Supporting Free Markets Means Rejecting Perfect Competition

– April 10, 2019

Intersecting supply and demand curves are perhaps the most iconic image in economics. In a simple picture they convey fundamental truths about how free markets find a price that aligns the interests of buyers and sellers, and how the price adjusts to basic shocks to either supply or demand.

But elegance aside, the standard economics textbook that begins with those graphs and the framework of “perfect competition” has held hostage our debates about markets, government, and society. In fact, the very concept that markets can be perfected sells real-world markets far too short.

The Problem With Perfection

Virtually all introductory economics textbooks begin with perfect competition. In addition to those intersecting lines, we learn that free markets create the most possible wealth for society when buyers and sellers are atomistically small, have perfect information, and trade in identical products. The optimality of markets under these conditions has been incorrectly emphasized by advocates of laissez-faire policies. But more frequently this idea has been incorrectly used by advocates of greater government intervention.

Much of the rest of the standard textbook deals with market failures — deviations from those benchmark assumptions that make real-world markets fall short of the idealized outcome. Externalities, monopolists, and imperfect information lurk around every corner.

These phenomena are real and important, but they raise a question that while obvious also misses the point: how can we intervene to make markets more like they were in chapter one? If we break up monopolists, remedy externalities with taxes, and mandate services like insurance in markets that are rife with imperfect information, we’re told, we’ll move ever closer to the ideal system.

Misguided Policy

The assumptions embedded in the standard textbook are so deeply ingrained in our debate that we rarely realize we are making them. Even the current Far Left in the United States can’t escape the pull of perfect competition. Carbon taxes,individual insurance mandates, and regulation of monopolies all strive to move us closer to chapter one.

Entire subfields have arisen to challenge individual assumptions found in the perfect-competition model. Behavioral economics rightfully questions the assumed hyper-rationality of homo economicus but focuses on how we can “nudge” real people to behave more like this idealized construct.

Why shouldn’t perfect competition be the benchmark toward which policy makers strive? First, designing appropriate top-down policies in the real world often amounts to flying blind.

If a factory pollutes more than a “socially optimal” amount, standard theory says that factory should be taxed. Solving for the size of the ideal tax is easy enough in an undergraduate problem set but riddled with uncertainty when we need to predict the decisions of corporations and consumers.

How about market power? Thousands of court opinions and expert reports in antitrust cases attest to the fact that even deciding how much market power a firm has is so subjective as to render any policy response inescapably uncertain in its impact.

Second, even if an optimal policy could be written on a piece of paper, implementation by human beings creates another complicating factor. Writing about a proposed carbon tax, my colleague Phil Magness catalogued the numerous political pitfalls that plague the execution of even the best-designed policy.

Finally, perfect competition is not a useful policy benchmark, because it is fatally flawed as a representation of virtually any market for a real product or service. AIER Senior Fellow Donald Boudreaux described the strange logic of the model, where competition along dimensions such as quality and innovation creates distortionary market power rather than delivering a better product to consumers.

Removing the Rose-Colored Glasses

I first mentioned this confused debate in an article titled “Markets Are Not Perfect, They Are Essential.” This mantra forms the basis for a better conversation about the role of markets in modern society.

Great theorists such as Adam Smith and F.A. Hayek, along with cold hard empirical fact, tell us that a system based around free exchange is the only means by which a complex society can survive. That doesn’t mean we have to like everything that happens in markets, but we usually can’t fix what we don’t like by pushing markets toward an ideal that is both unattainable and unrealistic.

Nobody likes the human suffering that ensues when a company closes a factory in a town that depends on its employment. Both the protectionist and the socialist say we need to somehow control these firms so that they continue to provide jobs in their original locations. Both are wrong. Even the centrist, advocating incentives or penalties to make the market do what we want, treads on shaky ground.

The chapter-one fundamentalist says the factory closing isn’t a problem at all, just the natural process of finding a new equilibrium in the market for labor. They may be correct in the long run, but this position glosses over a degree of suffering nobody should accept.

The theoretical perfection of markets is not a valid argument against government intervention, nor is it a valid reason for governments to intervene in service of that ideal.

Let Markets Be Markets

Does this mean we must accept the bad with the good in a market-driven economy? Absolutely not. Imagine if we took the energy and resources currently spent on debating and implementing policies that strive in vain to push markets to perfection and instead simply helped those around us who struggle. Safety nets and investments in human and social capital are best provided locally by those on the ground who know their neighbors.

In his recent book The Third Pillar, economist Raghuram Rajan discusses the importance of supportive communities alongside markets and government in a well-functioning society. Many well-intentioned government interventions have crowded out roles historically played by the community.

This bottom-up community support is not the pure altruism that is sometimes simplistically dismissed by free market advocates. It is an emergent phenomenon in healthy economies and societies. The idea that we can rig markets to solve all of our problems is the greatest impediment to this type of decentralized micro-philanthropy becoming the norm. It’s time to close the book on chapter one.

Max Gulker is an economist and writer who joined AIER in 2015. His research focuses on two main areas: policy and technology. On the policy side, Gulker looks at how issues like poverty and access to education can be addressed with voluntary, decentralized approaches that don’t interfere with free markets. On technology, Gulker is interested in emerging fields like blockchain and cryptocurrencies, competitive issues raised by tech giants such as Facebook and Google, and the sharing economy. Gulker frequently appears at conferences, on podcasts, and on television. Gulker holds a PhD in economics from Stanford University and a BA in economics from the University of Michigan. Prior to AIER, Max spent time in the private sector, consulting with large technology and financial firms on antitrust and other litigation. Follow @maxgAIER.