Previously in Sequence: Moloch Hasn’t Won, Perfect Competition

This post looks at a few examples of imperfect competition to illustrate various ways in which perfect competition is kept at bay and value is preserved. Concrete examples seem more likely to enlighten than abstract principles.

Let’s start with the most literal of markets, the market for food, and then talk about the market for cars.

As I noted last time, I noticed after writing this that a Local Farmer’s Market was Google’s top response to asking for an example of perfect competition. Which makes it kind of perfect as the central example of imperfect competition.

For length, I’ll stick to these examples. I am happy to give quick models for other markets in the comments if anyone wants to work through different examples.

1. The Local Farmer’s Market

A few times a week, at various places around the city, local producers open stands to sell their goods to the public. Many people choose to shop here, rather than at the supermarkets a few blocks away in every direction. They typically pay higher prices, do a lot of investigation and sampling of goods, and eventually often become loyal to producers and products that provide strong value. When I was growing up, we often got our cheese and apple cider from one such market (along with more healthy foods that I was incapable of eating, and therefore don’t remember as well).

What’s going on here? A lot of different things are combining at once – and this list likely isn’t even complete. Each of these is a violation of perfect competition.

Products and producers are not homogenized, and information about them is costly. Even the relatively homogenized farmers’ market products, like the apple cider, differ in quality from batch to batch, from season to season and harvest to harvest. There is no reliable way to differentiate high quality from low quality products or producers, or any way to divine the product details you might prefer or dislike, without sampling the goods, which is costly outside of the occasional free sample. When buying produce, one needs to pick out the items one likes and things get even more variable. Reputation and experience matter a lot.

Market information is costly for consumers. Different producers bring different goods to market at different times, with no known schedule. Often the goods sell out. The only sure way to know is to go to the market and look around. If one wants to be sure, one would even walk around the full market and examine things before making any decisions, but that takes a while. Once you’re there, it often makes sense to buy something even if you wouldn’t have bothered going out there if you’d known what was available today.

Market information is costly for producers. Farmers and bakers and cheesemongers tend not to be those with a deep interest in market dynamics. They don’t know what consumers will want or what prices they’ll be willing to pay, and find out by trying to sell goods and seeing what people buy. They are quite bad at maximizing profits from what they produce. We like it that way. Someone who was good at maximizing profits would be bad at producing quality goods. Each producer has a unique situation, so they can’t rely on general surveys to price goods correctly. Goodwill is vital to the business, making pricing experiments generally a bad idea. That leads into a key additional concept, which is complete skill stacks are rare. This allows being very good at one aspect to compensate for being relatively poor in another, whether or not this is by choice, or provides slack.

Unknown unknown information exists. We know little about nutrition and what is dangerous for us. Some of what we are buying, when we buy from small local producers, is their inability and unwillingness to use various industrial methods we don’t know about or understand, that may have unknown and hard to measure long term effects on our health. We are uncertain about the order of magnitude of this effect, but such effects are highly unlikely to be good. This pushes us away from homogenized products.

Fixed costs exist and production costs are asymmetric. Skills differ. Each farmer and producer both specializes in a different set of products, and faces the quirky resource constraints of their own land, skills, tools and background, and what they know how to and like to grow and make. Economies of scale exist due to many fixed costs. Even if you did know how to grow crops, doing so on too little land would be prohibitively time inefficient. Even if it wasn’t, you would still have no practical way to bring those goods to market, as that too requires fixed costs. You can’t participate in these markets unless you’re big enough to be a full member and committed to sustaining relationships and reputation.

Producer preferences differ. This is an important variation on variable production costs. Farming in the modern age is often a labor of love. If a farmer likes extra sharp cheddar or plum tomatoes, they’re going to produce them even if it isn’t the best thing for the bottom line, then bring them to market anyway. They’ll also produce more variety than the market would reward on its own. Seeking this out is one way to find the best quality.

Location matters. The farmer’s market exists largely because it’s better to buy local products with lower money and time spent in transportation, resulting in cheaper and higher quality goods. The goods in supermarkets often were engineered to travel better and keep longer, which reduces quality in other ways. When you go to the market for local goods, those closer to the market have a huge advantage. Those farther away will choose to go to a different market, even if its customer base isn’t quite as good.

Consumers care about the individual producers. Local farmers also often get extra business from those who like to support local production for various pro-social reasons, or even develop personal relationships over time. Most people at the farmer’s market would pay a non-zero amount extra to buy from the farmer’s market over an identical product at the supermarket.

Skin in the game. Skin in the game doesn’t mix with perfect competition, because in perfect competition there’s no skin available to have. When owners operate and stick around for the long term, and face the consequences of their decisions in terms of skill development, reputation, capacity, and so on, they have to care about more than just creating a homogenized product, or even creating a product. Everything matters, and those who let longer term things slide do not survive for long.

No boss. No one is telling the producers they’ll be fired if they make trade-offs. No shareholders are putting on extreme pressure to maximize profits. People get to do the things they want to do, and not the things they don’t want to do, and accept the consequences.

What happens in the long term?

We used to mostly have these types of markets, and now we mostly have supermarkets.

2. Supermarkets

Supermarkets are a rough business to be in. They are much closer to perfect competition than farmer’s markets. The products are more commoditized and homogenized, and are more predictable in quality. Information is easier to get. Often goods are identical across sellers. The relationships are mostly purely transactional. The store owners are mostly in it for the money.

Identical packages of Kerrygold butter are $3.19 at Trader Joe’s on 3rd Avenue, $3.79 at Whole Foods a block farther west, and something like $4.49 at Westside Market two blocks to the south. Sometimes I see them for $5 or more.

That’s weird. Sounds remarkably uncompetitive. What happened to the law of one price? What’s going on?

Here’s my model. People care a lot about distance when picking a supermarket, and care a lot about batching their purchases so they don’t have to go too often. Customers are choosing between a handful of potentially reasonable bundles of options. Each has some unique offerings in terms of product variety and quality, a unique location, a unique brand identity and reputation, and a history with each potential customer. It takes time to learn what each one has to offer, to remember where everything is located so things can be found quickly, to know which things are being overpriced at each store. Stores often price some items lower than normal and/or below cost to tempt customers in (hence the term ‘loss leader’) and then jack up the prices of other items (like the Kerrygold butter) where customers are likely to be price insensitive.

Thus, when I enter a new supermarket, I price check the Kerrygold butter before buying items whose fair price I do not know.

Supermarkets are effectively in oligopolistic competition with local alternatives and a handful of services like FreshDirect. They’re not in anything like perfect competition with each other.

The same is true for different brands within the supermarket. We have what almost any other culture in history would consider amazing product variety and choice. It is very rare for there to mostly be multiple brands that sell essentially identical products at the same price point, in the same store. It’s rare for there to be even two best options that are essentially identical. Often, the choice will be close between multiple brands, but that’s because they’re offering different trade offs. Attempts to copy gold standard products like Heinz ketchup somehow don’t work. Most consumers don’t know the quality or details of most options of things they’re considering buying. And there’s a ton of brand loyalty. There is intense competition. The system works well. But it’s definitely something very different than perfect competition.

Online grocery services like FreshDirect also face sufficient scale and distance requirements that there are only a handful available in a given area, and they tend to not have that much product variety either, and to market themselves as unique options complete with many unique items (e.g. for FreshDirect I recommend the take and bake Ciabatta rolls).

One can imagine a world in which transportation costs continued to fall, and skill in preservation continued to improve, as did the ability to communicate what you want online and get what you asked for (this is much less reliable than my priors would have predicted), to the point where location stopped being important and it made sense to break up orders into individual products. One can imagine better market knowledge becoming available and known to more customers. Or the food is made in replicators, or by robots using standardized open-source procedures. That day may come. For now, a lot of things stand between here and there.

3. Restaurants (in brief)

Restaurants are a strange case.

I am told that no one makes money and competition is super rough, largely because people are often opening and running places for non-monetary reasons. A lot of people think they can do it when they can’t because they don’t understand what it takes (and because their friends and family often lie to them about their cooking). Which can all cause super-perfect competition.

Despite that, we clearly see highly imperfect markets. We regularly see places that can produce sufficiently superior products to command strong pricing power, which they rarely fully use. There is little doubt that many places have huge advantages over the marginal competition. Places have sustained reputations and relationships with regulars, earned by Playing in Hard Mode. Seeing people play in hard mode is a sure sign competition is far from perfect. And those who do these jobs well earn the ability to charge more and often get more business than they can handle.

My model says the central stories here are that location matters a lot, skill and experience matter a lot, products are highly differentiated, information is expensive on many fronts, and people have different values with skin in the game. Too many participants enter, and exiting is expensive, so making zero profits is really hard. But there are huge marginal returns to being great, so huge success remains possible.

4. Buying a Car

I don’t drive, so I’ve never bought a car. But buying a car is traditionally so frustrating to so many people that I know a reasonable amount about the process.

In the first phase, different companies attempt to convince you to buy their car instead of another car.

This is done through some combination of bragging about small features or arbitrary industry awards, selective comparisons (which my brain always reads as, ‘that other car you’re mentioning is probably worth checking out’), creation of emotional resonance and identity affect assignment, loading up more observable features, periodic ‘good deals’ and ‘sales’ with superficially cheap structures, offering test drives, and providing in the background real information resources.

Customers then combine this with personal anecdotes and ideally some information from plausibly objective third parties (e.g. my parents used Consumer Reports magazine and the NPR show Car Talk) to evaluate salient choices along numerous axes, narrow things down to choices that feel appropriate and reasonable, then consider what ‘deals’ are available and make a final choice however big final choices are made. One must also then choose expensive new car versus cheaper new car versus premium used car versus cheap used car.

Economies of scale, both in production and distribution and then in marketing and reputation, keep the market limited to a handful of producers, each of whom produces a handful of models each year. Even major participants can only efficiently highlight a handful of offerings, or the messages get muddled. Different customers care about wildly different things. One will care about safety and reliability, another how the car looks or whether it is seen as sexy, another primarily cost to own, a fourth comes from a family that drives Fords, a fifth wants everyone to know how good and responsible and forward thinking they are with their electric model, and the last is a sixteen year old who just got their license and wants really good air conditioning and sweet cup holders.

You want to differentiate yourself from the competition, not match them, even if you’re better on objective quality and value, since those are hard to measure and communicate.

The products do their best to not be homogenous.

It’s not that one element of perfect competition is missing. It’s that all the elements are each on their own missing.

Entry and exit are costly.

Economies of scale are central.

Market knowledge is expensive and difficult.

Mobility of goods is not only not free, it is what is being sold.

There are massive restrictions on trade.

Past this point, I have no personal experience, so this could be unfair, obsolete, inaccurate or all three. And of course, the whole point is that these markets are not perfectly competitive, so experiences wildly differ from person to person and location to location. Great experiences do exist, and only some of them involve not realizing you’re being had.

Once a car has been selected, it’s time to head to the dealer. To negotiate and make a deal.

This process is not less absurd than it sounds. It’s also mandated by the government in the United States, which bans systematic automobile sales that don’t go through physical dealerships.

Customers come in and look around the shiny cars. They are then likely to be accosted by salesman who share selective information, hide other information, frame shift, anchor on absurd retail prices, manipulate, outright lie, ‘check with their manager’, cajole, play good cop bad cop and other similar games, create expectations of reciprocity, bait and switch and so forth. They do this so brazenly and reliably that ‘everybody knows’ that car salesman are out to get you, and people study up on how to navigate this in reasonable time and not get taken for a ride.

Most customers rightfully dread this. Many find it so unpleasant that they knowingly accept losing hundreds or even thousands of dollars in value to make the process less painful. They are often unable to bring themselves to use tactics like “call multiple dealers and ask for quotes” or “take a day to think about it or see if the deal improves,” and even those who know rarely hold out for the most powerful, “wait for the end of the month,” whose mechanism will be explained in a bit.

And that’s for new cars. Used car salesman carries even worse connotations.

Importantly, it’s not maximally bad connotations. It’s nothing close to perfectly competitive fraud. It’s wildly varying magnitudes of fraud.

The common question, ‘would you buy a used car from this man?’ highlights that there are people you under no circumstances should buy a used car from, and others, even professional used car salesman, that you should be cautious with but who it would be reasonable to purchase a used vehicle from.

New car salesman pursue a wide range of strategies at a wide range of skill levels. They even radically adjust tactics based on the time of the month. They have targets to meet and will do whatever it takes to meet those targets if they’re about to miss, but find doing so unpleasant on many levels, as well as expensive. It not only burns slack and isn’t fun, it degrades the long term and bottom line to push too hard. So most salesman avoid doing this when it isn’t necessary, and pick a trade-off between short term profits, long term profits, intensity of work, and their own sense of morality.

When we do see the worst behaviors, my model says it is usually because of pressure from bosses and quotas from higher up the corporate ladder, rather than any need to be maximally competitive.

It is done haphazardly and inefficiently to save people’s hides. That you can typically literally save hundreds to thousands of dollars by buying your car on the last day of the dealer’s sales incentive period speaks to how distorted all of this has become.

We are seeing the results of immoral mazes.