We should stop chasing ‘perfect competition’

Eamonn Butler

March 10, 2020

Back in the 1950s, Nobel economist Robert Solow calculated that a remarkable 87 per cent of economic growth came from innovation. The science writer Matt Ridley, whose new book on innovation will be published in May, believes the figure is even higher today, since new materials, new machines and more efficient methods allow us to spend less and less time and resource on supplying our needs and wants.

And you can thank entrepreneurs for that tidal wave of innovation. Entrepreneurs create new and better products and better, cheaper production systems. They even create new resources, turning valueless things like sand into valuable ones like silicon computer chips that in turn create things of even greater value, such as smartphones, robots and driverless cars.

But innovation is not just about new gadgets. It is, says Ridley, “the great equaliser”. Today, people in the poorest countries have mobile phones that work as well as any in the richest. Innovation is why the number of people living in extreme poverty is shrinking fast, and why it will continue to do so.

Innovation transforms our lives – and it is new, smaller, growing, entrepreneurial companies that account for most of it. So how can we promote entrepreneurship and all its benefits?

Not by throwing subsidies at entrepreneurs. Vital as innovation is, most attempts to create new products and processes fail. Typically, a fifth of new businesses fail within a year, a third within two years, and around half within five. Only a tiny few become hugely successful. Subsidise small business and you subsidise a lot of failures. Government attempts to “picking winners” are notoriously unsuccessful.

Mainstream economists too give us scant guidance on how to boost entrepreneurship, since they largely ignore it. They recognise land, labour and capital as “factors of production” but ignore the most important one – the entrepreneurial mind that puts the other factors to work and directs them to the highest-value ends.

The textbook “perfect markets” scenarios eclipse the fact that markets are dynamic; a perpetual flux of changing demand for and supply of countless goods and services. Like the whirlpools and eddies that open up in a fast-flowing mountain stream, temporary shortages and surpluses stream through markets, until they are spotted and filled by entrepreneurs.

And all without “perfect information”. Indeed, the process is mostly guesswork; albeit, in the case of many successful entrepreneurs, inspired and thoughtful guesswork. Entrepreneurs take risks, make investment decisions, and commit time, effort, capital and other resources into their project, without knowing for sure what the future will bring and what the needs and choices of future consumers will be.

Who would have dreamed, for example, that nearly half the world’s population would even want a smartphone, never mind buy one? What producer of encyclopaedias, atlases, reference books, diaries, newspapers, calculating machines, cameras, music players or department stores would have predicted that their businesses would be devastated by some pocket gadget?

No, what we need to do is to create the right conditions under which entrepreneurship might arise and thrive. The entrepreneurial process, by which innovative companies and products either fail or break through to economic success, is an evolutionary process, much like the natural selection process by which living species evolve.

The more experimentation we can encourage, the more the chance we have of finding success. And for the same “trial and error” reason, the easier it is to fail, but still recover, the more fertile the process becomes. Indeed, most successful entrepreneurs have had past failures, often many of them.

Thomas Edison had more than a thousand failed attempts to develop a lightbulb. Steve Jobs lost Apple millions with his Apple I and Apple Lisa and even got fired from his own company. Sir James Dyson tried over five thousand prototypes before creating his bagless vacuum cleaner.

It’s not entrepreneurs, or even ‘big business’, that decide which products come through this evolutionary selection process. It is consumers, constantly choosing the products that best satisfy their needs and give them the highest value for the least price.

If someone else can produce a better or cheaper product that delivers them better value for money, they can (and will) drop their existing suppliers and spend their money on that new product and new supplier instead. Build a better mousetrap, as the saying goes, and the world will beat a path to your door, though there is much more to entrepreneurial success than mere invention.

The mainstream economics approach has yet another shortcoming. It underestimates, indeed ignores, the importance of diversity. In so-called ‘perfect competition’, products are identical. In reality, they are obviously not. Think of the variety and choice we have in everyday goods: different kinds of tea, bread, footwear, hats, chairs, phones, cars or housing; and in different services too, like hairdressing, banking, entertainment, job training, transport or veterinary services.

True, the “perfect competition” model is only a theoretical abstraction that is designed to help us think. But by glossing over the real diversity and complexity of economic activity, it actually misleads us and encourages some very mistaken ideas. It makes may people conclude, for example, that having more than one producer of anything; cars, chemicals, ships, paper, clothing or whatever else; must be ‘wasteful’.

After all, “economies of scale” mean that a single large firm should be able to produce things far more cheaply than numerous small ones. At the same time, distribution systems could be unified and there would be no need for competitive advertising.

Yet, far from promoting any “wasteful” duplication of identical products, real-life competition spurs entrepreneurs to create products that are different. They want to win customers from their competitors by offering them products that are not the same, but better or cheaper or both. They want to create products that stand out from the crowd, products that capture customers’ attention and imagination and make them switch their spending patterns.

As a result, consumers enjoy a huge variety of products to choose from, with different features and at different levels of price and quality. No two models of car, computer or cosmetic are identical. Even seemingly standard products like soap or orange juice or hamburgers are made, styled, packaged and marketed in different ways.

Nor would we even want to have the same clothes, footwear, watches or hairstyles as everyone else. Yet the “perfect competition” model ignores this diversity and therefore overlooks the role and importance of entrepreneurship in creating it. And, indeed, in driving innovation and human progress.

In the real world, there is certainly plenty of competition. But entrepreneurs are not trying to give us all some identikit product. They are striving to find out what sorts of products we prefer. That brings their ingenuity and innovation to bear on supplying what the public really wants. In the process, they make new discoveries, develop new systems, improve productivity, increase value and promote progress.

Those are all very important reasons why we should care about entrepreneurship and try to understand it and encourage it. But let’s do that in ways that actually work.


Written by Eamonn Butler

Eamonn Butler is Director of the Adam Smith Institute.


Capitalism and freedom are under attack. If you support 1828’s work, help us champion freedom by donating here.

Keep Reading



Sign up today to receive exclusive insights