I was at first puzzled by Professor James C. W. Ahiakpor’s charge that I had misrepresented mainstream economics (by my statement that mainstream economics’ use of its supply-and-demand apparatus relies on the assumption of perfect competition, and thus perfect knowledge). I was puzzled because mainstream textbooks are quite explicit on this point.
Upon re-reading Professor Ahiakpor’s comment, especially his quotations from Stigler and other mainstream writers who emphasize the unrealistic nature of the assumptions of the perfectly competitive model, and particularly its assumption of perfect knowledge, I believe that I can put my finger on the source of Professor Ahiakpor’s misunderstandings. In fact, I will use several passages from Stigler’s textbook on price theory (not the source of Professor Ahiakpor’s Stigler quote) to attempt to clarify matters.
As a prelude to his discussion of how demand and supply determine price, Stigler carefully articulates the conditions (especially that of perfect knowledge) needed for perfect competition. He then proceeds to address possible misgivings concerning these conditions. “If the reader bristles at the acceptance of assumptions such as perfect knowledge . . . he is both wrong and right. He is wrong in denying the helpfulness of the use of pure, clean concepts in theoretical analysis: they confer clarity and efficiency on the analysis, without depriving the analysis of empirical relevance. He is right if he believes these extreme assumptions are not necessary to the existence of competition . . . .” (Italics in original.)
Clearly, Stigler’s position can be stated in three points: (a) the real world is not perfectly competitive; it is not characterized by perfect knowledge; however, (b) the economist is best able to explain price determination in the real world by referring to a “pure and clean” analytical model of supply and demand under conditions of perfect competition; and (c) this pure and clean model is then useful in understanding the real world because the degree of competition and of perfection of knowledge in the real world is sufficiently close (to the pure and clean concepts of the analytical model) as to render that analytical model a useful basis for understanding price determination in the real world. Ahiakpor has focused exclusively, it seems, on points (a) and (c), and somehow concluded that mainstream explanations for price determination do not depend analytically on perfect-knowledge assumptions. But surely this conclusion is quite mistaken; point (b) cannot be denied.
For mainstream economics (and particularly for Stigler) the applicability of the pure and clean analytical model of supply and demand to the real world of imperfect knowledge is based entirely on the belief (hope?) that the degree of such imperfection in knowledge is not serious enough to compromise the applicability of the pure model. But the analytical basis for such application remains the pure and clean model itself. Any explanation of real world price determination rests, in mainstream economics, on the validity of the explanation for price determination offered by the pure and clean model of supply and demand, under conditions of perfect knowledge. The Austrian critique points out the internal, analytical inadequacy of that pure and clean model (quite apart from the unrealism of its assumptions). As Hayek and the modern Austrians point out, the true explanation for the emergence of the market price refers strictly to those very imperfections of knowledge that mainstream economists find it necessary to downplay.
The Model’s Uses
I would like to make a concluding observation. The asperity of Professor Ahiakpor’s comment suggests that he has read my pieces as expressing complete dismissal of mainstream economics and as doing so with complete hostility toward it. This is by no means the case. Speaking strictly for myself (rather than on behalf of Austrian economists), I can say that there certainly are important uses for the mainstream perfect knowledge model. For many rough and ready purposes of applied economics, it is this model that is the most useful practical tool. I have often stated that if students had to be exposed to only one lecture in economics, I would hope that that lecture would be the mainstream supply-and-demand lecture. But, I must insist, such usefulness, as a matter of pure science, is severely limited. For adequate understanding of how markets work it is necessary to go beyond the perfect competition/perfect knowledge analysis, and to explore the processes that flow from imperfect knowledge and from the entrepreneurial decisions set in motion by such imperfection of knowledge. The truth is that recognition of this scientific insight turns out to be of utmost importance for developing enlightened public policy. For as Austrian economists know, it is in and through these processes that free markets make their contribution to human well-being.
- I list here three examples, at different levels of sophistication: George J. Stigler, The Theory of Price, 3rd ed. (New York: Macmillan, 1966), pp. 87-89 (leading into his discussion of price determination through demand and supply); J. M. Henderson and R. E. Quandt, Microeconomic Theory: A Mathematical Approach (New York: McGraw-Hill, 1958), chapter 4 (and especially p. 86, leading into the discussion of market equilibrium in terms of supply and demand analysis); and D. Salvatori, Microeconomics (New York: HarperCollins, 1991), p. 26.
- Stigler (p. 87) treats perfect competition as equivalent to the state in which each market participant faces infinitely elastic supply or demand curves—the state which corresponds to the price-taking assumption to which Professor Ahiakpor refers.
- Many mainstream economists would follow Milton Friedman in arguing that the absence of realism in the assumptions of the perfectly competitive model is almost irrelevant to the usefulness of the model in predicting real world outcomes. For Friedman’s well-known position on this see his Essays in Positive Economics (Chica go: University of Chicago Press, 1953), pp. 14f.
- It was Hayek who, in his brilliant 1946 critique of the perfectly competitive model, identified its central flaw as an explanation for price determination. The model cannot explain how price comes to be that which the model predicts. The model can only, given its assumptions, postulate that that is the price. The model assumes the result the emergence of which we are seeking to explain. See F.A. Hayek, Individualism and Economic Order (London: Routledge and Kegan Paul, 1949), pp. 93f.