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Thursday, November 17, 2011

Markets Are Messy, Part 2: The Errors of the Economists

Beware economic models.

Last week I argued that critics of markets are wrong when they point to imperfections as an ipso facto case for government intervention and when they criticize defenders of markets for being unable to explain exactly how they would solve a particular problem.  Markets are inherently messy and imperfect, I argued, because they are processes through which we discover what we otherwise would not know.  Asking markets to be perfect or for defenders of them to know what they will do in the future is asking the impossible.  The argument for markets has to recognize their imperfections but also note that they are still better than the alternatives.

One commenter on Facebook noted that we should not be surprised that market critics expect perfection when so many economists and others use models that do indeed stress how markets solve problems “perfectly.”  This is quite correct, and it raises some points worth exploring in more detail.

The mainstream economists’ foremost model describes “perfect competition.” It shows how, under particular assumptions, markets will produce ideal results: Resources will all be allocated to their highest valued use, prices of goods will reflect marginal costs of production, and producers, knowing exactly what goods consumers want, will produce them at minimum average total costs.  Any firm that makes a profit above opportunity cost will attract in new rivals to compete away those excess profits.  The world of perfect competition is a world of optimal resource allocation across the board.

To get that result, the model requires five assumptions:

  1. Everyone has perfect relevant information;
  2. There is a large number of buyers and sellers so no one has monopoly power;
  3. Each market has one perfectly identical product;
  4. Everyone takes the price determined by the market as given;
  5. There is costless mobility of resources.

Not in This World

Obviously these are extremely strong assumptions, pretty much none of which ever holds in the real world.  Not surprisingly, no part of the economy looks as perfect as the model predicts.  As Austrian economists have argued for decades, the fundamental problem with this model is that it misunderstands the nature of the economic problem.  In particular, by assuming everyone knows what they need to know and that firms are selling identical products, the model assumes away the discovery process at the heart of competition.  As F. A. Hayek wrote in “The Use of Knowledge in Society,” the fundamental problem facing us is a problem of the dispersion of knowledge.  Competition is justified by our very ignorance.  We need competition to figure out what demand is, what our costs are, and what sorts of products and features people want.

The deeper problem arises when economists and others confuse “perfect competition” and “free markets.”  The perfect-competition model may well have a few useful elements to it, but it is only a model and not a description of how real-world competition will or should work.  To the extent that defenders of markets rely on the model to argue for free markets, they are setting themselves up for precisely the response I discussed last week: Markets are in fact never perfect.  If we premise our case for their desirability on their alleged perfection, our case will be impossible to make.

Antitrust Fallacy

Thankfully, this confusion of perfect competition with laissez faire is less common than it used to be.  However, in antitrust law there still is often a presumption that any behavior which seems to deviate from the ideal of perfect competition is highly suspect.  The government’s challenge to the proposed merger of AT&T and T-Mobile is a good example. The merger would indeed reduce the number of competitors, but from a more Austrian perspective, the merger would be pro-competitive since it would better enable the combined company to take on Verizon.  Using the perfect-competition model as the goal of competition policy confuses the model with actual competitive processes and leads to really big policy errors.  As Robert Bork once said, using antitrust to make the economy look like perfect competition would have roughly the same effect as several well-placed nuclear weapons.

Defenders of markets make a mistake when they rely on perfect competition and similar models to defend free markets.  The perfect-competition model assumes away the key function of actual competition, which is to discover the very things the model takes as given.  Economists who ignore this point, as well as the messiness of markets, have no one to blame but themselves when the unavoidable imperfections of the market’s discovery process become the critics’ reasons for rejecting it.

Read this article in Portuguese here

  • Steven Horwitz was the Distinguished Professor of Free Enterprise in the Department of Economics at Ball State University, where he was also Director of the Institute for the Study of Political Economy. He is the author of Austrian Economics: An Introduction.