Adam Smith, in his book The Wealth of Nations, wrote: “Every individual . . . intends only his own gain; and he is in this . . . led by an invisible hand to promote an end which was no part of his intention . . . By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it.”
In the 400,000-word epic that is The Wealth of Nations, the above quote stands out as Adam Smith’s only reference to the “invisible hand.” Nonetheless, his metaphor has inspired the belief, particularly over the last half century, that laissez-faireism promotes economic development. However, contrary to the orthodoxies of classical and neoliberal economics, free markets do not, and never did, create perfect competition. Perfect competition is, in fact, a theory that does not hold water upon closer examination.
Let’s demystify the theory by examining the assumptions underlying a perfectly competitive landscape:
– Products and services are homogeneous, substitutable, and interchangeable: This argument could justify market concentration, as it can lead to economies of scale allowing a few major players to dominate industries with indistinguishable products.
– Firms cannot set their own prices: In reality, many firms proactively influence prices and market conditions, leading to the potential for monopolistic behavior.
– The market is fragmented: Extreme concentration is common across numerous sectors, from grocery stores to social media platforms.
– Consumers and producers have perfect information about products and prices: In today’s digital and global economy, there is an overwhelming amount of data and variables to consider, undermining the assumption of perfect information.
– Barriers and costs to market entry and exit are low: In reality, there are numerous barriers that make it difficult for new entrants to compete with established players.
Economist Léon Walras formulated the concepts of perfect competition and market equilibrium a full century after the publication of The Wealth of Nations. However, by the time these concepts were introduced, free markets were meant to evolve towards an equilibrium that has never actually existed.
In the real world, many buyers meet many sellers, and neither side of a transaction unduly affects the price discovery process. Yet, the 19th-century saw industries quickly consolidating as small and local operators gave way to national juggernauts, highlighting that perfect competition was a myth from the very beginning.
Nowadays, the only fragmented industries that avoid consolidation tend to have low barriers to entry or serve diverse or personalized needs, rendering commoditization difficult. Various competitive advantages that favor industry leaders underpin consolidation. New entrants strive not only to disrupt the status quo but to dislodge incumbents and secure market leadership.
In a free market, supernormal profits should be transient glitches, but they persist in sectors as varied as Big Pharma, Big Tech, and Big Tobacco. This indicates that market dominance can endure, and suppliers often have the power to set prices to the detriment of customers over extended periods.
The real world, for the most part, is classified in the realm of “imperfect competition.” But even the term “imperfect competition” may fall short in describing the reality that free markets induce more oligopolistic rather than monopolistic behavior due to regulations. Without anti-trust legislation, monopolies could very well prevail in most industries.
