On the concept of perfectness

The concept of perfectness and related concepts are very popular in economic and finance literature. There are perfect market, complete contracts, rational investor, complete information, perfect competitive market. When people point out these concepts don’t relate to reality very well, economists often argue that similar concepts are used in natural science as well. In science, there are frictionless world, ideal gas and rational numbers.

In physics, we do have the concept of frictionless world and develop a corresponding mathematical theory. But researchers don’t stop there. They strive to develop models that represent reality more closely. People later developed the mathematical theories that model movements with friction. Today, we can calculate the trajectories of moving objects through mediums of various frictions.

In economics, we develop various theories that suppose to work in “perfect” market. When a theory fits market data poorly, the market is called “imperfect”. A prominent example is Modigliani and Miller theory, which was developed sixty years ago. From the Modigliani and Miller theory, the concept of Weighted Average Cost of Capital (WACC) is developed. WACC is used to calculate asset values. Very often, asset values calculated from WACC and other methods are not the same.  Researchers  often attribute these mismatches to various “imperfection” of the market. But it turns out the theory itself was proved on very specific assumptions that cannot be generalized [1].

In mathematics, there are rational numbers and irrational numbers. Initially, there must be strong emotions attached to these terms. But over time, rational numbers and irrational numbers acquire very technical and precise definitions. Irrational numbers are in no way inferior to rational numbers.

Similarly, in physics, frictionless is not necessarily better than friction. When making shoes, we often try to add more frictions to the bottom of the shoes to make them less slippery.  

But this is not the case in economics research. A perfect market is supposed to be better than an imperfect market. In standard value theory, a perfect market is where many companies are competing in the same line of business. In such market, profit margin is very low. The highly profitable and dominant companies are the ones that achieve monopoly or near monopoly. In the view of standard economic theory, monopoly or near monopoly markets are highly “imperfect”. This means all companies are striving to make the market less “perfect”. Many of the important institutional structures, such as religions, governments, unions, patents and regulations, obtain high valuation through monopoly [2].

Incomplete information is supposed to be an “imperfection”. Will you share with everyone else the password of your bank account? That will make the information more complete. But you wouldn’t share. So why the economic literature calls incomplete information an “imperfection”?

When we utter the concept of perfect market, it means we already know what the best society looks like. All we need to do is to reduce the amount of “imperfectness” over time. There is no more fundamental change in the society. There is no more fundamental change in the social theory. However, this is not how biological and human systems operate. Whenever a system posts positive returns, it will expand, however imperfect you might think. Whenever a system posts negative returns, it will shrink, however perfect you might think.

Very often reality cannot fit into standard economic theory very well. The discrepancy between theory and reality is often attributed to imperfection of reality, such as “imperfect market”, “imperfect information”, “imperfect contract”, “imperfect competition”, “inefficient property right”, “market failure”, “government failure”, “externality”. A brief review of the concept of imperfection in old astronomy will help us gain more understanding about it. Ancient people had long observed that stars moved in perfect harmony in the sky. Several planets, however, moved in irregular trajectories. It was thought that this was caused by the imperfectness of the planets. There were many elaborate theories why the planets were imperfect. Kepler, however, derived that all planets moved in perfect elliptic orbits around the sun. This story tells us that “imperfection of the world” often reflects imperfection of the theory that is used to understand the world instead of the world itself.

It is often the theory itself that needs to be improved. The concept of imperfect market and related concepts obscure that reality.

References

1.        The Scope of Validity of Modigliani and Miller Propositions, The Asian Journal of Economics and Finance. (2019), Volume 1, Issue 3, 109-119

2.       An Entropy Theory of Value, Structural Change and Economic Dynamics, (2018), December, Vol 47, 73-81