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10 Things You Didn't Know About Economics: Numbers 4-6
The ongoing economic crisis has occurred against a backdrop of flawed economic theory. Much of this faulty thinking on the part of professional and academic economists has been obscured from the general public by the impenetrable jargon and complex mathematics that has become part and parcel of the profession.
However, the profound implications that economic theories have for society's prosperity mandate a solid understanding of the field and its assumptions. So, without further ado, here are 10 big ideas and assumptions in the modern economics profession that you probably didn't know about: numbers 4-6.
4. Information is perfect
And we do mean perfect. The doctrine of "perfect information" says that all consumers, firms and other economic actors have access to ALL relevant information, period.
So if you run a motorcycle repair shop in Los Angeles, modern economics says that you have access to ALL the information on prices, supply orders, employment and services offered by EVERY SINGLE motorcycle repair shop in the country--in New York, Florida, Texas, North Dakota, etc. Not only that, but you are privy to the most detailed knowledge and information on your customers' attitudes, their budgets, their level of wealth, their overall demand for your service, and so on.
When it comes to consumers, the Wikipedia article on perfect information says this:
Perfect information would practically mean that all consumers know all things, about all products, at all times, and therefore always make the best decision regarding purchase. In competitive markets... perfect competition does not require that agents have complete knowledge about the actions of others; all relevant information is reflected in prices.
True perfect information is obviously a ridiculous assumption, bordering on delusion. But might the economist be saved by the idea that all relevant information is reflected in prices? That way, as the article says, every single person doesn't have to know every single thing. It sounds somewhat reasonable until you remember that the price is itself set by human beings: humans working in the marketing departments and board rooms of companies. The price is "set by the market" only in a metaphorical sense--the market is composed of people. People with imperfect information.
Although anyone with half a brain should be able to see that perfect information doesn't exist (and never has), nonetheless it is essential to much of economic theory. And it has real-world consequences: if you can assume that all consumers and businesses know everything about each other, then you believe they can make the absolute best decisions on their own. And you are more likely to view an external agent--like government--as unnecessary or destructive to the process.
5. Competition is perfect
Like perfect information, "perfect competition" is an assumption that must be made for a huge number economic ideas to make sense. A perfectly competitive market has:
- A very large number of firms (in the hundreds)
- Identical products produced by each firm
- Perfect information (see above)
- No strategic behavior on the part of consumers or firms, and
- A free flow of resources into and out of the industry, and no barriers to entry.
Sound unrealistic? Sound like it characterizes almost not a single market on earth? Yeah, that's because it doesn't. It's almost impossible to find a real-world industry that has any of these qualities, much less all 5.
And yet the idea of perfect competition enjoys more time, attention and prestige in economic theory than any other explanatory framework. To be sure, attention is given to monopoly and other imperfect competitive scenarios. But by far the main thrust of economics today is based on perfect competition more than any other idea. Rather than being treated as an interesting but basically useless theoretical tool or curiosity, perfect competition is used as the default standard.
To give you a taste of how stupid, idealistic and contrived this notion is, just remember this: in a perfectly competitive industry, it's impossible for any company to make more money than any other company. There goes the whole basis for capitalism.
6. Financial markets are... you guessed it--perfect
Financial markets are typically considered to be the most "perfect" markets around. Traders and investors have a lot of money on the line, so they make it a point to know information quickly. It's pretty easy to open an account and start trading, so there are low barriers to entry. And units of stock, currency or commodities are all identical. So it might seem like financial markets can be treated as "perfect." In finance, this assumption underlies the Efficient Market Hypothesis.
But one big caveat is that despite millions and millions of participants, the vast majority of the money is controlled by a handful. In the global currency market, the top ten traders account for 80% of the market share. The overwhelming majority of the stocks and bonds in the US are owned by a small minority of the population. Not to mention that believers in this theory evidently have never heard of corporate scandals, investor fraud, insider trading, or creative accounting.
Most importantly, since traders and investors are human, we know they can't be perfect. They are not automotons, constantly crunching an infinity of numbers to come up with the best decision in their own self-interest. They have families, health problems, they eat, sleep, read about celebrities and watch reality TV. Countless market crashes, including the most recent one, are real-world proof against perfection.
Since perfect financial markets are just a different take on perfect competition, the theory holds that it's impossible to make more money than anybody else. Countless failed stock traders notwithstanding, Warren Buffet and Goldman Sachs would seem to disagree.
What is so dangerous about the assumption of perfect financial markets is the policies that it has led to: little regulation, minimal oversight, and an overall attitude that "the market will take care of itself." Welcome to the financial crisis. Brought to you by establishment economics.