Key Points:
- Perfect competition is a myth and does not exist in real-world markets.
- The assumptions of perfect competition, such as homogeneous products and perfect information, are not valid.
- Oligopolistic behavior and monopolies are common in various industries.
- Free markets tend to lead to consolidation and monopolization, rather than promoting competition.
- The pursuit of self-interest in markets can create negative externalities and environmental degradation.
“Every individual . . . intends only his own gain; and he is in this . . . led by an invisible hand to promote an end which was no part of his intention . . . By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it.” — Adam Smith, The Wealth of Nations
In his book “The Wealth of Nations,” Adam Smith mentions the concept of the “invisible hand” only once. However, this metaphor has influenced the belief that free markets and laissez-faireism lead to economic development.
Contrary to this belief, perfect competition, which is often associated with free markets, does not exist in reality. It is a myth that can easily be debunked.
Demystifying the Theory
Let’s examine the assumptions that underlie a perfectly competitive market:
1. Products and services are homogeneous, substitutable, and interchangeable.
However, many industries are dominated by a few major players that offer broadly indistinguishable products. For example, the global grain trade is largely directed by the four ABCD firms (Archer Daniels Midland, Bunge, Cargill, and Dreyfus), and the palm oil sector is controlled by four major players.
2. Firms cannot set their own prices.
In reality, many firms have the power to influence prices. Retail supermarkets, for example, can counterbalance the pricing power of big brands by making access to consumers conditional.
3. The market is fragmented.
However, extreme concentration is common in various sectors, such as grocery stores, digital operating systems, social media, automotive, and audit.
4. Consumers and producers have perfect information about products, substitutes, and prices.
In a digital and global economy, it is impossible for individuals to have perfect information due to the overwhelming amount of data and variables to consider.
5. Barriers and costs to market entry and exit are low.
In reality, many industries require heavy capital commitments, benefit from network effects, or rely on brand reputation built over years of advertising spend.
Opening Up to Competition
The concept of perfect competition and market equilibrium, formulated by economist Léon Walras, came long after the publication of Adam Smith’s “The Wealth of Nations.”
In Smith’s time, free markets did not exist as they do today. Industries were often controlled by monopolies or small local operators. The Industrial Revolution was just beginning, and the idea of perfect competition had not yet emerged.
Visible Sleight of Hand
According to modern economic theory, unregulated markets with many buyers and sellers should lead to an efficient level of inputs and outputs.
However, market dominance and monopolies have endured throughout history. Even when corporations are broken up due to their monopolistic positions, they often reconsolidate over time. AT&T, for example, dominated the telecom industry in the US for most of the 20th century. After being split into regional operators, the sector eventually reconcentrated around three major players.
From Economics 101 to 21st-Century Economics
In reality, industries tend to exhibit oligopolistic behavior rather than perfect competition. Competitive advantages such as economies of scale, barriers to entry, and improved negotiating power with suppliers and customers favor industry leaders and contribute to consolidation.
New entrants often aim to dislodge incumbents and secure market leadership. Monopolies and market concentration are not temporary market failures but rather the natural result of the constant battle for finite resources.
While Adam Smith’s idea of self-interest leading to societal benefits has some truth, the natural equilibrium of a market economy is not perfect competition but a process of elimination and monopolization. Free markets can lead to negative externalities and the concentration of power.
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All posts are the opinion of the author(s) and should not be construed as investment advice. The opinions expressed do not necessarily reflect the views of CFA Institute or the author’s employer.
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