Are Markets Imperfect? Of Course, That’s The Point!

UNCATEGORIZED / Friday, May 21st, 2021

By Rosolino Candela on

In her fantastic book, The World in a Model, Mary Morgan provides an intellectual history of how economists have evolved in their construction of models as a device to think about how markets work. As she states, narratives about markets “are built into the identity of the model from the start” (Morgan 2012, 362, emphasis in original). This is an extremely important observation, which is relevant for the point I want to make here. Economic theory is not a public policy conclusion. Rather, it is a way of thinking, from which public policy conclusions emerge as a by-product of the narrative constructed about how markets work.

The narrative that is usually told about markets, not only in the popular press and social media, but also in modern economics textbooks, is that markets are “imperfect.” I do not wish to dispute that claim here. Rather, what I wish to address is how this narrative is constructed, based on the models we utilize in economics, and the public policy conclusions that emerge from this constructed narrative.

In modern neoclassical economics, the benchmark of analysis from which real-world markets are judged is the model of perfect competition, in which a homogenous good is bought and sold by a large group of buyers and sellers, respectively, none of whom have an influence on the price. Moreover, under such conditions, there exists free entry and exit of sellers in the marketplace, defined by perfect information.

The narrative that is constructed and logically follows from this model is that observed deviations from perfect competition in the marketplace are indicative of imperfections, also known as “market failures,” associated with the existence of monopoly power, pervasive externalities, the provision of public goods, and macroeconomic instability. According to this narrative, government intervention is the deus ex machina that saves the market from its own “imperfections” through regulations, taxes, subsides, and other public policy measures. Why? To use a quote from Frank Knight often used by James Buchanan, “to call a situation hopeless is to call it ideal.” The narrative that is constructed is one in which, outside the conditions of the ideal of perfect competition, there is no hope but for government intervention to save the market from itself. Anyone who has taken an economics course is well aware of what I’ve stated thus far, and therefore this should not be surprising.

But what is the implicit meaning of the word “imperfect” that is baked into the narrative, which is constructed into the model of perfect competition? What is implied when we postulate that markets are “imperfect” in comparison to the benchmark of perfect competition is that markets are flawed, non-ideal, or otherwise sub-optimal, and therefore in need of correction through government intervention. Who could dispute the logic of this narrative?

However, if we simply reinterpret our understanding of the word “imperfect,” not only will it reframe the narrative being told about the marketplace, but also the public policy implications that flow from this narrative. If we analyze the etymology of the word imperfect, breaking it down from its Latin origins, you will learn that “im” expresses the negation, “per” comes from the Latin word meaning “thoroughly” and “fect” comes from the Latin verb “facere,” meaning “to do”. Thus, rather than saying that something, or some state of affairs, is flawed, suboptimal, or non-ideal, another way to interpret the meaning of “imperfect” is an act or process that is not thoroughly done, or incomplete. In fact, from a quick perusal of the Merriam Webster’s Dictionary, you will find a similar definition of the word imperfect: “constituting a verb tense used to designate a continuing state or an incomplete action” (emphasis added).

Rather than regarding the market as a flawed or sub-optimal state of affairs, a better understanding of an “imperfect market” reveals that the market is a process of continuous tendency towards perfection, or completion, where are all the gains from trade are exhausted and all plans between buyers and sellers are perfectly coordinated. As Ludwig von Mises states in his magnum opus, Human Action, the “market process is the adjustment of the individual actions of the various members of the market society to the requirements of mutual cooperation” (1949 [2007]: 258).

Thus, markets will always be imperfect, but that is precisely why markets exist in the first place! Markets never conform to the “ideal” of perfect competition, but this is completely irrelevant, since under such state of affairs, markets are unnecessary and redundant, since all resources are already perfectly allocated to their most valued uses. Market processes exist precisely because to generate the information necessary to better coordinate the plans and purposes of individuals in a peaceful and productive manner. The entrepreneurial lure for profit and the discipline of loss is what guides such imperfect processes in a tendency towards the creation of more complete information between buyers and sellers.

The narrative I wish to highlight here does not deny that “market failures” associated with monopoly power, externalities, public goods, and macroeconomic instability do not exist. But taking the inverse of the quote by Knight expressed above, a market that is non-ideal, or “imperfect” as I’ve defined the word here, is one that builds hope into its narrative! The source of that hope, or the “hero” of this narrative, is the entrepreneur, precisely because, under the proper institutional conditions of private property and freedom of contract under the rule of law, the very existence of market failures represent the very frictions that set the market process in motion, and sows the seeds for their own destruction. The omnipresence of “market failures” today present continuous profit opportunities for entrepreneurs to correct such imperfections through adjustments of price, quality, and institutions, which dissipate monopoly profits, internalize externalities, exclude non-payers from free-riding on public goods, and better coordinate borrowers and savers through time.

Thus, from this standpoint, the question of public policy is not whether or not a deus ex machina of government intervention must save imperfect markets from failure, in comparison to a perfect standard. Rather, the question becomes whether public policy has set the market process up for failure, specifically by undermining the process by which markets become more complete, or “perfect.” After all, this is why markets are imperfect and will always be imperfect. Markets embody continuous processes of learning from our mistakes and incentivize corrections of those mistakes through entrepreneurial adaptation, adjustment, and discovery.

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