Sunday, April 17, 2011

Frictionless Competion

Austin Frakt over at The Incidental economist states:

Traditional Medicare, being immune from market forces (though not political forces) can counter that provider market power, essentially setting “below market” prices by fiat. (Don’t go thinking this is an affront to a perfectly competitive market. High provider market power is itself a deviation from a perfect market.)

I don't understand the fascination some economists have for the "perfectly competitive market."

In physics, I can see the advantage to improving our understanding of force and inertia by experimenting and theorizing in a frictionless system. But when it comes time to build machines in the real world, we'd be in big trouble not to account for friction.

Seems to me like the same thing goes for economics. Simplification has its advantages to understanding the economic principles and how they function, but when you get into the messy world of voluntary exchange between free individuals, with its innovators, early adapters, laggards and the rest, perfect competition does not and can exist. We can identify and account for the differences between the idealized system and reality, but any attempt to "correct" for the "failure" is try and substitute what someone thinks the world should be for what the world actually is ---and that is courting disaster.

Am I missing something here?



Realist Theorist said...

Yeah, ironically, the economists' perfect competition is where there is no competition at all, because there's no point competing.

It is really a hypothetical world, dreamed up by economists idealizing and egalitarian where everyone can figure values out just as well as the next guy. With this assumption, the "market is always right" because the average wisdom is always right.

Chris Hibbert said...

You're not missing anything. In fact you've come up with an alternative argument for the Austrian insight. The Austrian economists often talk about "Market Process"; the point is that markets are dynamic. There is no equilibrium, there is only entrepreneurs seeking advantages, and consumers making trade-offs between changing alternatives.

Perfect competition as frictionless mechanics is a good metaphor. It helps explain the value of the model and makes the shortcomings evident.

Anonymous said...

Is the Perfect Competition philosophy behind the econometric claim that Austrian economics has been "debunked"? Economists like Paul Krugman frequently make the argument that under laissez-faire there is "non-optimization" of resources, etc.. I keep asking myself: "Optimization? By what standard and to what end?"


HaynesBE said...

What Does Perfect Competition Mean?
A market structure in which the following five criteria are met:

1. All firms sell an identical product.
2. All firms are price takers.
3. All firms have a relatively small market share.
4. Buyers know the nature of the product being sold and the prices
charged by each firm.
5. The industry is characterized by freedom of entry and exit.

Sometimes referred to as "pure competition".

--Realist Therorist is right. If there is "pure competition" --there is little to distinguish one producer from another. And this is supposed to be to the consumer's advantage?

--Re: optimization, I think what is usually being referred to is Pareto efficiency:
"Given an initial allocation of goods among a set of individuals, a change to a different allocation that makes at least one individual better off without making any other individual worse off is called a Pareto improvement. An allocation is defined as "Pareto efficient" or "Pareto optimal" when no further Pareto improvements can be made."

A blatantly collectivist way of defining "optimal."

Mike said...

I don't think they say Austrian theory is debunked because of their so-called pure and perfect competition. I think they say it because they feel the Kant-of-economics, Keynes, proved that there must be a central bank with control over money and interest to prevent depressions due to insufficient money, etc etc etc

Keith said...

The Austrian theory is that there is no such thing as equilibrium. Look at actual prices in a market, they do not exhibit the behavior one would expect in a system moving towards equilibrium. It is actually a DISequilibrium.

To see why, one must realize that there are two prices for everything: the bid and the offer. If you want to buy something, you must pay the offer. Note that this lifts the offer. If you want to sell something, you must take the bid. This presses down the bid.

The entrepreneur seeks to make profit by buying something low, and selling it elsewhere high. But this tends to lift the offer on the thing he is buying (i.e. the long leg of an arbitrage) and press the bid on the thing he is selling (the short leg). Over time, his profits shrink. Another way of saying this is that economic coordination becomes more efficient. There isn't riches to be made by moving produce from farm to city 20 miles away any more.

So entrepreneurs must keep looking for ways to make a bigger margin. They can source new ingredients that are cheaper, find a customer who wants to pay more ... or add more value (which is harder but more rewarding).

Because of this (and many other arbitrages) markets are constantly moving, with some bids being pressed by one set of forces, other bids being lifted, some offers being pressed, and others being lifted. There is always the tale of the tape recording prices at which the market cleared. But what's interesting and revealing is the bids and offers and various spreads.

As several people have rightly commented here, any market with tiny spreads would not only not *attract* entrepreneurs, but the entrepreneurs who were already in it would be looking for ways to get out of it.

What's important is that the government not erect barriers to coordination by passing laws to:
- set minimum or maximum prices
- set min or max wages
- set min or max interest rates
- prohibit certain kinds of trades
- prohibit certain people from certain kinds of production
- tax some transactions more adversely than others
- etc.

Keith said...

Mike: your comment looks like a cut and paste of what I said on the wall of Michael Phillips on Facebook!

HaynesBE said...

Keith--Thanks for that crisp, clean summary.