The most basic definition of markets would be a place - physical or otherwise - where people can exchange goods of equivalent value in such a fashion that all parties to the exchange are better off than before the transaction. This is an elastic definition that covers a wide range of markets. We are all familiar with traditional markets. These are places we go to shop and hang around in. These are sometimes classified as business to consumer (B2C) markets. We are also aware of business to business (B2B) markets. Then there are financial markets, commodity markets, internet markets and even virtual markets. These are all types of markets that exist in the real world.
Do the assumptions of perfectly competitive markets hold for them? Examining these assumptions one by one, we are forced to conclude that they largely do not hold true in reality. Studying perfectly competitive markets therefore may make sense at an elementary level when students need to be given a model that can be compared to the real world. When these assumptions are applied to the latter, the wrong conclusions will be drawn and these will result in misguided policy prescriptions.
Take one of the most basic assumptions of economics: rationality. Are humans rational? Economists certainly assume so. Assuming rationality is an extremely tempting simplification to make of a complex reality. After all, each of us has the power of our intelligence to make decisions that will best suit our circumstances given the information on hand. Yet, despite our powerful brains we continue to make important decisions based on emotions.
Emotions are integral parts of our personality. Our rationality is tempered by our emotions. When these two are in balance, it is only then that we make optimal decisions. Unfortunately, often our emotions overrule our rationality. This is most obviously seen in financial markets particularly the stock exchange. If any market is considered to be the closest in characteristics to perfectly competitive markets, then stock exchanges are it. Elaborate models have been built that show that we cannot beat the market and that bubbles and busts cannot happen. But they do. With annoying regularity. And often devastating effect. For example, in 1987 Wall Street crashed by 22.6%. This was the largest single drop ever and was considered to be statistically improbable. In fact its probability was calculated as happening once every 20 billion years. An event so extremely unlikely that it could not happen in any human lifetime. Nor was this a one-off. Wall Street crashed again in 2001 and then once again in 2007. Three statistically improbable events happening within a lifetime! What happened? Economic models based on rationality ignore the elements of greed and fear which play important roles on the stock exchange. When greed rules, the market goes up and a bubble can form. When fear rules, the opposite can happen and the market can crash.
Stock exchanges are not the only places where emotions sway people. Research has shown that people value possessions very highly even at the expense of rational economic calculations. People also fear loss more than they fear gain. They will make a less than optimal choice based entirely on this. So one of the most important assumptions of perfectly competitive markets do not hold in the real world. Yes, people are rational but this rationality is tempered by emotions. Marketers know this and in many markets, they take full advantage of emotional impact. Fear is a great motivator to persuade people into courses of action they would otherwise be reluctant to take. Models that do not take emotions into account simplify reality to an extent that they become useless. Relying on such models is not only pointless but can cause needless suffering and misery.
Next time - an examination of another assumption of perfectly competitive markets.
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