1.1.16 Perfect Market

With the fiction of the perfect market, economics entered the world of the parallel universe. The perfect market is the door through which economics has left the real world. Perfect markets assume

- that there are no personal preferences
- that there are no temporal preferences
- that the products are homogenous
- that adaptation to new situations don't requiere no costs, no effort, no time
- that everybody is perfectly informed

That means that a market economy is not needed. The strength of a market economy consists of the decentral information processing based on prices. That doesn't mean that the market player can get the information allowing them to make the best choice possible, that they can allocate for instance the resource optimal. That only means that the market economy is the best information processing system we have. If from the very beginning we assume perfect information, then the problem to be resolved doesn't exist.

If we had perfect information, a planned economy would be preferable. The economic development could be predicted with the same precision as the position of the Venus in two weeks with some mathematical equations. See mathematical modeling.

That is actually the methodological approach of Léon Walras. This approach is similar to the Marxism approach. Everybody believes that neoclassical thinking, what is understood nowadays by neoclassical thinking is actually Léon Walras and not Alfred Marshall, is the opposite of Marxism. That's not the case. Léon Walras is similar to Marxism. In Marxism, workforce and goods are homogeneous products, labour and capital flows without any effort to the best use, there is no entrepreneur needed, everybody is perfectly informed. The difference is, nobody had ever tried to put Léon Walras into practice, therefore, nobody ever realised that his concept works only in a planned economy. Marxism was implemented and, therefore, it becomes evident that markets are very imperfect, and we see that a system for decentral information processing is needed.

Perfect information means perfect security. If we are perfectly informed, the result of our decisions will alway be what we expected. We will see later on, in the chapter about Keynes, that the idea of classical and neoclassical thinking that market always leads to equilibrium collapses if this is not true.

Something like perfect information is only thinkable in the short run. At least, in the short run, we can assume that the technology, the preferences, cultural changes, the size of the market, the organization of the economy, the price of raw materials doesn't change. We have some change to be more or less informed if things are stable for a certain time.

What we find in today's textbooks on economics, the famous cross of supply and demand of Alfred Marschall is only valid in the short run. The point is that Alfred Marshall distinguishes between the short run and the long run. An important distinction, that got lost in modern textbooks.

Alfred Marshall is a very different category and can't be compared with fools like Léon Walras or Pareto. Alfred Marshall realised clearly that something like a producer surplus can only exist under imperfect information. Only if there are entrepreneurs that are better informed than others and, therefore, more efficient, we can have a producer surplus. The more efficient companies with lower costs earn more than, the less efficient companies. However, in the long run, this information asymmetries will disappear, the cost structure will be the same everywhere, and the producer surplus will melt away.

From this point of view, it is logical that in the theory of David Ricardo the producer surplus, what he calls rent, only exists related to land. If one assumes total information and that the capital and labour, both imagined as homogeneous, flows automatically in the most profitable use, there are no producer surplus. The cost structure is the same everywhere.

To formulate it in a somehow philosophical way. In the short run, never changes something. This is good definition of the word moment. A moment is a period of time, in which nothing changes. That's why a moment can be very long or very short in the sense of the clock time.

If we assume perfect information and that the productive factors flow by themselves to the most efficient use, that's what Léon Walras assumes, there is not only no need for entrepreneurs, there is as well no need to pay them. If there is no effort required to allocate the resources, we don't need this kind of people. That's why we don't have entrepreneurs in the three thick books of Karl Marx. We have only capitalists, what we can perfectly substitute by capital, what is actually the name of this thick book. The function of the entrepreneur can be realised as well, or even better, by computers and robots.

Even innovations happen alone. Karl Marx assumes that capital becomes more and more productive, but that happens without the interference of human beings. There is no incentive needed. Capital by its own becomes more and more efficient.

The whole tragedy of this concept, the assumed perfect information will become obvious later when we talk about Léon Walras. We have already discussed about the problem in mathematical modeling. The basic problem is that in the case of perfect information, we don't need a market economy.

If we abstract from all individual circumstances and if the only variables taken into account are the price and the amount, which actually only are the effects of the underlying economic structure, we can get a lot of "economic laws". The notion laws suggest that they are the cause of a process and that they don't describe merely the adaptations to technological, organisational, psychological, social etc. changes. To put it clearly, the law of gravitation doesn't adapt itself to changes in the structure, it is the force which determines the structure.

An economic law describes the process of adaptation to foreign changes but is not the force itself. The conception of the economy as a natural science, this is the methodological approach of Léon Walras and followed by modern textbooks is bullshit. Natural laws are not the expression of SOMETHING; they are this something. The gravitations law doesn't depend on anything.

All the funny exercises we find nowadays in economic textbooks are based on the ideas of Alfred Marshall, but Alfred Marshall saw all these problems. Instead of illustrating the consumer surplus in a mathematical, graphical and verbal way it would have been much more intelligent to understand the concept.

We can't actually calculate the consumer surplus if we don't know how much time the situation remains the same. The producer surplus is calculated by the amount but that doesn't make any sense if we don't know the time in which this amount is sold and if the situation remains the same for the next period.

The contradiction didn't become obvious because, in modern textbooks, little attention is paid to the main function of a market economy being overcome or at least reduced insecurity by an efficient information processing system. Under the assumption of perfect information, there are no producer surplus because every company has the same cost structure.

What actually happens in a market economy is the opposite of what we find in textbooks. We find excellent descriptions of what is going on in the theory of Joseph Schumpeter. Equilibrium is only obtained step by step through trial and error and more unconsciously than based on consciously taken decisions.

The equilibrium we find in textbooks is never obtained. In market economies there is a tendency to the equilibrium, but before the optimal allocation of ressources can be obtained, the underlying economic structure changes. Perfect information is not needed for the working of a market economy. It's enough, in other words the maximus that can be obtained, that there is tendency toward equilibrium.

The assumption of perfect information can't be justified with the argument that modelling needs simplification and modelling is required to reduce complexity. A model that abstracts from the fundamental problems and leads to an infinite number of errors is not useful.

The error is crucial and understandable. The "economic laws", so adored by Léon Walras, Vilfredo Pareto and Carl Menger, that we found in any textbook suggest that they explain causal relations in other words that economics alone explains relevant issues. Most of them DESCRIBE something very different than EXPLAIN, economic relations. A statistical relation describes the relationship between two phenomena but doesn't explain the relationship.

By taking the effects of the causes, economics suggest that they can explain the world. If a change in cost and prices is the reason for a change in the amount, the question why the cost and price structure changed is obsolete. If the change in the cost and price structure is a mere effect of underlying causes, then the change in cost and prices is irrelevant. It is a small effect of a change in the underlying structures.

Abstracting from the causes economics succeeded to get a bunch of mathematically modelled trivialities, see mathematic modeling, called economic laws, although the practical relevance for analysing the concrete problem is almost zero. In public debate about relevant issues, the concepts we found in economic textbooks about microeconomics don't play virtually any role. .

Due to that, at least, economist believe that economics is the "queen of social science" because, in economics, some funny plays with math are possible. For the mere fact that math can apply, that they use the same methods as physics, they believe that economics is a science as exact as physics. We will see throughout this manual that the mere fact that we have some mathematical equations doesn't guarantee that we get useful insight. Abstraction in social science means trivialisation.

It is impossible to know exactly why a particular methodological approach established itself as the unique approach. However, the tendency is apparent. The only concept that can be mathematically modelled entered the canon of economic teaching and lots of concepts which were not presented in this way in the original work, the most prominent example is the Keynesian theory, are nowadays presented in a graphical/mathematical model, see IS-LM Modell.

Prominent figures like Joseph Schumpeter are silently ignored.

Textbooks on microeconomics run they same risk as the three volumes of Karl Marx. After the fall of the wall in 1989, on could by then buy tons of everything for almost nothing. Marxism was taught in universities and colleges, and The Capital was kind of Bible for fifty years, but when it lost its systemic value, it disappeared from one day to the other. Actually, it was a strange phenomenon. What happened to all the teachers who taught that for fifty years?

The preference for models which abstract from reality can be explained in part as well by the fact that academic teachers has, in general, no professional experience outside the university and have therefore little to say about reality. That explains that public statements of economists are almost always so trivial. The Walrasian, paretian bullshit is worth nothing if it comes to analyse concrete problems.

What can be said in two minutes, should be said in two minutes. There are many problems to resolve and time is valuable. There is no need to explain with many functions, curves, equations and differentiations that a company will increase the output if the price of the last product sold is higher than the costs. Put like that every idiot understands that. When it comes to reality, when there are many products which depend in part on the same infrastructure and need in part their own infrastructure things are bit more complicated, and we need some knowledge of cost accounting, but then the whole staff we find in textbooks about microeconomics is of no help.

The concept of marginality is explained in modern textbooks by differentiation of the supply and demand function. Actually, the idea can be explained in two minutes with the concept of natural price/market price from Adam Smith. The natural price is the price that allows to cover all costs, in the theory of Adam Smith the wage (labour), the profit (capital) and the rent (land) needed to produce the good. This price is natural if the productive factors, labour, capital and land, are equally paid for all uses, because otherwise they would be reallocated until the difference is eliminated. The natural price describes, therefore, the total equilibrium in the sense of Léon Walras.

(The same argument valid for the Walrasian theory is valid as well for this logic, but Adam Smith talks about a tendency and as tendency it is correct.)

If the demand increases, for instance because the preferences change, the market price can be higher than the natural price. That would lead to a reallocation of the productive factors, but only until the last unit reallocated is as profitable in the new use as it was in the old one. We have to pay attention to the last unit. We have two effects. By reallocating resources, the profitability of the early use increases and the profitability of the new use decreases until the profitability of both uses are the same.

That's all. Marginality explained in two minutes. No need for mathematical modeling. The assumed neoclassical marginal revolution never happened, because we have this idea already in Wealth of Nations.

The famous Marshallian cross of supply and demand which we found nowadays in any textbook on economics is helpful to analyse some issues, at least if we understand that this is examined based on a short run perspective.

In the short run, it is plausible that the prices increase if demand increases even if in normal life, at least in highly industrialised countries, we observe that phenomenon not very often. Actually, we observe it only, if the amount can't increase in the short run, for instance in the housing sector, or if it can't increase at all, because supply depends on something beyond human influence, for instance, the harvest.

Actually, this very elementary conception, the cross of supply and demand is the result of an intuition, nothing more. It looks very scientific if mathematically of graphically modelled, but is nevertheless based on pure intuition. What people can observe in reality is the rise of prices, but they cannot know if this increase in prices is due to raise of wages or production of the same amount. Furthermore, they are not sure if it is due to higher prices, an increase in the supply of money or if the raise of prices is actually due to an increase in demand that allows less efficient companies to enter the market or to make a less efficient production necessary in order to satisfy the increased demand.

A lot of "economic laws" are actually nothing else than the mathematical modeling of an intuition.

In the long run, prices in relationship to the wages decrease and don't increase. It is even possible that a decrease in prices and a therefore increased effective demand reduce the costs. In most cases, computers, smartphones, electronic devices, the cost of production decrease when the output is increased. Most of the costs are fix costs and these coste decrease, per unit, if the output increases.

The supply curve we find in any textbook more or less one hundred times is, therefore, atypical and only valid, if at all, in the short run, when the economic structure didn't have the time to adapt itself.

We can learn that mathematic modeling is not more exact than a verbal description we can found in the works of Adam Smith, Alfred Marshall or John Maynard Keynes. On the contrary, mathematical modeling very often obscure the causal relationships.

Not really important, but related to the demand function we find in any textbook, the lower the price, the more people buy, the explanation for this course of the curve is actually wrong. The course of the function is explained by the law of diminishing marginal benefit. With increasing consumption the benefit decreases. (The more apples we eat, the less benefit we get eating another one.) Therefore, people pay more for the first unit and less for the last unit. The demand curve has, therefore, the same course at a microeconomic and a labour macroeconomic level. The macroeconomic demand curve is just an aggregation of the microeconomic demand curve, and the decreasing marginal benefit can explain both. That's what we found in textbooks explained with a lot of mathematical modeling. That's bullshit, even if it looks very scientific.

The law of decreasing benefit is only valid for some goods, especially food. However, from the vast majority of products we consume only on. We only need one refrigerator, one car, one apartment, one smartphone, one bicycle etc. What actually explains the decreasing course of the macroeconomic demand curve is the competition between the goods. If a smartphone for 500 dollars delivers a benefit of 420 units and a bicycle for 500 dollars gives only a benefit of 390 units, then people will buy the smartphone. The situation changes if the price of the bicycles decreases to let's say 450 dollars. In this case, people save 50 dollars which they can spend on a watch that delivers a benefit of 40 units. They can get more benefit buying the bicycle and the watch (430) than buying the smartphone (420). The decreasing course of the macroeconomic demand curve of the bicycle has, therefore, nothing to do with the marginal benefit. It is the competition between the different choices that explains the decreasing course.

In economics, mathematical modeling leads almost every time to nowhere. It obscures reality, but most of all it's a loss of time. If we can explain something in two minutes, we should explain it in two minutes and dedicate the time saved to relevant issues.

The whole concept of the perfect market is so weird that it doesn't make sense to analyse all the errors of this model. It's just a fascinating example showing how modeling narrows the perspective.

Actually, in Wealth of Nation, Adam Smith doesn't mention explicitly the perfect market, but implicitly he does. He assumes that the productive factors, labour and capital, flows automatically in the most profitable use. That requires perfect information and no transaction costs. Concerning Adam Smith it is not really critical, because he conceive that as a tendency and as a tendency it is right. In the long run, labour will flow to the most profitable use. People will qualify for better-paid jobs and will abandon the sectors where payment is low.

The situation changes in the theory of David Ricardo and Léon Walras. In their theory, a tendency becomes a law. Conceived as a law, as an automatic mechanism, no information processing by individuals is needed. If the optimal allocation happens automatically, we don't need a market economy.

Modeling in economics means that some people make a model based on some situations they know, very often models are based on an "intuitive" obtained evaluation. The course of the supply function for instance is an example for that, see above.

The conception of the producer surplus doesn't adress all the phenomens of this kind. The producer surplus only addresses where several companies produce the same product, but with a different cost structure. Another, similar effect, is not addressed by this logic. In the case of an innovatiton,for instance smartphone, we can have the situation that there is, at least for some time, only one company producing it. In this case it has a producer rent as well, but in this case it is not due to a better cost structure in comparison to their competitors, but to the fact that it is the only company producing it.

The concept of producer and consumer surplus can be useful, provided that we understand the concept and its limitation. We have to understand that a producer surplus can only exist in the case of no transparency and imperfect information. If every company is equally well informed, they are all equally efficient, and they get the capital they need, because, in the case of complete transparency, the capital flows automatically in the most profitable use. Producer surplus and perfect information are to concepts that are not compatible with one another. Second we have to understand, that the producer surplus makes only sense, if there is a period of time given. 4000 dollars in one month is something, 4000 dollars in ten years is nothing. In the long run, producer surplus will disappear, because the competitors will improve their cost structure.

If we understand what this concept actually means, we can use it. If we just do some math but don't understand the meaning, it is worthless.

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1.1.16 Perfect Market

The perfect market is exactly the opposite of a free market economy