Perfect Competition and the Transformation of Economics

Frank Machovec

• Publisher: Taylor & Francis
• Year: 1995
• Print ISBN: 9780415115803
• eBook ISBN: 9781134820221
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Frank Machovec argues that the assumption of perfect information has done untold economic damage. It has provided the rationale for active state intervention and has obscured the extent to which entrepreneurial activity depends upon the exploitation of asymmetric information.

1 INTRODUCTION AND OVERVIEW

The single most important concept in the history of economic analysis is perfect competition.

(Cochrane: 3)

The mainstream’s historical perspective on competition and entrepreneurship has been based on its belief that the perfectly competitive model was the product of incremental intellectual maturation of a long-standing equilibrium vision of the market. My thesis is that the concept of perfect competition and the analytical habits of thought attendant to it were generally alien to the classical network of ideas on market activity. My contention—that the classical sense of the market was distinctly different from the neoclassical—is not new; however, none of the past writers who have raised the issue has provided sufficient supporting material to ignite a serious challenge to the dominant interpretation, an interpretation which assumes that the term ‘the market’ evoked essentially the same ideas in the classical era as in the neoclassical era.

In Kuhnian terms, the classical economists shared a vision that was substantially different from the vision promoted by the neoclassical equilibrium paradigm. In particular, evidence suggesting a classical lineage for the concept of perfect competition is tenuous, at best; the perfectly competitive model should more aptly be characterized as a mutation, for its genes bear little resemblance to those of its presumed parents. Adam Smith’s ‘state of natural liberty’ was the free-entry nexus of advantage-seeking forces that cease to exist under the Walrasian vision. The nowfamiliar neoclassical idea of competition—the state of affairs prevailing after the entire process of rivalry has run its course— emerged, like a phoenix, from Cournot’s long-ignored 1838 treatise on mathematical economics. It was resurrected by Walras to accommodate his mathematical model of general equilibrium. Modern comparative-statics reasoning—based on the idea of firms who react helplessly to given prices—was not the reflexive centrepiece of the classical tradition.

Until the 1920s, the criterion employed by economists to evaluate whether or not a market was competitive (i.e., serving consumers) was freedom of entry. Classical competitive analysis emphasized the incessant creation of profit via entrepreneurial action and reaction, not the hypothetical conditions that would exist if all profit opportunities were eradicated by the emergence of perfect knowledge. To the classical economist, competition was the means by which information was gradually revealed to all participants, thereby altering expectations and behaviour, and driving the long-run market price toward average cost (natural value). The notion of equilibrium, therefore, was indeed of high interest to the classicals. Their main interest, however, was insuring that the new political-economic framework of post-mercantilist society enabled the process of competition to continue churning, for they understood that it was through the knowledge-discovery process itself, not through the zero-profit endpoint of equilibrium, that the wealth of a nation was created and its welfare enhanced. As one writer has adroitly explained, ‘equilibrating forces’ in classical treatments were the ‘limiting…elements’ that paralleled the endogenous forces that promoted change and growth. In short, the ‘motor mechanism’ of classical economics has been overlooked because the equilibrium paradigm of the modern era has caused us ‘[to] mistake the shadow for the substance’ (Beach: 17). Appropriately, Mark Blaug has cautioned us not to infer—from the uniformity outcome of capital returns and homogeneous product prices—that the classical model is ‘a species of general equilibrium theory except in the innocuous sense of an awareness that “everything depends on everything else”’ (Blaug 1987:443).

My research offers the first real challenge to the neoclassical claim that the classical theory of the market was entrepreneurless. By ‘first real challenge’ I do not mean that I am the first person to highlight widely held misperceptions about the classical view of the market. Numerous others have pointed to this problem, and their contributions will be acknowledged at various points in subsequent chapters; however, none of these writers has attempted to unearth the substantial bibliographic ammunition required to stimulate a reevaluation amongst equilibrium scholars. It is my hope that this essay will prompt a fruitful examination of this issue and, for the first time, cast serious doubt on the long-accepted impression within the mainstream that equilibrium thinking in general, and the model of perfect competition in particular, are conceptually rooted in the classicals’ portrayal of market behaviour.

This would be a significant milestone, for it would undermine the continuity assumption by which leading neoclassical economists have argued that the present-day static models of market analysis represent a mathematically formalized rendering of the classical vision. If the introduction of the equilibrium paradigm altered the economic way of thinking in a way that misrepresents the market process, then the prevailing conception of the market is flawed and part of the policy focus flowing therefrom has been maldirected.

ROADMAP OF UPCOMING ISSUES

The International Encyclopedia of the Social Sciences (1968) ‘included no essay on the market, the most fundamental institution of modern Western economies…’ (North 1981:33). Likewise, The New Palgrave: A Dictionary of Economics (1987) included no essay on the market. The early work of Hayek, and the more recent writings in the field of constitutional economics, have done much to stir a reevaluation of the precise meaning and function of the bundle of institutions known collectively as ‘the market’. However, the entrepreneurless mode of thinking associated with equilibrium analysis still dominates the vast majority of doctoral training programmes, and thus modern economics portrays the market in a way radically different from treatments written in the nineteenth and early twentieth centuries. Hence, in his Nobel Memorial lecture in Stockholm in 1991, Ronald Coase pointed to ‘the neglect of the market or more specifically the institutional arrangements which govern the process of exchange’. In neoclassical economics, ‘[t]he firm and the market appear by name but they lack any substance’ (Coase 1992:3, 4).

At the November 1991 regional meeting of the Mont Pélèrin Society in Prague, Gary Becker, in his opening remarks, noted that the profession was intrigued with Oskar Lange’s model of a collectivized society in much the same way scientists are fascinated by the prospect of a new, improved species. Becker found this reaction perplexing: ‘Why’, he asked, ‘were most Western economists so willing to doubt the superiority of the vision bequeathed by Adam Smith?’ The answer to his question lies in understanding how the perfectly competitive model revolutionized and disarmed the field of economics. First, it deflected attention from the front-line importance attached by the classicals to the behavioural impact of sociopolitical institutions. Second, it removed the entrepreneur’s indispensable catalysis, and thereby drew us toward the appeal of a designed vision that could not only carry out the functions of the market, but improve upon its overall operation. My objective is to stimulate a civil yet spirited debate over how and why we came to think this way. As a stalwart of the profession has advised, ‘the temperate, restrained, utterly fairminded treatment of one’s own theories does a disservice to these theories as well as to one’s professional status and salary’ (Stigler 1982:111). Accordingly, five areas of thought that were transformed by the equilibrium paradigm (whose primary tool is the perfectly competitive model) will be explored in subsequent chapters. The following capsulized listing of these five areas describes the flavour of the research programme from which this book evolved.

● How prices change: Before 1920, relative price changes were attributed to endogenous entrepreneurial initiative, such as the promotion of new products and methods, the discovery and eradication of imperfect markets via arbitrage, and the detection (and adjustment) of future supply shortfalls via intertemporal trade. After 1920, relative prices could change within our general equilibrium model only from exogenous shocks, because, as Stigler has noted, the perfect-information postulate ensures that endogenous supply changes are always proportionately forthcoming to match any endogenous changes in demand. So in the classical era, prices were not seen as data; i.e., some agents did not respond to current prices as if they were immutably given. Whereas, after 1920, all prevailing prices were assumed to be at equilibrium, and every agent was assumed to act accordingly, a step which facilitated the mathematical determination of production levels.

● Modelling and predictability: Perfect knowledge is the precondition for the realization of the neoclassical vector of equilibrium prices and quantities. What is unsatisfying here is that the quantities calculated in Walras’ Elements were premised on the foreknowledge of the equilibrium price vector. For the classical case, in which information is revealed incrementally, the equilibrium price vector is solely an ex post phenomenon and hence cannot be determined (calculated) ex ante. This, in turn, inspires entrepreneurial judgment on the appropriate level of production. Moreover, the temporary existence of above-equilibrium prices (due to imperfect information on the part of sellers and buyers) causes irreversible decisions to buy substitutes, and the culmination of such a process is a set of equilibrium prices and quantities different from those yielded mathematically by Walras’ system of simultaneous equations—yet Walras erroneously believed that his model’s prices were identical to the market’s equilibrium prices.

● Redefinition of monopoly: The entrepreneurial introduction of new products and differentiations of existing products—initiatives considered beneficial to consumers under classical economics— were redefined as harmful under the static models of neoclassical economics and were portrayed as such in the influential texts of the 1950s and 1960s. For example, consider the pre-1980 treatments of monopoly profit, as well as the ‘waste theorem’ from ‘excess capacity’, etc. Also, antitrust policy was certainly affected, so an entire chapter will be dedicated to the impact of the perfectly competitive ideal on the Supreme Court’s treatment of competition and monopoly. Recently, a mainstream rethinking on the value of variety and the role of knowledge dissemination (via advertising) has begun to reshape the profession’s approach to industrial organization and social welfare.

● Attitude toward central planning: Adam Smith, in his Theory of Moral Sentiments, castigated the ‘conceited men of system’ who believed that a more rational order (designed in the mind of man) could function better than the spontaneous order promoted by the invisible hand (Smith 1976:231–4). However, due to the triumph of Walras’ model of general equilibrium, many leading-edge economists became fascinated with the technical beauty of the proposal of the new Marxian men of system of the 1930s—a proposal that was fashioned using a Walrasian infrastructure. ‘Oskar Lange’s [reply to Mises]…. was significant …because it reconciled many pre-war economists to a sentimental belief in socialism’ (Blaug 1994:1570). Even Joseph Schumpeter, who had laboured to explain that dynamic concepts could not be understood via static models, readily accepted the efficacy of Lange’s proposal, for he could not divorce himself from his profound admiration of the Walrasian formulation, which was the most influential factor in his professional life (Schumpeter 1991:165). An attempted resolution of this paradox can be found in Goodwin: 39–42.

The Lange model was welcomed on ideological grounds as well; that is, most intellectuals, including some economists, had always been uncomfortable with the Smithian self-interest axiom and with the unchecked inequality promoted by the private ownership of property. The profession’s endorsement reached its zenith with the award of the 1975 Nobel Prize to Tjalling Koopmans and Leonid Kantorovich, whose work had affirmed economists’ longstanding support of the theoretical feasibility of Lange’s model—a perfectinformation model that employed a Central Planning Board to obviate the entrepreneur’s role in facilitating the classical divisionof-knowledge problem. The impact of the parametric-pricing assumption on the profession’s new conception of the market has not been adequately addressed outside the Austrian literature. The entrepreneurless vacuum created by the model of perfect competition pronouncedly coloured the discipline’s sympathetic reaction to Lange’s claim that a collectivized system could achieve static efficiency by algorithmically applying the Lerner conditions within a new system called market socialism. Specifically, the vast majority of Western economists were misled (by the appealing logic of their equilibrium vision) into accepting the plausibility of a collectivized society that could function as smoothly as a free-enterprise economy. They reasoned that: If all information were available to the managers of socialized firms (as in the case of private firms in the perfectly competitive model), then the economy’s efficiency would not be reduced by the nationalization of resources. This seductive mindset haunted model-building economists from the 1920s to the 1980s. For them, mathematical models revealed a new, higher social outcome; reality came to be seen as a second-best approximation of what presumably could be accomplished with proper direction from a fully-informed centre. The effect of this thinking was especially pernicious in the field of development economics, where the monopoly of the top-down mindset led to a body of theory that is akin to recommending that a tree should be watered by spraying its leaves and bark instead of soaking its roots. Neoclassical economics—moulded by the presumption of off-the-shelf, entrepreneurless production functions—implanted and has continued to reinforce a pro-planning intellectual climate that has impeded Third-World progress.

● Analysis of international trade: The constant-returns assumption of the model of perfect competition precluded the consideration of currently-existent economies of scale as a basis for profitable exchange. Hence for many decades the profession ignored this important source of trade between developed countries. That is, convex production-possibility frontiers (for two variants of the same basic good in two nations with identical factor proportions and tastes) serve as a source of unusually large trade gains without the trade-inhibiting, politically-problematic income redistributions (between factors) that ineluctably follow trade extensions with concave P-P frontiers, as noted in the Stolper-Samuelson Theorem. (The Stolper-Samuelson Theorem is described clearly in Lindert: 72– 3; also, see the English translation of Eli Heckscher’s 1919 essay on the impact of trade on relative factor returns, in Heckscher: 43–69.)

The forthcoming chapters will not only explore the five areas enumerated above, but will also explain how the neoclassical model of perfect competition was created and how the classical notion of the market was abandoned. I will examine when the transformation of economic theory occurred, why it occurred, and most importantly, how it altered the discipline’s perspectives. Hopefully my research will convince the reader that the equilibrium paradigm, while greatly sharpening our technical skills in predictive analysis, submerged the classical view of the market, which, in turn, led to some seriously wrong-headed conclusions on theory and public policy.

My future references to the desire of economists to make their discipline more scientific are based on the Popperian notion of positive science, namely, that a paradigm can label itself as scientific only if it generates falsifiable propositions. I have no objection to this criterion for defining hard science. Moreover, I have no hidden agenda to support those deconstructionists who contend that the neoclassical paradigm’s intellectual genesis is to be found in the now-discarded principles of nineteenth-century physics, such as the conservation of energy and reversibility of outcomes. (See Mirowski: 361–79; Ingrao and Israel: 31–60, 161– 6; and Koppl: 23–5.) I remain neutral yet open on this issue, but I do not want to join this debate. My purpose is to demonstrate that the rejection of key classical perspectives engendered a proplanning bias in several branches of economics, though I readily acknowledge that the basic Robbinsian prescription (Robbins 1969:12–20) has led to an exhaustive list of valuable insights in spheres where static-allocation techniques are entirely appropriate. The exact source of Walras’ inspiration, whether rooted in nineteenth-century physics or in his possible desire to promote public ownership, does not undermine the usefulness of modern equilibrium analysis in a broad number of areas. Why/how Walras came to think as he did is, at best, tangentially relevant to my research; the ultimate impact of his thinking, especially the casualties and future disabilities imposed, are of primary importance.

Finally, this writer is well aware of the admonishment by Samuelson and Machlup to he who would ‘damn another man’s theory by terming it static, and advertise his own by calling it dynamic’ (see Machlup 1975:24, including fn. 50). Although several important shortcomings linked to the virtually exclusive reliance on static modelling will be highlighted, these discussions should not be interpreted as part of an invidious attack on the use of equilibrium analysis, per se, nor as a back-door assault on the calculus of optimization. Rather, the purpose of the upcoming coverage (particularly in Chapters 2 and 3) is to acquaint readers with the full flavour of a sidestream position which remains unfamiliar to many conventionally-trained economists. This is particularly true of the Hayekian view of knowledge; consequently, this concept is presented in different formats at several appropriate points throughout the book. Only in this way can one begin to sense that our habits of thought were indeed changed by the notion of perfect competition. Of course, mainstream apologists will no doubt be quick to reply that my criticisms are misplaced because static models are not the last word in neoclassical economics. Yet, as Hahn has pointed out, ‘it is the models that lead people to view the economic system as they do’ (Hahn 1970:1). The equilibrium lenses through which we study the market have seriously misled us at certain critical junctures; the purpose of this essay is to examine those junctures to see how several branches of the discipline were affected.

One of my subgoals is to demonstrate that the competitive system in the minds of the classicists was not the perfectly competitive ideal that captivated the attention of neoclassical economists; however, I must reiterate that my interpretation of the classical approach to competition and monopoly should not be misread as ‘an obscurantist effort to undermine all the standard techniques of economic analysis’ (see Bishop’s remarks in Auerbach: 26). As one who holds undergraduate degrees in mathematics and meteorology, I am an equivocal supporter of the value of formalism in economics. I fully concur with Jevons’ observation that, in a discipline devoted to the study of small marginal effects, the widespread employment of calculus is inescapable (Jevons: 5, 13–14). However, I also concur with his warning: ‘It does not follow, of course, that to be explicitly mathematical is to ensure the attainment of truth’ (Jevons: xxiii).

On balance, I strongly endorse the following viewpoint: ‘Neoclassical theory has made economics the preeminent social science by providing it [with] a disciplined, logical analytical framework’ (North 1978:974). Nevertheless, I have serious reservations about the costs that have been imposed by the neoclassical fixation on the results of optimizing behaviour, as opposed to the cultivation of an understanding of the optimizing behaviours themselves and their implication for the notion of a calculable general equilibrium. Hence I believe that some methodological change is warranted. My purpose, however, is not to criticize the abstract nature of perfect competition nor the model’s frequent employment as an analytical tool. I readily concede that equilibrium models play a cardinal, irreplaceable role in the study of the process of competition. My primary objective is to demonstrate that the adoption of perfect competition as the benchmark—and the employment of static models as the only acceptable engines of market analysis—combined to transform the way later economists thought and taught about economics generally and the activities of firms in particular. This, I believe, was a major event and should be recognized as such.

There were several important, concurrent intellectual strains in classical economics, such as the limit of competition (price equals cost) and the flow of national income amongst various groups. These two topics have received the overwhelming attention of latter-day analysts of the classical tradition. But a third, equally important characteristic of the works of our forefathers was their abiding interest in the process of competition via their forthright concern with fostering the sociopolitical forces that spark and sustain it. The historian of economic thought builds upon the insights of predecessors and contemporaries in search of an answer to the following critical question: How did we come to think as we do? Hopefully, my research will contribute to this goal by stirring debate over my contention that the emergence and impact of the perfectly competitive model were more revolutionary than evolutionary.

BRIEF RECAP OF RESEARCH RESULTS

The new technical economists of the 1920s and 1930s ardently believed that their work was either a mathematically sophisticated restatement of, or reaction to, the so called ‘classical model of perfect competition’. However, the conceptive framework implanted by the model of perfect competition represented a sharp break in continuity from the vision of the market in classical and early neoclassical writings. The classical approach to industrial organization, which was carried into the twentieth century, portrayed the entrepreneur as one who faces uncertainty and incessantly pursues pure profit via three means: intertemporal trade (speculation); the introduction of cost-reducing methods of production; and the marketing of new products. From Adam Smith to Alfred Marshall the spotlight was aimed, first o...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Figures
• Preface
• 1 Introduction and Overview
• 2 Statement of the Problem
• 3 The Magnetic Lure of Market Socialism
• 4 Competition and Entrepreneurship in Classical Political Economy
• 5 Uncertainty and Entrepreneurship in Classical Political Economy
• 6 The Perfectly Competitive Model: Evolution or Revolution?
• 7 Competition and the Law
• 8 Evolution Versus Revolution: the Conventional Wisdom
• 9 Alfred Marshall, Increasing Returns, and Competition
• 10 Perfect Competition: Ascendance and Impact on Habits of Thought
• 11 Stylized Assessment of Gain Versus Pain
• 12 Summary and Conclusions
• Notes
• Bibliography