Edited and written by David Gordon, senior fellow of the Mises Institute and author of four books and thousands of essays.

# Perfect Competition and the Transformation of Economics

## Frank Machovec

###
3 1997

Volume 3, Number 3

**No Contest**

Fall 1997
PERFECT COMPETITION AND THE TRANSFORMATION OF ECONOMICS

Frank M. Machovec

Routledge, 1995. xi + 391 pgs.

Doctoral dissertations seldom make good books. Even the most trivial assertion in a thesis must be footnoted; and the author, much to the reader's discomfort, must demonstrate his control of his subject in excruciating detail. But occasionally, the virtues of the form triumph over its limitations; and Frank Machovec's excellent work is one of these happy exceptions. His extraordinarily thorough research illuminates many areas of economics.

Machovec's choice of topic manifests his courage. The mathematical formalism favored by Lon Walras has come to dominate modern economics. Elaborate models of perfect competition are the prime topic of contemporary microeconomics; and newcomers to the subject often think that they have walked by mistake into a seminar of the mathematics department.

Like other Austrians before him, Machovec contends that models of perfect competition do not adequately account for the characteristic features of competition in the real world. Our author is not an Austrian of the strictest observance, and he does not renounce the use of these models altogether. "As one who holds undergraduate degrees in mathematics and meteorology, I am an equivocal supporter of the value of formalism in economics. I fully concur with Jevons's observation that, in a discipline devoted to the study of small marginal effects, the widespread employment of calculus is inescapable" (p. 9). But the dominant theme of his book is not the benefits of formal models, but their limitations.

When formalists face attack, they are liable to respond with derision. "Who are you," they will say, "to challenge the way economics is done? If you do not like our mathematics, found your own discipline." Machovec neatly turns the flank of this rejoinder. The mathematical economists are themselves interlopers. They falsely contend that their models develop the insights of the great classical economists of the nineteenth century. In fact, our author contends, they do not do so: formalistic analysis neglects the process approach to competition favored by the classicals. The Austrian critics of perfect competition, not its latter-day proponents, carry on the study of economics as it has been historically conceived.

But what exactly is wrong with mathematical models? For one thing, they assume that the market price cannot be changed by the actions of an individual producer: prices are parametric. Further, individuals operate with perfect information. "Since Knightian perfect competition assumes perfect knowledge by all producers and consumers, a market populated solely by price- taking firms will have only one price charged to all buyers" (pp. 101-102). And of course if the law of one price obtains, mathematical analysis gains a firm foothold.

Machovec's argument must confront an objection. Perhaps, it will be claimed, the models of past days rested on overly restrictive assumptions; but we have overcome all that. Do we not now have models that allow for imperfect information?

Our author is not to be put off this easily. These models, he contends, fail to take account of genuine uncertainty. "The equilibrium theorist assumes that the decision-maker is already drilling in the right field, whereas the process theorist emphasizes that recognizing the appropriate place to start digging is the big hurdle. In equilibrium theory, the probabilistic outline of the unknowns is already known, thereby enabling a Stiglerian marginal benefit, marginal cost analysis to reap an optimal outcome. Equilibrium theory simply cannot address the real problem: where to search and what to search for" (p. 171).

This response gives rise to a new objection. What if the mathematical economist says: All right, we do use unrealistic assumptions. So what? They work. Have you never read Friedman's "The Methodology of Positive Economics?"

Machovec directly confronts this counterargument, and to my mind his answer is the best feature of the book. He shows that adoption of the mathematical model leads to serious mistakes, especially when the model is taken as a welfare ideal by which to judge the actually existing market.

Our author's account of the socialist calculation debate impresses me as especially insightful. When Ludwig von Mises demonstrated in 1920 that a socialist economy could not rationally allocate production goods, he left socialists in disarray. What were they to do? Oskar Lange, a Marxist who was also a leading neoclassical theorist, found what he took to be an escape. Whatever the market could do, so could socialist planners: they had merely to allow the managers of socialist enterprises to compete for resources. "Lange concluded that the problem of socialist calculation can be solved, theoretically, through a series of trial-and-error prices. Producers react to shortages (or surpluses) by raising (or lowering) their prices until general equilibrium is reached" (p. 53). Mises, in Lange's view, was hoist with his own petard: his demonstration that the market worked efficiently by that very fact showed that socialism also is efficient. The equations of equilibrium are the same in both systems. Lange's argument won over most of the economics profession, until the collapse of communism made it clear that Mises was right.

What blinded so many eminent economists for so long to the validity of Mises's argument? For our author, the culprit is equilibrium analysis. Wrongly taking the perfect competition model to be a picture of an economy as it ideally ought to work, economists saw no reason a socialist system could not allocate resources according to the model's requirements. Had they grasped that, for actors in the market, uncertainty is rampant, they would have realized that their models of efficient socialism were useless.

Machovec uncovers a surprising fact about the debate over Lange's model. One of Lange's sharpest critics was Maurice Dobb, a Cambridge University economist who was a committed Communist. Lange's system allowed considerable governmental redistribution of income; and here Dobb found a fatal flaw. "By moving toward a more equal distribution of income, the socialist state buys more equality only by inducing inefficiency. This wrote Dobb, 'is the central dilemma' faced by socialism" (p. 54). I hasten to add that Dobb did not agree with Mises that socialism was inefficient. He favored full-scale central planning and failed to confront Mises's argument at all.

Our author devotes considerable attention to showing that economists before the mathematical revolution had a much more accurate conception than their successors of how the market works. They realized that, in a world of uncertainty, the entrepreneur's role is vital. Prosperity depends on enterprisers whose judgment enables them to anticipate the wishes of consumers and shift resources accordingly. The linchpin of the economic system is that information is not perfect.

Among the nineteenth-century figures who clearly saw this, I was surprised to learn, was Jeremy Bentham. "Every thing which is routine today was originally a project...; and when new, it was the production of that mischievous and bold race...of projectors [Bentham's term for entrepreneurs]!" (p. 115, quoting Bentham).

Bentham's views, though innovative, were by no means anomalous in the nineteenth century, as Machovec abundantly shows. But readers who wish to study the historical details should consult the book directly. I found especially valuable Alfred Marshall's warning against too much reliance on static models (p. 243).

Inevitably, at least when I am the reviewer, a few details arouse misgiving. While Machovec has conclusively shown the falsity "of the neoclassical claim that the classical theory of the market was entrepreneurless" (p. 2), he has not shown false the claim that mathematical models formalize particular aspects of the classical view. I doubt that his claim that Bakunin was influenced by "the practices of early communal Christians" is correct (p. 327, n. 12). He seems to me to allow too much scope for the state to regulate monopoly (p. 303). And the claim that "[I]f I already know the consequences of each available course of action open to me, then the ultimate path is, in effect, given, not chosen" (p. 72) seems dubious. To know that something will happen does not fix how one values it.

I'm sorry I had to insert that last paragraph. The remarks in it do not detract from the fact that Machovec has made an outstanding contribution to economics.