society foots the bill

I have been arguing that institutions represent cultural adjustments to specific circumstances faced by societies, so that an institution that works well in a particular cultural environment does not necessarily work well in a different environment. Democracy is a case in point. This is a peculiar Protestant institution which is not fit for a Catholic society.

I now turn to another typically Protestant institution, free market competition (or capitalism) to show how different are the effects it produces in a Protestant environment as compared to a Catholic environment. I consider the perfectly competitive model of economists with the standard assumptions of many sellers and many buyers, a homogeneous product, no barriers to entry or exit the industry, no information and transaction costs, etc. I assume further that the typical firm is in a position of long-run equilibrium (point a in the exhibit above).

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In this position the typical entrepreneur is just earning normal profits, that is the minimum required to keep him in this business. This is a very risky position, as any slight reduction in price or increase in costs will put him out of business. He has thus a strong incentive to move out of this position, and he can do this only through innovation. He can innovate on some product feature increasing demand and making it less elastic (1); or he can innovate on technology reducing the costs of production (2). It is in this sense that the free market has often been called a discovery process as it continuously produces incentives for innovation and discovery.

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The process of innovation, however, requires a cultural environment where people are capable of independent thinking, and a society which is tolerant to error and failure and receives with enthusiasm innovation and discovery. This is the Protestant society. Thus, an entrepreneur who discovers a new, cheaper, production technique lowers his costs of production and earns short-term economic profits. In the long-run his competitors will follow suit and the industry will end up in a new position of long-run equilibrium at a lower price. The process of competition is beneficial to the innovator himself and to the whole of society.

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I consider now the adjustment process in a Catholic society. This is a conservative society. People are not used to think for themselves. Innovation - as I argued in a previous post -, never comes from the private sector; it always comes from authority - that is, government. How are the entrepreneurs going to react when faced with that risky situation of long-run-equilibrium where they just earn normal profits? Certainly not through technological or product innovation. How then? Their most likely reaction is to get together and ask the government to impose some barriers to entry in the industry. The competitive market has just been converted into a corporative market. As demand grows over time and supply is restricted by preventing new firms to enter the industry, the new long-run equilibrium will be set at a higher price than the current market price. Producers have been protected from competition, society as a whole foots the bill.

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(1) In technical jargon, demand for the firm (D) shifts from its current horizontal position to a downward slopping position intersecting the original demand curve to the right of point a.

(2) The Average Total Cost (ATC) and Marginal Cost (MC) curves shift downwards.