Myth: Markets only work when an infinite number of people with perfect information trade undifferentiated commodities

When thinking about the difference between government action and action taken by free people trading voluntarily in markets, we find that many myths abound. Tom G. Palmer has written an important paper that confronts these myths about markets. The fifth myth — Markets Only Work When an Infinite Number of People With Perfect Information Trade Undifferentiated Commodities — and Palmer’s refutation is below. The complete series of myths and responses is at Twenty Myths about Markets.

Palmer is editor of the recent book The Morality of Capitalism. He will be in Overland Park and Wichita in May speaking on the moral case for capitalism. For more information and to register for these events see The Morality of Capitalism.

Myth: Markets Only Work When an Infinite Number of People With Perfect Information Trade Undifferentiated Commodities

Myth: Market efficiency, in which output is maximized and profits are minimized, requires that no one is a price setter, that is, that no buyer or seller, by entering or exiting the market, will affect the price. In a perfectly competitive market, no individual buyer or seller can have any impact on prices. Products are all homogenous and information about products and prices is costless. But real markets are not perfectly competitive, which is why government is required to step in and correct things.

Tom G. Palmer: Abstract models of economic interaction can be useful, but when normatively loaded terms such as “perfect” are added to theoretical abstractions, a great deal of harm can be done. If a certain condition of the market is define as “perfect” competition, then anything else is “imperfect” and needs to be improved, presumably by some agency outside of the market. In fact, “perfect” competition is simply a mental model, from which we can deduce certain interesting facts, such as the role of profits in directing resources (when they’re higher than average, competitors will shift resources to increase supply, undercut prices, and reduce profits) and the role of uncertainty in determining the demand to hold cash (since if information were costless, everyone would invest all their money and arrange it to be cashed out just at the moment that they needed to make investments, from which we can conclude that the existence of cash is a feature of a lack of information). “Perfect” competition is no guide to how to improve markets; it’s a poorly chosen term for a mental model of market processes that abstracts from real world conditions of competition.

For the state to be the agency that would move markets to such “perfection,” we would expect that it, too, would be the product of “perfect” democratic policies, in which infinite numbers of voters and candidates have no individual impact on policies, all policies are homogenous, and information about the costs and benefits of policies is costless. That is manifestly never the case.

The scientific method of choosing among policy options requires that choices be made from among actually available options. Both political choice and market choice are “imperfect” in all the ways specified above, so choice should be made on the basis of a comparison of real — not “perfect”– market processes and political processes. Real markets generate a plethora of ways of providing information and generating mutually beneficial cooperation among market participants. Markets provide the framework for people to discover information, including forms of cooperation.

Advertising, credit bureaus, reputation, commodity exchanges, stock exchanges, certification boards, and many other institutions arise within markets to serve the goal of facilitating mutually beneficial cooperation. Rather than discarding markets because they aren’t perfect, we should look for more ways to use the market to improve the imperfect state of human welfare.

Finally, competition is better understood, not as a state of the market, but as a process of rivalrous behavior. When entrepreneurs are free to enter the market to compete with others and customers are free to choose from among producers, the rivalry among producers for the custom of customers leads to behavior favorable to those customers.