The Theory of Perfect Competition Is Wholly Misleading

This article discusses the theory of perfect competition and argues that it is misleading. It explains how neoclassical economists define competition and why their conception of competition is flawed. The article also highlights the assumptions made in the theory of perfect competition and how they do not accurately describe real-world markets. It concludes by questioning the usefulness of this theory in understanding competition in reality.

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If neoclassical economists are correct, economic competition reaches its apex —
state of perfection — only when it ceases.
The Theory of Perfect
Competition Is Wholly
Misleading
By Donald J. Boudreaux
TUESDAY, NOVEMBER 27, 2018
ECONOMIC EDUCATION
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According to the supposed experts, competition is at its zenith when zero of it
exists. It follows that any activity that to a non-economist appears to be
competitive is, in econ-speak, an instance of “imperfect” or “monopolistic”
competition. That activity isn’t competitive at all.
Has that automaker improved the styling of its mid-priced SUV? Does this motel
chain advertise and boast about the increased spaciousness of its guest rooms? D
that bakery introduce a new, tastier mix of granola? When a non-economist
witnesses such activities, she immediately understands that these sellers are
competing for buyers.
But when a neoclassical economist witnesses such activities, he detects
nefariousness afoot. Any seller that manages by means other than cutting prices
make its product more attractive to consumers thereby escapes the necessity of
cutting its prices as much as possible. Some degree of competition might still exi
insofar as this seller is restrained by market forces from raising its price.
But to the extent that this seller successfully uses, not price cuts, but the likes of
advertising, branding, or product differentiation to persuade consumers to buy
more of its output, this seller has monopoly power. And use of this monopoly
power distorts the allocation of resources by causing that allocation to differ from
what it would be in the absence of this monopoly power.
In this world, to build a better mousetrap is not to compete and to enrich but to
monopolize and to impoverish.
Consumers Care About More Than Prices
How can it be that economists’ conception of competition is so bizarre? The
answer is that for neoclassical economists competition is defined to operate only
on prices. Successful attempts to increase sales by doing anything other than
cutting prices, therefore, are not only not competitive, they are monopolistic
because they decrease sellers’ need to cut prices.
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Further, this competition isn’t perfect until all firms are under such intense
pressure to keep prices as low as possible that even the slightest price hike by an
individual seller causes that seller to lose all customers. This outcome is
guaranteed by the assumed existence of such a multitude of other firms selling th
identical product that consumers who abandon the price-hiking seller can
effortlessly satisfy all of their demands for this product simply by switching their
patronage to the other sellers.
In a “perfectly competitive” market, sellers have no further need to cut prices. An
because competition is defined only as cutting prices, sellers also have no further
scope to compete. The only decision consistent with “competition” left for each
seller to make is how much output to sell at the prevailing market price.
Sellers, then, don’t actually compete in perfectly competitive markets. Instead,
they merely react to given market prices exclusively by adjusting the quantities
they produce.
Not All Simplifying Assumptions Are Created Equal
Although economists have long recognized that the assumptions on which the
theory of perfect competition rests never actually describe reality, this theory
nevertheless sets the standard against which economists continue to assess the
competitiveness of real-world markets. The more closely real-world market
structures and outcomes resemble those of a perfectly competitive market, the
more competitive do neoclassical economists judge real-world markets to be.
These economists justify their use of the theory of perfect competition by correct
noting that no theory accurately describes the reality that it is meant to explain.
But in this case this justification fails completely.
It’s true that all theories rest on simplifying assumptions. Yet when neoclassical
economists justify the unreality of the assumptions at the heart of the theory of
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perfect competition, they reveal an apparent belief that simplifying assumptions
are a sufficient condition for generating useful theories.
Yet this belief is false. Assumptions are not justified merely because they are
simplified. Instead, simplifying assumptions are justified only if they result in
theories that enhance our understanding of phenomena that we seek to better
understand.
Do the assumptions at the heart of the theory of perfect competition enable us to
better understand competition in reality? You decide. This theory assumes that
Except, perhaps, for the last of these assumptions, to use this set of assumptions
to assume away the very phenomenon that the theory of perfection competition
the products available for sale have already been developed in all relevant
details;
firms never compete for customers by improving the quality or otherwise
changing the features of products they offer for sale;
each firm in an industry produces outputs that are identical in consumers’
minds to those produced by every other firm in that industry;
such a very large number of firms exist that no firm has any control
whatsoever over the price it charges; each firm can sell as much as it wishes
the prevailing market price, but if it charges any higher price, it makes no
sales;
both consumers and producers are fully informed about all relevant features
of the products and of the market, including knowledge of the most efficient
means of producing and distributing the outputs; and
firms enter and leave each perfectly competitive industry instantaneously.
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ostensibly is meant to explain: competition.
In real-world markets, for a firm to compete means for that firm to strive in any
peaceful manner it likes to entice consumers to purchase more of its outputs. On
way of so enticing consumers, of course, is to cut prices. But cutting prices is
hardly the only way, and it’s certainly not the way that’s most creative. Other wa
of competing include improving a product’s appearance, performance, and
durability.
Even better is to introduce an entirely new product. The most casual survey of
reality reveals these means of competing to be just as important to consumers as
are cuts in prices. Yet in the theory of perfect competition, these non-price mean
of competing are assumed away.
Also assumed away are advertising and other marketing efforts by sellers to bette
inform consumers about available product offerings. After all, consumers who by
assumption are fully informed can learn nothing worthwhile from advertising or
other means of marketing.
And to assume the existence of a multitude of producers each selling outputs
identical to those of other producers in their industry is to assume that
entrepreneurs have already learned not only that it is profitable to operate in
whatever perfectly competitive industries they now operate, but just how to
operate profitably in those industries.
According to this theory, firms enter industries mechanically and instantaneously
whenever the prevailing market prices are sufficiently high to allow entrants to
operate profitably. A firm entering a perfectly competitive industry performs a fe
that is no more competitive than that which is performed by a pedestrian who,
noticing a $20 bill on the sidewalk, bends down to pick it up.
The Theory of Perfect Competition Is Wholly Misleading as a Guide to
Real-World Competition
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If the above disquisition reads too much like inside baseball (or inside academic
economics), it is warranted by the recent rise in the number of calls for more act
antitrust enforcement. Very many such calls refer, explicitly or implicitly, to the
theory of perfect competition. These calls treat this theory as if it supplies an
unquestioned, and unquestionably sound, standard against which to judge real-
world markets.
But in fact the theory of perfect competition should be utterly rejected, both as a
theory of competition (which it is not) and as offering an appropriate standard
against which to judge real-world markets (which it does not).
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Donald J. Boudreaux
Donald J. Boudreaux is a senior fellow with American
Institute for Economic Research and with the F.A. Hayek
Program for Advanced Study in Philosophy, Politics, and
Economics at the Mercatus Center at George Mason
University; a Mercatus Center Board Member; and a professor
of economics and former economics-department chair at George Mason
University. He is the author of the books The Essential Hayek, Globalization,
Hypocrites and Half-Wits, and his articles appear in such publications as the Wal
Street Journal, New York Times, US News & World Report as well as numerous
scholarly journals. He writes a blog called Cafe Hayek and a regular column on
economics for the Pittsburgh Tribune-Review. Boudreaux earned a PhD in
economics from Auburn University and a law degree from the University of
Virginia.
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