Academic journal article
By Prasch, Robert E.
Journal of Economic Issues , Vol. 29, No. 3
Within neoclassicism, the theory of perfect competition describes the ideal operation of the market system. This paper will question the adequacy of this idealized conception of the theory of exchange by challenging the generality of the assumptions underlying the model.
The argument is that the theory of perfect competition does not describe the essence of the market process. Rather, perfect competition addresses the processes of a specific kind of market. To have a full understanding of the exchange process, we must allow that other types of markets exist. Specifically, the situation of the traders in the market and the characteristics of the good traded can actually affect the market process and the eventual outcome of this process. A consideration of these realities leads to a contemplation of the possibility that there is a "general theory" of exchange within which the perfectly competitive model of the textbooks is a special case.
The paper begins with a short discussion of the role of assumptions in economic theory. I then explore the implications of an alternative approach to the market through an examination of a variety of cases. Each of these cases will be illustrated through some well-known events in economic history. This paper will conclude with a short section on policy.(1)
Assumptions in Economic Theory. Abstraction vs. Oversimplification
Defenders of the perfectly competitive model argue that assumptions are necessary for scientific work. However, an argument for the hypothetical deductive method of science does not automatically mean that theorists must accept the specific assumptions behind the theory of perfect competition.(2) In particular, we would do well to remember that there is an important difference between an abstraction and an oversimplification. Stated briefly, an abstraction examines the essential aspects of a situation. It extracts fundamental relationships that can be subjected to further study by application of the rules of deductive logic. On the other hand, an oversimplification distorts our knowledge to the extent that it focuses on, and generalizes from, an inessential or ephemeral aspect of the process at hand. In its error, an oversimplification inhibits our search for the truth of the subject at band.(3) Contrary to Milton Friedman's widely cited essay on method, assumptions do matter.(4)
In this paper, I argue that the theory of exchange can be enriched if we do not accept two oversimplifications that are characteristic of the received theory of exchange. The first is the presumed homogeneity of rational economic actors. This important assumption makes the objective situation of the persons trading in the market immaterial. Within standard microeconomics, all persons are ontologically identical since they are presumed to be rational maximizers. The only acknowledged differences between persons are their individual preferences and respective endowments.
A second oversimplification occurs when users of neoclassical theory assume that the specific characteristics of commodities do not substantively affect the operation of the market. This latter assumption is implicit in textbook presentations that illustrate "the" theory of the market by discussing an undefined abstract good such as the proverbial "widget"(5)
I will argue that by not accepting these assumptions, the homogeneity of actors, and the homogeneity of the market process, the theory of exchange can be broadened into a much more "general theory" of exchange. This more general theory can assist in understanding the specific institutional structures of various markets as they have evolved over time. More specifically, it can provide institutional economists with a better theoretical understanding of current and anticipated policy changes than is allowed by either transactions cost or public choice analyses. Indeed, notions of economic "fairness" and unequal exchange can be shown to have substantive theoretical content insofar as they are grounded in a general theory of exchange. …