Recently, a thought occurred to me regarding the disconnect between economic models/assumptions and the economy they purport to represent. It is demonstrated aptly by a quote, via Jonathan Catalan, from Frank Knight:
To begin with a general abstract answer, it will be evident to anyone with a rudimentary understanding of economic processes and analysis that profit (always in the sense of pure profit) would be absent under the conditions of equilibrium with “perfect competition,” (which may be defined in more than one way). The”tendency” of the competitive processes of buying and selling and the control of production is to impute the whole product to the productive agencies which create it, leaving nothing for entrepreneurship as a distinct function (except for monopoly gain, referred to below). This means that under the conditions of ideal equilibrium (stationary or moving) the function of entrepreneurship itself is entirely absent from the economy.
This isn’t the only time that economic assumptions undermine themselves. For example, another problem with perfect competition is that it assumes everyone is a ‘price taker’; that is, they cannot set prices themselves. But if everybody is a ‘price taker’ and nobody can be a ‘price maker’, how is there a price?
The assumption of perfect information also undermines the study of the economy, for it assumes away most real world services. Obvious examples are pure data processing companies: if everybody had access to, and the capacity to retain, information on this level, then the companies would simply not exist.
Furthermore, many services are born because of
information asymmetries lack of information. If you hire a lawyer, it’s primarily because you don’t have a comprehensive knowledge of the law; if you hire a stockbroker, it’s because you don’t know what to do with your stocks, or how to do it; if you use a teacher, it’s because you don’t know something that you want to know.
Rationality also potentially undermines entrepreneurship. Consider this quote from blogger Matt Sherman:
The process of going from nothing to something…is inherently irrational…To embark on it is to leave the world of economic modelling…[P]rogress requires madness, that is, the freedom to pursue choices whose rationality can’t be measured.
A rational, reasonably emotionless, utility maximising individual, when faced with the choice between steady wage income – which they can casually trade off against leisure as they please – and the alternative of highly volatile and uncertain profits, would clearly opt for the former.
Perfect competition, perfect information and pure rationality are not always used in the higher echelons of modern economics, but that’s not the point. The fact is that they are often used as starting points, and are still taught in most courses, despite their clear incoherence.
Capitalist economies thrive on the inefficiencies and ‘frictions’ presumed to be the only obstacle to the economy functioning ‘efficiently’, in the sense of economics textbooks. Should you remove all these ‘frictions’, it seems that the foundations of economic theory would leave us in a world with no firms, no entrepreneurship and few business opportunities. In other words, large portion of economics could barely be said to be a theory of capitalism.