like a lake with unrestricted access, to grasp more than a smaller and
a free market can be regarded as a smaller fraction of what economists re-
"common property resource": anyone gard as market behavior. Incentive is-
can enter to fish for profits, using what- sues, in particular, are beyond its scope,
ever lures they like. When will the out- and for a very good reason: they were
come be socially efficient? We have em- largely outside the mind-set of the
phasized that only when there is full model's originators.
appropriation can one expect that indi- The purpose of the reformulation is
viduals will have the right incentives to to regard perfect competition not only
maximize the social value of their catch. as a model of price-determination, but
also as the focal point for a broader
8. Concluding Remarks range of incentive-related topics. Econo-
mists have long prided themselves in
Competition may be the spice of life, but in having a unified theoretical core. The
economics it has been more nearly the main
dish. (Stigler 1968, p. 181)
reformulation of perfect competition as
full appropriation is intended to pre-
The base of widespread agreement serve perfect competition as economists'
concerning the importance of competi- central model for achieving efficiency.
9. References for the Reformulation petitive equilibrium 'by itself (without

the help of an exogenous Walrasian
In this section, we provide references auctioneer), notably Edgeworth's pio-
to formal counterparts underlying some neering core bargaining story and mod-
of the informal claims made in previous ern dynamic matching and bargaining
sections.26 models.
Properties of Perfectly Competitive Thin Market Perfect Competition.
Equilibrium. The Adding Up Theorem, The possibility of perfectly competitive
that innovation was first demonstrated in
full appropriation Hart (1979); interestingly, at this point
=> price-taking equilibrium, there still was some confusion about
whether perfect competition or monop-
is proved in Ostroy (1980) for exchange olistic competition was involved (see
economies and extended in Makowski Hart's title). Further development, in-
(1980a) to production and exchange. cluding a clear identification that per-
These articles contain further discussion fect competition was involved, came in
why the converse does not hold in gen- Hart (1980) and Makowski (1980b).
eral. They also demonstrate the equiva- Both Hart and Makowski have applied
lence between full appropriation and the idea to stock market economies
PEDS, that when firms can innovate new equity
price-taking equilibrium + PEDS securities (for some references see
* full appropriation. Makowski, 1983).
Economies with a continuum of indi-
In these papers full appropriation is re- viduals but only a finite number of com-
ferred to by an alternative name, no sur- modities are necessarily thick market
plus: when an individualfully appropriates, economies, the natural setting for per-
he leaves others with no surplus. Since fect competition without much creativ-
then, we have found "full appropriation" ity. With a continuum of individuals
to be more useful. and a continuum of commodities ("large
The analogy to neoclassical marginal square economies"), there is again suffi-
productivity theory, and the-demonstra- cient room for the complementarities
tion that a full appropriation equilib- between individuals to dominate the
rium involves the adding up of individu- substitutability between individuals. So
als' marginal products so that they just price-taking equilibria in large square
exhaust the total gains from trade is the economies need not be perfectly com-
subject of Ostroy (1984) and Makowski petitive; see Ostroy (1981, 1984), and
and Ostroy (1991). The latter goes into Ostroy and William Zame (1994). For a
depth on the connections with the (old) model with commodity heterogeneity
adding-up controversy centered around where substitutability dominates, see
the pioneering work of Wicksteed. Neil Gretsky, Ostroy, and Zame (1999).
The characterization of competitive Efficiency and Privacy. The view that
equilibrium as the elimination of arbi- achieving efficiency is fundamentally
trage opportunities is in Makowski and connected to appropriation rather than
Ostroy (1998). This article also includes price-taking, is the subject of Makowski
references to other related stories about and Ostroy (1995). The MarketEfficiency
how an economy might get to a com- Theorem (Opposite Side) and the quali-
26We are currently working on a book-length
fications leading to the Appropriability
exposition of the reformulation. Theorem are discussed there.
That perfect competition allows for Coase, Ronald H. 1960. "The Problem of Social
Cost," J Law Econ. 3, pp. 1-44.
the possibility of allocation mechanisms . 1988. "Notes on the Problem of Social
which are both efficient and incentive Cost," in The Firm, the Market, and the Law.
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Dasgupta, Partha and Eric S. Maskin. 2000. "Effi-
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American Economic Association

Perfect Competition and the Creativity of the Market

Perfect Competition and the

LOUIS MAKOWSKIAND JOSEPHM. OSTROY1

Thecompletetheoryof competitioncannotbe knownbecauseit is an open-ended theory;it is

1. Introduction associated. The historical part helps ex-

The Correspondence Principle was

zero profit conclusion. Given Walras' 3. Absence of Creativity in the

not only Schumpeterian innovation of The debate represents a boiling over of

tradition of price-taking, so market- instead of juxtaposing the firm and the

flanks. With respect to the creativity of goals is to argue that competition is a

individuals being more informed than system to cut through asymmetric

Once that is established, the signifi- proach is informal, we prefer a more

unfamiliar pairing points in a direction marginalism. On the opposite side of

any one individual i's participation in would contradict profit maximization,

which of course gives it very good more strategically, to try to appropriate

5.1.6 Disequilibrium Presents Profit lishing equilibrium by eliminating

In section 2.3, we remarked that 5.1.7 The Same Coin

0 q 100 200 houses

figures prominently. Here we illustrate among individuals: (1) The presence of

example. Suppose a firm is considering By way of contrast, in the absence of full

provides the correct indicators as to more familiar market price externalities

competitive equilibrium is a giant Vick- Privacy Theorem. When information

valuations By design, Nintendo did not fill all of the re-

The point emphasized by Branden-

ensures that the incentive compatibility 6.4.1 Common Value Auctions23

concern with (a) non-excludability, John Bates Clark (1899), a pioneer of

information. It is not the assumptions due to incomplete contracting. This

9. References for the Reformulation petitive equilibrium 'by itself (without

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