Freeman

ARTICLE

Israel Kirzner on Supply and Demand

Must We Assume Perfect Competition and Perfect Knowledge?

JULY 01, 2000 by JAMES C. W. AHIAKPOR

Israel Kirzner misrepresents mainstream economics by his assertion that in explaining market price determination by supply and demand curves, it always assumes “perfect competition,” worse yet, perfect knowledge.[1] “The mainstream textbook approach . . . is, in one way or another, explicitly or implicitly, based on the assumption of perfect knowledge” and in which the “market-clearing price is instantaneously (or, at least, very rapidly) established.” In contrast, “the Austrian version of the law [of supply and demand] avoids reliance on any presumption of universal perfect market knowledge (a presumption that . . . pervades much standard economics).”[2]

Mainstream economics uses the upward-sloping supply and downward-sloping demand curves simply to reflect the basic self-interested pursuit of net gains by market participants: sellers looking for higher prices in order to offer more quantities for sale per unit of time, and buyers looking for lower prices in order to purchase more quantities per unit of time. All such bargains are made by the market participants with as much knowledge as they may possess, but there is no insistence on complete or perfect information on the part of sellers or buyers.

Thus to say that there is an upward-sloping market supply curve for “capital” or savings in the financial market simply means that people or financial institutions would be willing to offer more funds on loan if offered higher interest rates. Similarly, to draw a downward-sloping demand curve for “capital” or savings is to suggest that more loans would be taken by borrowers if they were offered at lower interest rates. It is from such contrary tendencies of lenders and borrowers that classical and neoclassical economists explain that the rate of interest is determined by the supply and demand for “capital” or loanable funds (an explanation many Austrians fail to recognize[3]). The same model of supply and demand may be used to explain the determination of wage rates in different occupations or rental rates in different housing markets, but without invoking the assumption of perfect knowledge.

Few mainstream economists believe that the model of price determination in a “perfectly competitive” market is a satisfactory representation of real market situations, and few invoke the assumption of perfect knowledge. Rather, they consider oligopolistic and monopolistic competition as the norm. As George Stigler points out, “it seems improper to assume complete knowledge of the future in a changing economy. Not only is it misleading to endow the population with this gift of prophesy but also it would often be inconsistent to have people foresee a future event and still have that event remain in the future.”[4] Several textbooks now talk about price-taking firms rather than perfectly competitive firms. Paul Samuelson and William Nordhaus, after teaching the perfect competition model and without invoking the assumption of perfect knowledge, also remark, “By the strict definition, few markets in the U.S. economy are perfectly competitive,” and “If you look out the window at the American economy, however, you’ll find that such cases [of perfect competition and complete monopoly] are rare; you are more likely to see varieties of imperfect competition between these two extremes. Most industries are populated by a small number of firms competing with each other.”[5]

Marshall and Mill

Classical economists and such early neoclassical economists as Alfred Marshall also discussed equilibrium market-price determination by the forces of supply and demand but without invoking the assumption of “perfect competition.” Thus, summarizing classical value theory, J.S. Mill notes that:

if a value [price] different from the natural value [long-run average cost, including normal profits] be necessary to make the demand equal to the supply, the market value will deviate from the natural value; but only for a time; for the permanent tendency of supply is to conform itself to the demand which is found by experience to exist for the commodity when selling at its natural value. If the supply is either more or less than this, it is so accidentally, and affords either more or less than the ordinary rate of profit; which, under free and active competition, cannot long continue to be the case.[6] (emphasis mine)

Marshall talks about “free competition, or rather, freedom of industry and enterprise” and by “competition” means “the racing of one person against another, with special reference to bidding for the sale or purchase of anything.”[7]

It is also well known that the modern perfectly competitive model is one in which firms or sellers do not compete—they can’t change prices or product quality, two of the principal means of competition: “it is one of the great paradoxes of economic science that every act of competition on the part of a businessman is evidence, in economic theory, of some degree of monopoly power, while the concepts of monopoly and perfect competition have this important feature: both are situations in which the possibility of any competitive behaviour has been ruled out by definition.”[8] Moreover, “the theoretical concept of [perfect] competition is diametrically opposed to the generally accepted concept of competition.”[9]

For his strictures to be useful, Kirzner needs to justify his insistence that the use of market supply and demand curves to illustrate equilibrium price determination in mainstream economics always must entail the assumption not only of perfect competition but also of perfect knowledge.


Notes

  1. See Israel M. Kirzner, “The Law of Supply and Demand,” Ideas on Liberty, January 2000, pp. 19-21.
  2. See Israel M. Kirzner, “Entrepreneurial Discovery and the Law of Supply and Demand,” Ideas on Liberty, February 2000, pp. 17-19.
  3. James C.W. Ahiakpor, “Austrian Capital Theory: Help or Hindrance?” Journal of the History of Economic Thought, Fall 1997, pp. 261-85.
  4. George J. Stigler, “Perfect Competition, Historically Contemplated,” Journal of Political Economy 65 (1) 1957, pp. 1-17.
  5. Paul A. Samuelson and William D. Nordhaus, Economics, 16th ed. (New York: Irwin-McGraw-Hill, 1998), pp. 155, 170.
  6. John Stuart Mill, Collected Works, vol. 3, J. M. Robson, ed. (Toronto: University of Toronto Press, 1965), p. 457.
  7. Alfred Marshall, Principles of Economics, 8th ed. (Philadelphia: Porcupine Press, 1990 [1920]), pp. 10, 4.
  8. Paul McNulty, “Economic Theory and the Meaning of Competition,” Quarterly Journal of Economics 82 (4) 1968, p. 641.
  9. S. Charles Maurice, Christopher R. Thomas, and Charles W. Smithson, Managerial Economics, 4th ed. (Homewood, Ill.: Irwin, 1992), p. 431.

ASSOCIATED ISSUE

July 2000

comments powered by Disqus

EMAIL UPDATES

* indicates required

CURRENT ISSUE

October 2014

Heavily-armed police and their supporters will tell you they need all those armored trucks and heavy guns. It's a dangerous job, not least because Americans have so many guns. But the numbers just don't support these claims: Policing is safer than ever--and it's safer than a lot of common jobs by comparison. Daniel Bier has the analysis. Plus, Iain Murray and Wendy McElroy look at how the Feds are recruiting more and more Americans to do their policework for them.
Download Free PDF

PAST ISSUES

SUBSCRIBE

RENEW YOUR SUBSCRIPTION