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Wholly Imperfect

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In my latest column for AIER I express some of my discontent with the so-called “theory of perfect competition. [2]” This theory is not at all a theory of competition; instead, it’s a theory of price determination (as Harold Demsetz has pointed out). And as a theory of price determination it leaves a great deal to be desired. Some slices:

Although economists have long recognized that the assumptions on which the theory of perfect competition rests never actually describe reality, this theory nevertheless sets the standard against which economists continue to assess the competitiveness of real-world markets. The more closely real-world market structures and outcomes resemble those of a perfectly competitive market, the more competitive do neoclassical economists judge real-world markets to be.

These economists justify their use of the theory of perfect competition by correctly noting that no theory accurately describes the reality that it is meant to explain. But in this case this justification fails completely.

It’s true that all theories rest on simplifying assumptions. Yet when neoclassical economists justify the unreality of the assumptions at the heart of the theory of perfect competition, they reveal an apparent belief that simplifying assumptions are a sufficient condition for generating useful theories.

Yet this belief is false. Assumptions are not justified merely because they are simplified. Instead, simplifying assumptions are justified only if they result in theories that enhance our understanding of phenomena that we seek to better understand.

Do the assumptions at the heart of the theory of perfect competition enable us to better understand competition in reality? You decide. This theory assumes that

  • the products available for sale have already been developed in all relevant details;
  • firms never compete for customers by improving the quality or otherwise changing the features of products they offer for sale;
  • each firm in an industry produces outputs that are identical in consumers’ minds to those produced by every other firm in that industry;
  • such a very large number of firms exist that no firm has any control whatsoever over the price it charges; each firm can sell as much as it wishes at the prevailing market price, but if it charges any higher price, it makes no sales;
  • both consumers and producers are fully informed about all relevant features of the products and of the market, including knowledge of the most efficient means of producing and distributing the outputs; and
  • firms enter and leave each perfectly competitive industry instantaneously.

Except, perhaps, for the last of these assumptions, to use this set of assumptions is to assume away the very phenomenon that the theory of perfection competition ostensibly is meant to explain: competition.

…..

But in fact the theory of perfect competition should be utterly rejected, both as a theory of competition (which it is not) and as offering an appropriate standard against which to judge real-world markets (which it does not).

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