Ludwig Erhard: Getting the Economy to Work

In a previous part of the course, we saw that Ludwig Erhard’s economic policies included the lifting of price controls. Ludwig Erhard and other ordoliberalists, in the tradition of the Freibrug School– Freiburger Schule– argued that the scope for government should be quite limited. Government should provide the conditions so that competitive markets can allocate resources via market prices. To this end, market prices need to be unrestricted. And in particular, there should not be price controls. Ordoliberalism argues that the government should only maintain property rights and enforce private contracts. In, addition competition policy should promote individual freedom. This would promote economic efficiency as a byproduct.

Today, the aim of economic efficiency and the allocation of resources is more central than it was in the view of the ordoliberalists. Different ways to allocate resources are usually ranked by how efficient they are. Also, today’s role of prices and well-functioning markets is uncontroversial. In fact, this is not a new idea. In 1776, already Adam Smith suggested that competitive markets are efficient. Smith was a moral philosopher, and a political economist, and author of the book The Wealth of Nations. He is regarded by many as the father of modern economics. In his view, prices aggregate the decisions of many market participants in a decentralised manner. Smith use the term invisible hand to describe this idea.

Even though each market participant only pursues his or her own interest, the outcome is good for society. Prices direct resources to the production of those goods that are most valued by society. This is why competitive markets are efficient. In free markets, a good is exchanged when the seller values it less than the buyer. If the good is sold at the price between the valuation of the seller and the buyer, then both the buyer and the seller are better off through the trade and the good has a more efficient use than before. Today we also know that there are situations in which the market mechanism does not work well and the outcome will not be efficient.

These situations are known as market failures. When there is a market failure, the government might be able to improve upon the market outcome. An example is the so-called natural monopoly. Surprisingly, in such a situation, a monopoly that has only one seller is a more cost-effective market structure than competition that has several sellers. This is often the case with utilities like telecommunications, gas, electricity, or water. The distribution of these utilities requires an important investment in physical infrastructure. But once this infrastructure has been provided, additional distribution costs are very low. In such a situation, competition is undesirable because it requires duplication of the infrastructure investment. On the other hand, a monopoly firm has market power which it might use to its advantage.

Therefore, it might be necessary to regulate the monopolist in such a way that the market price is not too high, but covers production costs. An important aim of public policy is to avoid cartels and collusion. Examples are firms fixing prices, establishing output restrictions, or dividing markets. These practises usually lead to inefficient outcomes in which income is transferred from consumers to producers. In addition, these practises might result in lower productivity growth and inefficient firms surviving in the market. On the other hand, cooperation between firms is sometimes desirable because it improves market performance. So even though collusion is illegal, it is often difficult to distinguish cooperation that is good for efficiency and cooperation that is anti-competitive.

Merger policy is another important area of modern competition policy. Should a given merger between firms be approved, the first might argue that it allows to organise production more efficiently, perhaps because of rationalisation. On the other hand, the merged firm might obtain a dominant position in the market. As a result, it might obtain a market power that it might take advantage of. Merger policy must balance these possible anti-competitive effects with the potential efficiency gains. Modern competition policy also deals with monopolisation and firms that have a dominant position in the market. A firm might obtain monopoly power through anti-competitive conduct like predatory prices below cost.

A firm can also be in a dominant position and abuse this position– for instance– in its pricing decisions. Again, competition policy must balance these anti-competitive effects with the possible benefits. Competition policy must also consider incentives for innovation. Innovation leads to technological progress that, in turn, creates economic growth and is thus a very important activity. But innovation requires important investments that a firm is only prepared to make if it will be rewarded. Patents are frequently used to reward innovative activities. A patent creates a temporary monopoly right, because it excludes rivals from using the innovation, usually during 20 years. Hence policymakers need to strike a balance between providing sufficient incentives to encourage innovation, and avoiding monopolisation and inefficiencies.

Summing up, we can say that prices play an important role in well-functioning markets and should, in general, not be restricted. But there are also situations in which the market outcome is inefficient and government policy might lead to better outcomes. This includes the regulation of natural monopolies. Another important policy is competition policy. Competition policy often needs to balance the conflicting aims of improving efficiency and mitigating anti-competitive effects. Hence efficiency considerations are central and not only a byproduct, as in the thinking of the ordoliberalists like Ludwig Erhard.