The Textbook Definition of the Perfect Competitive Market

The theoretical definition of a market found in any standard textbook would include the following characteristics:

1. a public gathering held for buying and selling commodities

2.

3. a single, equilibrium market price for each commodity traded in the location

Thus, what we usually mean by a market is a homogeneous geographical location, where buyers and sellers meet to exchange a single, uniform commodity, for a common uni­form price expressed in a common uniform means of payment called money at specific periods of time. Indeed, the first markets in history were held at the pleasure of the sovereign in specified locations on specific days of the week with restricted participa­tion. The diversity of continuous, bilateral free market exchange seems to have required uniformity, at least on the spatial and temporal levels. Exchange can only take place at specific times and specific places for well-defined commodities with uniform characteris­tics. Thus, while the benefits of free markets depend on diversity, the operation of these markets depends on uniformity

The interesting point is that this problem is not new in economics. Indeed, it con­cerned one of the founders of modern political economy, William Petty, who was the first to confront this conundrum between diversity and uniformity In his little book on Petty (Roncaglia, 1985), and then in his magnum opus The Wealth of Ideas, Alessandro Roncaglia notes that Petty was among the first to recognize that “the commodity is not the smallest existing unit of matter of which the economic universe is composed, but it is itself an abstraction” (2005, 64). Petty dealt with the “notions of commodity and mar­ket [... in] a brief essay written in the form of a dialogue, the “Dialogue of Diamonds”:

The protagonists of the dialogue are two: Mr.

The existence of a market, on the contrary, allows transformation of a large part of the elements that distinguish each individual exchange from any other into sufficiently sys­tematic differences in price relative to an ideal type of diamond taken as a reference point.

Thus the paradox of supply and demand as determinants of price: a uniform commodity is neces­sary for the creation of a market, but the uniformity that creates a commodity requires a market and a market price.

There is thus a relationship between the emergence of a regular market on the one hand and, on the other hand, the possibility of defining as a commodity a certain category of goods, abstracting from the multiplicity of effective exchange acts, a theoretical price representative of them all.

Thus, for Petty, the market itself is an abstraction, in the sense that each individual act of exchange concerns a specific diamond, exchanged at a specific time and place, at a specific price. The market exists as a concept that is useful, indeed indispensable, to an understanding of the functioning of a mercantile and then a capitalistic eco­nomic system, precisely because it allows one to abstract from the myriad of individual exchanges a given set of relationships that can be considered as representative of actual experience and that can provide a guide to behavior. The same considerations apply to the concept of the commodity. In fact, reality is composed of an infinite number of spe­cific individual objects. We group them into categories, such as diamonds, on the basis of some affinities to which we attribute central importance while ignoring elements of differentiation considered as of secondary importance. In other words, the commodity is not an atom of economic reality, but is itself an abstraction, which already implies a certain level of uniformity. The most opportune level of uniformity is determined by the extent of the interrelationships between the various acts of exchange. Thus, it is possi­ble to consider different specific diamonds as the same commodity, with its own specific market, only because the separate exchanges of specific diamonds make plausible the hypothesis that they are the same good since they allow traders to reduce qualitative dif­ferences to quantitative price differences. The same process is required for consideration of a market for apples, or a fruit market, or the market for food in general: apples, fruit or food may be considered, in turn, as a commodity according to the level of aggrega­tion thought to be most adequate, keeping in mind the relationships that come into play within the group of producers and within the group of buyers.

Some abstraction is also necessary in formulating the concept of price so as to deal with the analytical problem of determining relative prices, namely exchange ratios between different commodities. Indeed a “price” corresponds to a “commodity”; it represents a multiplicity of values, each relative to an individual act of exchange, when such acts of exchange con­cern goods sufficiently similar among themselves as to be included under the unique label of the same commodity (as in the case illustrated above of the “price” of the “diamond”). Furthermore we have to delimit the set of acts of exchange to which we refer as the basis for our notion of price, relative to the time and space in which they take place. (Roncaglia, 2005, 66)

Thus, the theory offree markets requires markets to furnish the prices that render homogeneous the diversity of aspects of commodities, but a market can only exist if there are homogeneous commodities.

This internal contradiction between uniformity and diversity is usually hidden behind the assumptions that are set out to define a perfectly competitive market, which are defined in textbooks as the existence of a single price for a given commodity:

1. There are many suppliers, each with an insignificant share of the market—this means that each firm is too small relative to the overall market to affect price via a change in its own supply—therefore each individual firm is assumed to be a price taker.

2. An identical, homogeneous output is produced by each firm—in other words, the market supplies homogeneous or standardized products that are perfect substi­tutes for each other. Consumers perceive the products to be identical and perfect substitutes.

3. Consumers have perfect information about the prices all sellers in the market charge—so if some firms decide to charge a price higher than the ruling market price, there will be a large substitution effect away from this firm, and vice versa, for those selling below the ruling price.

4. All firms (industry participants and new entrants) are assumed to have equal access to resources (technology, other factor inputs), and improvements in production tech­nologies achieved by one firm can spill over to all the other suppliers in the market.

5. There are assumed to be no barriers to the entry and exit of firms in the long run— which means that the market is open to competition from new suppliers—and this affects the long-run profits made by each firm in the industry. The long-run equi­librium for a perfectly competitive market occurs when the marginal firm makes a normal profit only in the long term and each firm faces a horizontal demand curve for its output.

6. There are no externalities in production and consumption, so that there is no diver­gence between private and social costs and benefits.

7. There are no advantages or disadvantages from a geographical location, since all exchanges take place in a single location at the same time.

Thus, the definition of the competitive market eliminates the diversity that emerges from Smith’s insistence on the individual assessments of one’s own utility to be derived from each exchange and is replaced by perfect uniformity in all aspects of market exchange.

It is interesting that most economists did not fully accept these preconditions for the existence of competitive markets. For example, both Walras and Marshall used as refer­ent financial markets where homogeneity assumptions appear to be satisfied—in partic­ular, Walras’s reference to the institution of the “auctioneer” operating a “call market” such as that used at the time in the Paris Bourse. Here exchanges took place at fixed peri­ods, in a fixed place, for financial assets that were homogeneous. There is no difference in the multiple shares issued by a company or the debts, rentes, issued by a government. They are homogeneous by design, as is the market design. But more on this later. Walras believed that this example generalized to market exchange.

However, there were dissenters. For example, in his Capitalism, Socialism and Democracy, Joseph Schumpeter (1942) argued that the kind of competition that actually takes place in capitalistic economies is that associated with the creation of a “new commodity, the new technology, the new source of supply, the new type of organization (the largest-scale unit of control for instance)—competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the exist­ing firms but at their foundations and their very lives” (1942, 84).

For Schumpeter, it is the creation of diversity from existing production that provides for the benefits of the capitalist market system. But this also requires the continual cre­ation of monopoly positions through the offer of better, different output, which provides for the “creative destruction” that produces wealth and accumulation in the economy. But, note that this is a different kind of diversity than that proposed by Smith, for it does not emanate from the idiosyncrasy of individual’s preferences. It results from a change in the given data, and is thus much closer to the kind of process that Fag Foster had in mind. Schumpeter rejected the existence of “an entirely golden age of perfect competition” (ibid., 81). Yet, he maintained the Walrasian framework of equilibrium, in the belief that the market would eventually eliminate competitive advantages and return to stationary equilibrium, although in his later years he saw the advent of the large corporation as dimming the force of creation for destruction.

Somehow, economists seem able to live with the juxtaposition of the two principles of diversity and homogeneity—market efficiency that requires diversity, perfect competi­tion that requires homogeneous products and Schumpeterian competition, which, again, requires differentiation to provide creative destruction.

There is a parallel to this argument at the macrolevel. A corollary of Sraffa’s criticism of supply and demand theories of prices produced the Cambridge capital theory con­troversies in which mainstream economists put forward models in which a homogeneous capital good produced a homogeneous commodity in a model meant to show the oper­ation of relative prices (which requires at least two prices) of capital and labor. But there is no market in which capital exchanges for labor; rather, there are only markets in which capital or labor-intensive goods compete.

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