James Rolph Edwards is assistant professor of economics at Northern Montana College.
As a professor of economics who wishes to convince his students of the importance of economic insights without overselling economic knowledge, I have always taught my students that even the best economic models have only heuristic value and cannot be expected to explain everything. The proper question to ask about such models is whether we understand more by having the model than we would without it. I argue that this is particularly true of the theory of perfect competition, with its numerous small firms, homogeneous product, and perfect information. It is, at best, a useful analytic device for illustrating, in a simple form, certain things about business decision-making and how economic profits and losses motivate firms to shift resources from lower to higher valued employments. However, there are many important features of the real world that are abstracted from the model. Austrian economists are correct in asserting that real states of market structure and competition which deviate from the model are not necessarily inferior, and may even be superior in crucial respects.
Assuming away such differences is sometimes useful for allowing clear focus on the relationships between a single pair of variables, or the effect of a single change, such as in demand or supply. The real world, however, is not only characterized by variation, but benefits enormously from it. Such variation cannot be ignored if economic and other social phenomena are to be understood.
Consider, for example, the fact that minerals and metals are not spread evenly throughout the earth’s crust, but are distributed randomly with concentrated lodes in some places, and almost none in others. Clearly, if such resources were spread evenly in the earth’s crust it would not have been economically feasible to mine any of them with primitive technologies. Note also, that in the history of economic thought, this uneven distribution of such resources has been one of the prime factors in the theory of comparative advantage used to explain trade flows.
Analogous to resource variability is climate, an under-represented factor in explanations of comparative advantage and trade. How often do we stop to think of the great variety of products that exists as a consequence of the variety of weather and temperature (in combination with soils, minerals, and other factors) around the world? Many types of plants and animals, which flourish in climates a standard deviation or so away from the mean, would not exist if the mean temperature prevailed everywhere. The variety of our consumption options would be greatly restricted as a consequence.
Now consider human variability. The two most crucial dimensions here are in abilities and tastes. Most of us go through life lamenting our apparently low endowment in one or more human abilities, even though we usually have above average endowments in some others. Consider certain obvious consequences that would follow from everyone having the same endowment, equal to the present mean value, of every human quality. For one thing, there would have been no Galileo and no Copernicus to advance knowledge of the universe, and no Edison to create practical products. The basic point here is crucial: The mean intellect is inadequate to make the kinds of discoveries such individuals make, but, amazingly, it is adequate to understand their basics once they are discovered and taught. The existence of individuals with extreme intellectual abilities therefore results in enormous advance in the knowledge of the general public. The absence of variation in such abilities would leave humanity in a perpetual primitive state, at best.
Variation in human abilities also has pervasive economic and social effects. It is another prime source of the comparative advantage that results in specialization, division of labor, and exchange which so greatly increase the aggregate production, wealth, and income of society’s members. Associated differences in knowledge and attitudes give rise to civilized discourse and communication, the arts, and so on, without which life would be much less interesting. In addition, each of us can gain pleasure from the mere observation of abilities we lack being applied. Who among ordinary mortals does not thrill at the sight of Michael Jordan leaping from near the foul line and sailing through an army of defenders to make a left-handed behind the back layup? In the absence of variation in human abilities there would be no Einsteins, Rembrandts, or-Michael Jordans, and I suspect we would all die of boredom posthaste. Such variation also gives rise, however, to differential attainment within all fields of human endeavor, hence differential acquisition of wealth and income. Some resentment results on the part of those who regard themselves as disadvantaged in terms of their endowment of human (or other) resources, or whose accomplishments seem meager. It is easy to argue, however, that under at least some institutional arrangements, specifically private property, limited government, and free markets, there are large social benefits that result from differential attainment of assets and wealth.
Consider, for example, differential skills and attainment in business activities. One of the abstractions of the theory of perfect competition already mentioned is that it assumes away differences in managerial and entrepreneurial ability among the decision makers of the firms in the market. It is often noted that in many real world markets the bulk of assets are concentrated in the hands of a relatively few firms, who also do the bulk of sales. But given the natural variation in managerial ability and entrepreneurial talent, and the great scarcity of extreme abilities of these types, how could things be otherwise?
With a normal statistical distribution of such abilities among corporate decision makers within an industry, there will be a distribution of costs among the firms, with some being high, a few very low, and most in between. But the highest cost firms will lose market share and leave the industry, while the low cost firms will gain market share, increasing both sales and assets. In essence, assets will be transferred within the industry from inefficient, high cost firms to efficient, low cost firms. That means not only that assets and sales in the industry will tend to concentrate in the low cost firms, which will make larger profits than others in the industry, but that industry total output (and hence market supply) will be larger and price will be lower than would be the case under an even distribution of managerial and entrepreneurial talent at the mean value. The consuming public will be enriched. This common, real world market condition is not inferior to the state described by the perfectly competitive model, but superior to it, from the crucial perspective of human well-being.
Human well-being is also enhanced by product differentiation, in which firms in the same industry produce different versions of the same product. This is another variability phenomenon that is omitted from the theory of perfect competition. Product differentiation has at least three sources. The first is that the perfect information assumption of the model does not hold in the real world. Information is an economic good which is costly to obtain, not a free good. In particular, the optimal specification of esthetic and utilitarian properties of the product, which best satisfies consumer taste, is not known a priori or by divine revelation. It must be discovered, and the only available method is to try various specifications on the market. Hence firms do so, each competing to be first to find what consumers regard as the best form of the product.
The second source of product variation is that consumer tastes vary. If consumer preferences were all the same, product variation would be transitory at best. Early in an industry’s history firms might try different specifications, but unsuccessful versions would be eliminated from the market, successful versions would be copied, and product variants would tend to converge over time on the single optimal specification. In reality, however, human tastes often vary widely with regard to the desirable characteristics of a particular product, hence there frequently is no single optimal product specification. Different versions, satisfying various subsets of the product’s consumers, will continually be produced. The third factor generating product variation is that consumer tastes change over time, so that experimentation in product specification is an ongoing necessity.
In this process as in others, participants in the market are continually responding to relative price changes and profit and loss signals in ways that shift scarce resources from the lower to the higher valued of diverse human ends. Here as in so many other ways, humans benefit from variation. The world really would not be a nicer place if all fast food chains produced identical hamburgers, and all cars were the same, as some economists seem to claim. As the Frenchman said, more wisely than he knew, “Vive la différence !”