On the concept of perfectness

The concept of perfectness and related concepts are very popular in economic 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. It states that capital structure of a company is irrelevant in a perfect market. Since there is a systematic mismatch between theory and reality, many empirical researches are devoted to find 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.

But this is not the case in economics research. CAPM is the theoretical foundation of financial investment. It describes the return distribution of assets when investors are “rational”. CAPM was developed more than half century ago. But its fit with empirical data is poor. Investor don’t trade so they appear to be “rational”, whatever that means. They trade to maximize expected gains. When we assume investors maximize expected gains, the derived return distributions of the assets are more consistent with empirical data [2].

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 [3].

Incomplete formation 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”?

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

References

1.       WACC is not the correct discount rate for general asset cash flows, Working paper

2.      On the Inconsistency between CAPM and the Utility Theory, Working paper

3.      An Entropy Theory of Value: Forthcoming in Structural Change and Economic Dynamics 

https://www.researchgate.net/publication/228398386_An_Entropy_Theory_of_Value