International Journal of Economics
and
Management Sciences
Vol. 2, No. 11, 2013, pp. 58-70
MANAGEMENT
JOURNALS
managementjournals.org
From Disorder to Order: Disequilibrium Price Adjustments by ‘Perfectly’ Competitive Firms
James Rolph Edwards, Ph.D. (Economics)
Professor of Economics, Montana State University-Northern Havre, Montana 59501
E-mail: Edwardsj@msun.edu
ABSTRACT
This paper shows that key assumptions of the theory of perfect competition, that agents have perfect
information and that firms are price takers, can only hold or be approximated when a market is in equilibrium.
When it is not clearing, information is not perfect, and each firm’s demand function becomes finitely elastic.
Each of them experiences observable effects of the market disequilibrium not only allowing but strongly
motivating its decision maker to alter price and output in ways that generate more information relevant to
further adjustments. These adjustments by the firms are correlated by the common conditions they face, and
are further coordinated by consumer search and substitution. Once equilibrium is restored, conditions of
‘perfect’ information and infinitely elastic firm demands are again approximated precisely as a final outcome
of the price adjustment process.
Keywords: Perfect competition, price adjustment
JEL Classifications. D01, D21, D41, D83
INTRODUCTION: Perfect Competition and Price Adjustments
The conventional neoclassical model of perfect competition, regarded by many economists as a welfare ideal by
contrast with which most real world markets are seen to be inferior, providing justification for coercive,
corrective government intervention, is, even to some of us who do not take that view, a highly useful model. Its
various abstract simplifications allow several crucial economic processes such as firm profit maximization, the
background nature of the supply function, how market entry and exit of firms on profit and loss motives shift
resources from lower to higher valued employment, and what constitutes the economically ‘correct’ amount of
scarce resources to be employed in a market, to be highlighted and illustrated in simple verbal and graphic
terms. Thus the model has much heuristic value even for some of us who, from a dynamic disequilibrium
market process perspective informed by von Mises, Hayek, and/or Schumpeter, do not regard it as a universally
valid efficiency standard.
Even economists who regard real markets as departures from a state of perfectly competitive bliss recognize the
highly abstract and unreal character of the model. Its simplifying assumptions are numerous, stringent, and
closely interrelated. First, there must be many, many, many essentially identical firms supplying the same good
or service, each thus providing only a trivial portion of total market supply (Aumann 1964). None has the
physical capacity by any possible change in its rate of production (from zero to maximum total product) to shift
total market supply enough to cause market price to change even a penny. Thus the decision makers of the firm
are price-takers, who find their economic problem simplified. Accepting the existing market price they simply
alter their rate of production up or down by using more or fewer of the variable input(s) ceteris paribus until
they find that rate at which that price equals their marginal cost and profits are maximized (or losses
minimized).
Another stringent assumption is that all suppliers and demanders in the market have ‘perfect’ information.
Oddly, given the stress put on this assumption by so many economists, one never finds a full and clear statement
of what that condition entails. Certainly it cannot mean that any or all of the market participants are omniscient,
so it must only mean that they have all of the relevant information they need in order to do the best they can
under existing technological and economic constraints. Indeed, it is sometimes asserted to mean simply that
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demanders know the locations of suppliers of the good or service and of the prices they charge, while suppliers
all have access to the best existing production technology (apparently including the most effective managerial
practices).
Given ‘perfect’ information in this limited sense, the necessities of shopping by customers to discover prices and
locations of suppliers, and of advertising by suppliers to inform consumers, are abstracted from, and the cost
structures of all firms are the same. 1 Among other things, this helps explain the price-taking assumption, in
which the demand for the output of each supplying firm is graphically shown as a horizontal (hence infinitely
elastic) line, constant for all output rates at the existing market price. Given perfect information by consumers
no supplier can charge even a penny above that market price per unit without losing all of its customers to
alternate suppliers. In addition, the decision maker of the firm has no incentive to charge even a penny less,
since among the things he/she has ‘perfect’ information about is that the firm can sell all that it wants at the
existing market price. The model assumes, then, a state of complete informational entropy, without explaining
in the slightest how that state was achieved.2
Moreover, the model assumes that the suppliers sell a homogenous product, either physically identical in all
firm iterations or, at the very least, regarded as perfect substitutes by consumers, so that they have no preference
for the output of firm ‘N’ over that of firm ‘Z’ and again, no firm can thereby charge a different price than the
others. In this regard it is worth noting that any and every product or service has a specification, consisting of a
bundle of different elements or characteristics. A car, for example, has a primary function of transporting its
owner reliably from point A to point B, but consumers care about more than that. They also like some degree of
comfort, aesthetics (style), and safety. Automakers engineer these things into their vehicles in different ways
and degrees in a competitive effort to please customers and maximize sales. To assume an existing product,
with an existing specification, as the model does, and that
the specification never changes, is to assume either that consumer tastes are uniform and stable, or that the
product is homogenous by some technical necessity (gasoline is gasoline is gasoline) without explaining how
that optimal specification was found in the first place. This seems to be another unexplained expression of
complete informational entropy.
Even many of the more troublesome assumptions of the model might be justified for its legitimate heuristic,
illustrative purposes, as long as the intent is to simply leave difficult and confusing issues to deal with later by
sequentially removing some of the model’s abstractions and bringing it step-by-step closer to reality. Thus it
would be easy to allow consumer ignorance and analyze how shopping, inter-consumer communication, and the
resulting substitutions would generate both greater informational entropy and a single price in the market,
ceteris paribus. And it would be relatively simple to assume a normal distribution of managerial talent and
knowledge across firms, rather than the even one the model now implicitly assumes, with a resulting normal
distribution of minimum unit costs among firms, to see how that would alter market structure, price, and
consumer well being ceteris paribus. And so on. Some would argue that the profession has actually done
something equivalent to this, since huge literatures on the economics of information, alternate market structures,
and other matters ignored by perfect competition have been developed.
There is, unfortunately, a crucial flaw inherent in the received model, a flaw reinforced by several of its
intertwined assumptions, that partly vitiates its usefulness even for simple illustration of market equilibration
and resource allocation processes. It is actually embarrassing to some Professors of economics who, having
1
Except perhaps for transport cost differences due to differences in distance of the various firms from labor, raw material, or
intermediate product suppliers, which would also show up in slight differences in product prices to cover those slight unit
cost differences.
2
Information is apparently being treated as a free good, on which market participants can satiate at zero cost. However, I
provide a better explanation below.
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There certainly are some assumptions of the perfectly competitive model that seem unobjectionable and even
necessary for its expositional purposes. Open entry and exit are good examples. I interpret them not to mean
costless entry and/or exit (since neither can ever be costless), but simply to indicate a lack of legal restrictions
on entering or leaving a profession, trade, or line of business. Indeed, it was one of the crucial institutional
transformations allowing modern democratic industrial market societies to emerge from the old feudal order,
first in Britain, then in America and other settler colonies, and then Europe, that many ancient legal restrictions
on who could work in what fields of employment were abolished. This, along with the extension of private
ownership, allowed increased personal freedom and market economization of scarce productive resources.
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early in a term taught students how market price rises or falls toward market clearing values in response to
excess demands or supplies, then later (after having explicated the basic theory of short-run firm product and
cost relations) have to try to explain market resource allocation through profit-seeking entry and loss-avoiding
exit of firms, using a model that does not allow or explain the necessary price adjustments, since all of its
participants are assumed to be price- takers, leaving none who can alter price.
Since World War II several prominent economists – including two Nobel laureates - have drawn attention to this
huge theoretical flaw, and each has subsequently been blithely ignored by the rest of the profession (Arrow
1959, McNulty 1967, Morgenstern 1972, Kirzner 1976 and 1981). Perhaps the most recent is Vernon Smith, the
Dean of experimental economics. In the published version of his Nobel Prize lecture (Smith 2003), he noted
and documented that in a variety of experimental games the conditions of the (perfectly) competitive
equilibrium (CE) regularly emerge even with as few as three firms in the market, without perfect information on
the part of transactors, and without transactors being price-takers. The following quotations, all taken from the
same page (Smith 2003, p. 475) may capture some of the flavor of Smith’s perspective.
The alleged “requirement” of complete, common, or perfect information is vacuous; I know of no predictive
theorem stating that when agents have such information their behavior produces a CE and in its absence their
behavior fails to produce a CE. . .
Further down the page he says the following.
What is missing are models of the process whereby agents go from their initial circumstances, and dispersed
information, using the algorithms of the institution to update their status, and converge (or not) to the predicted
equilibrium.
As a theory the price-taking parable is also a nonstarter: who makes price if all agents take the price as given?
With regard to that last point, one might even ask from where the price comes that all market suppliers take as
given? Arguably, the received theory of perfect competition not only lacks an explanation of price change, but
thereby of price determination itself, a point at least hinted at by Morgenstern (1972, pp. 1171-1173), if not
clearly stated.
This theoretical lacunae is most clearly seen in standard microeconomic text discussions of market resource
allocation, where a representative price-taking firm is (typically) shown operating at an output on its horizontal
demand curve where p = mc using the initial market clearing price. The firm, however, representing the typical
condition of firms in that market, is shown earning an economic profit or loss. As the case may be, entry or exit
of firms occurs, shifting the supply curve until, at the new equilibrium price, the industry profits or losses are
eliminated. The representative firm is then shown as passively adjusting its output along its new horizontal
demand curve until the new market clearing price, (say p’) = mc again, and at this point, p’= minimum short-run
unit cost as well.
The market price adjustment from the old equilibrium value to the new seems to be the operation of a Deus ex
Machina, to which each firm then passively adapts its output. This is completely backwards. Never is it even
hinted that the ‘market’ price merely represents the average of the prices charged by those firms, and can
therefore only change as a result of those firms changing their prices in the required direction, much less that
they can only do so if each firm faces a finitely elastic demand for its output and a finite excess demand (or
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Are Competitive Firm Price Adjustment Models Really Missing?
The essence of the problem perceived by the present author and the economists cited (Arrow 1956, McNulty
1967, Morganstern 1972, Kirzner 1976 and 1981, and Smith 2003) may be stated this way: standard economics
assumes that the price of a given good or service adjusts toward a new market clearing value in response to
excess demands generated by shifts in supply and/or demand, and seems to imply that the shortage or surplus
itself motivates some actual persons to do the price adjusting. However, the modern theory of the firm in a
perfectly competitive market, by assuming all transactors (including the decision makers of the firms) to be
price-takers, leaves nobody capable of doing so. What seems missing is a connecting model, showing that, just
why, and how, the emergence of disequilibrium itself causes the ‘perfectly competitive’ firms to face demand
functions with finite (rather than infinite) elasticities, finite (rather than infinite) excess demands or supplies, and
both the information and the motivation to begin competitively adjusting their prices up or down as they seek
out the new equilibrium. It must also be shown that, just why, and how, the demand curves of the firm go back
to being infinitely elastic when the new equilibrium is reached, so that market supply is a function of price,
which requires firm output adjustments on a p = mc basis.
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supply) over the range between the former and the new market equilibrium prices. The uniformity of this (non)
explanatory treatment of price change across standard texts strongly indicates that the needed connecting model
is missing.
One might ask whether Smith’s ‘missing’ models are to be found in nonstandard economics. The Austrian
school in particular, as a branch of modern economics whose leading members have been more concerned with
the ongoing disequilibrium market process than with the possibility and character of equilibrium states, might
seem to be a good place to look. Ludwig von Mises (1963, p. 315), in his Magnum Opus Human Action, makes
the key observation about price adjustments.
It is customary to speak metaphorically of the automatic and anonymous forces actuating the “mechanism” of
the market. In employing such metaphors people are ready to disregard the fact that the only factors directing
the market and the determination of prices are purposive acts of men. There is no automatism; there are only
men consciously and deliberately aiming at ends chosen.
A few pages later, in a paragraph that explains what the theorists of perfect competition may be presuming about
price change, but then gives insight into the actual market process, Mises (1963, p. 328) writes the following.
In an economic system in which every actor is in a position to recognize correctly the market situation with the
same degree of insight, the adjustment of prices to every change in the data would be achieved at one
stroke. . . The operation of the market reflects the fact that changes in the data are first perceived only by a few
people and that different men draw different conclusions in appraising their effects. The more enterprising and
brighter individuals take the lead, others follow later.
Only a few pages later, however, Mises makes the following observation.
The ultimate source of the determination of prices is the value judgments of the consumers. . . But the larger the
market is, the smaller is the weight of each individual’s contribution. Thus the structure of market prices
appears to the individual as a datum to which he must adjust his own conduct (Mises 1963, p. 331).
This is the Austrian equivalent of the orthodox neoclassical assumption that if markets are thick enough
everyone is a price-taker. Yet somehow, Mises sees no need to reconcile this with his earlier statements,
perhaps by recognizing that this can only be true in equilibrium. Persons, particularly firm decision makers, will
only alter their prices if they both see the need and don’t feel helpless to do so. For all the insight in Mises’
discussion of the market price system, in this and his other writings the specific kinds of models Smith (2003, p.
475) asks for, i.e. “models of the process whereby agents go from their initial circumstances, and dispersed
information, using the algorithims of the institution to update their status, and converge (or not) to the predicted
equilibrium” are missing.
As near as I can tell, the same is true of another of Mises’ prominent students, Israel Kirzner, though Kirzner
sees the need for the ‘missing’ models, and comes closer to providing one than does Hayek. In a paper
contrasting the equilibrium focus of modern economics with the Austrian market process focus Kirzner (like
others before him) notes the lack of anyone in the perfectly competitive model who can change prices and
wonders therefore how prices can change. After critiquing Marshall’s quantity-adjustment argument, Kirzner
(1976, p. 117) says the following.
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The same is true in the work of Mises’ greatest student and 1974 Nobel Laureate Friedrich Hayek. Dealing with
the market price mechanism in his most famous essay, Hayek (1949) objects to the notion that central planners
could use the allocative efficiency criteria of modern economics to set prices and allocate resources correctly,
arguing that the information necessary for them to equate marginal rates of substitution for commodities and
factors cannot be collected statistically. It consists of fragmentary bits of knowledge of local circumstances,
personal needs and preferences, etc., which are dispersed among the general public and could not be obtained by
the planners. He further argues, however, that the price system transmits, in an economical fashion, the
information on changes in relative scarcities needed by private parties planning to make the best use they can of
available resources. This market data constantly changes, hence participants must make constant adjustments,
which also precludes central planning. The immense importance of these insights aside, given Hayek’s focus on
the operation of the whole price system, he never develops, in this or in any other of his writings of which I am
aware, a specific model of how disequilibrium price adjustments made by private firms lead back, if left
unimpeded, to equilibrium in a particular market.
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. . . From the Austrian perspective, which emphasizes the role of knowledge and expectations, these
explanations take too much for
granted. What is needed is a theory of the market process that takes explicit
notice of the way in which systematic changes in the information and expectations upon which market
participants act lead them in the direction of the postulated equilibrium “solution.”
Kirzner then argues that the missing element in a theory of price adjustment is recognition that participants are
alert to opportunities, and that, particularly in response to inventory changes indicating disequilibrium, they will
pursue, through entrepreneurial adjustments of price and output the opportunities they sense.
This argument gets Kirzner to the edge of providing the missing model. He stops short, however. It is one thing
to note that market disequilibrium provides visible signals that alert entrepreneurs to possible financial gain or
loss-avoidance opportunities, and that they respond entrepreneurially through marginal price and output
changes. Both points are correct and must be vital elements of the needed model. It is quite another thing,
however, to explain how firms can change price in thick markets, i.e., whether or how disequilibrium makes
each firm’s demand finitely elastic, or what keeps them that way, or just what additional information is
discovered by the initial firm responses that may guide further adjustments, or just what (if anything)
coordinates the subsequent price and output adjustments by the firms, or how this all converges to the new
equilibrium. Moreover, Kirzner seems so averse to the notion of perfect competition that it does not occur to
him that in thick markets vital features of that model might end up being final equilibrium outcomes of the
unimpeded operation of the very entrepreneurial, disequilibrium price and output adjustment process that he
envisions.
The present paper is an effort to supply one of the ‘missing’ models by developing a theory of price adjustment
in response to market disequilibrium by firms in a market which, once equilibrium has been restored, essentially
conforms to the conditions of perfect competition. I assume up front a very large number of small suppliers,
open entry and exit, along with a homogenous product (the optimal specification having already been found),
and that those conditions prevail at all states of the market. Under market disequilibrium, however, Intentions
of buyers and sellers have diverged. Everybody knows his or her own internal preferences, but nobody knows
what the new equilibrium price will be. Information relevant to getting there is, as Hayek (1949) made clear,
fragmented, dispersed, and local.
In fairness, I must admit that I am not the only economist who has attempted to supply one of Smith’s ‘missing’
models, which are therefore not entirely missing. After writing and revising the initial version of this paper I
discovered that priority in this effort belongs to Arrow (1959). There are some matters of necessary parallel
development between his theory and mine. Arrow too recognizes that firms can only be price-takers when the
market is in equilibrium; that for price adjustments to occur under market disequilibrium each firm must face a
finitely elastic demand function; and that information they need under that condition must be sought through
marginal price and output adjustments. However, I find several problems with Arrow’s analysis of the matter,
and there has been a notable lack of interest in the subject since its publication. Because of Arrow’s prominence
and precedence, however, it is necessary to discuss his theory before presenting my own.
Arrow’s Theory of Competitive Price Adjustment
To begin the discussion of Arrow’s model it is worth quoting much of the first paragraph of his paper (Arrow
1959, p. 41).
Arrow notes correctly that the methodological individualist starting point of traditional theory begins with
construction for each market participant of a pattern of reactions to outside events. The theory of such reactions
under competition has made transactors on both sides of the market take prices as given. Thus for a single
market:
(1) D = F(p) and S = G(p).
The two equations have three unknowns, of course, but the problem is solved – mathematically at least - by
setting:
(2) D = S,
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In this essay, it is argued that there exists a logical gap in the usual formulations of the theory of perfectly
competitive economy, namely, that there is no place for a rational decision with respect to prices as there is with
respect to quantities. A suggestion is made for filling this gap. The proposal implies that perfect competition
can prevail only at equilibrium.
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Thus determining price. Arrow (1959, p. 43) imputes to economists a rationale for (2), by asserting that this
equilibration is regarded as the limit of a trial-and-error process describable by an equation of the general type
(3) dp/dt = h(S – D) where
(4) h’ = < 0 and
(5) h(0) = 0.
The prime denotes differentiation. Arrow (1959, p. 43) refers to relation (3) as the well known “Laws of Supply
and Demand” asserting that price changes in the direction of excess demand, positive or negative. A little
further down the same page he states his main point.
It is not explained whose decision it is to change prices in accordance with equation 3. Each individual
participant in the economy is supposed to take prices as given and determine his choices as to purchases and
sales accordingly; there is no one left over whose job it is to make a decision on price.
Since the only firms presumed by modern theorists to have the capacity to alter price are large firms with market
power, in searching for a theory of price adjustment under disequilibrium in a competitive market, Arrow resorts
to a theory of monopoly price adjustment provided by Lange (1958):
(5) dp/dt = f(U’)
where U is the difference between the total revenue
and total cost (i.e., profit) at each output rate, and where
(6) F’ > 0 and F(0) = 0.
Arrow (1959, p. 44) interprets this application of the gradient method of maximization as saying that the
monopolist adjusts price in the direction of increased profit.
Lange’s formulation assumes that the monopolist always equates production to quantity demanded at whatever
price it sets, implying that he has complete knowledge of the demand curve, and that there is therefore no excess
demand or supply at any time, even when supply and/or demand shift. Arrow (1959, pp. 44-45) makes clear
that he cannot quite accept such perfect information on the part of the monopolist. Hence he believes such
discrepancies may exist, though they provide information to the entrepreneur about his errors. They also alter
inventories, and thus possibly unit cost in the next period.
To motivate and explain the start of price adjustments once a disequilibrating market-level shock has occurred,
Arrow (1959, p. 46) resorts to an odd and, I think, unnecessary assumption that no firm can increase its output in
the short term. Implicitly, he is also assuming that every entrepreneur knows this about every other firm. Thus,
he argues, each entrepreneur knows that he can raise price even if the others do not raise theirs, because the
others cannot satisfy more of demand than they already are, and he will not lose sales to them. I see two reasons
why these assumptions are unnecessary. First, when the market disequilibrium appears each firm immediately
faces a discrete excess demand for its own output at the former equilibrium price, so it does not matter if it
prices some potential customers out as it raises its own price and increases its output, moving up its marginal
cost curve in the process. Second, because all firms face the same condition of excess demand for their own
output (though likely of varied magnitudes), each entrepreneur knows he/she can start raising price and feeling
out the shape and elasticity of his demand curve precisely because many, if not all of the others will also be
doing so, such that relative prices will not be changing much, hence consumer substitutions between them will
be limited.
In Arrow’s narrative, he emphatically argues that each firm, facing an upward sloping demand for its own
output in the market excess demand case, raises its price in accord with the profit-maximizing tactics of a
monopolist. Then, in a brief discussion (Arrow 1959, p. 46) that I find extremely hazy, he asserts that each
given firm’s demand is shifting up even as the entrepreneur explores it (so that the firm is literally chasing a
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Arrow’s next step is simply to argue that under excess demand in a perfectly competitive market, each firm is in
the position of being a monopolist as regarding the finite (imperfect) elasticity of its own product demand.
Under this condition (and the uncertainty that disequilibrium generates) the firms may charge different prices.
Thus, he (correctly) asserts, dispersion of prices increases and there is no ‘single price’ such as exists at
equilibrium. Arrow says nothing about the degree of such price dispersion under disequilibrium, however, and I
will show in the next two sections that there is an obvious mechanism limiting it.
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moving target) and that this causes the process of price adjustment to continue. Eventually the new equilibrium
(average) price is reached. The best sense I can make of this ‘upward shifting of firm demands’ argument is that
the shifts result from relative price changes and consequent consumer substitutions between the outputs of the
different firms going on even as the market (average) price rises toward the new equilibrium value. In what I
believe is a far better justified and clearer argument below, I show that the demand curves of late adjusting firms
twist, becoming more elastic in what is a process limiting the dispersion of firm prices as the average of firm
prices moves toward new market equilibrium. I also show how and why the horizontal firm output demand and
perfect information conditions of ‘perfect’ competition are restored once it gets there.
Going on, Arrow’s (1959, p. 46) narrative stresses the uncertainties entrepreneurs face as to supply and demand
conditions, the prices charged by other sellers, etc., during this price-adjustment process. In later sections
Arrow draws out implications and applications of his perspective, but those matters are not of concern here. It
is, however, worth noting several severe difficulties with Arrow’s approach. First, it is not clear, despite several
arguments Arrow makes, how firms in a perfectly competitive industry, having outputs that are perfect
substitutes, if not literally identical, can be treated analytically as mini-monopolies just because the market is in
disequilibrium. Arrow seems severely constrained in his options for analyzing disequilibrium price adjustments
in a competitive industry by the orthodox presumption that only firms with ‘monopoly power’ can alter price.
Second, and related, monopoly pricing involves the firm finding an output and price combination where it’s MR
= MC at a price above the competitive level and an output less than the competitive output. It is not clear, and
Arrow provides no formal argument or narrative discussion to make it clear, how the prices set by otherwise
competitive firms engaging in monopoly price adjustments in response to market disequilibrium could ever
converge on a new equilibrium price where, for each firm, p = mc, as the theory of the perfectly competitive
equilibrium requires. How can the basic supply and demand equations expressed in (1) above, perhaps the most
fundamental equations in economics, ever be satisfied with all firm prices and price adjustments being made on
a monopoly basis? Are we now to believe that monopolies have supply functions after all? And last, Arrow
provides no graphics to illustrate his view of the disequilibrium price adjustment process of the typical firm, and
how average price converges to the new equilibrium, that could be used in texts to illustrate the process. I hope
to do better on all these matters in my own analytical narrative.
If the product is a physical good, the owner/manager will observe that the firm’s rate of sales at Po exceeds its
rate of production (if it is a manufacturer) or of wholesale delivery (if it is a retailer), resulting initially in
inventory drawdown, and eventually - if he does not alter the firm’s price and/or rate of production - in literal
incapacity to sell that number of units to available customers. There may even be an observable queue, just as
every gasoline station in New York City and environs experienced after hurricane Sandy went through late in
October 2012.3 If the market is for a service, the typical firm experiences a similar set of observable effects. If
the price of haircuts is below equilibrium in some market area each barber experiences a queue. If the price of
home or office steam cleaning is too low each cleaning firm will get booked up and have more customers trying
to make appointments than it can serve, and so on. These phenomena are easily observable to the
owners/managers of the firms, and by being discrete and finite, immediately indicate that the firm’s demand
elasticity has become finite. In addition, they provide decision makers with both information and incentives on
which to act.
Figure 1 shows a line running from the firm’s marginal cost at the new equilibrium price, Pn, down to an
intersection with the firm’s horizontal demand curve at Po. The firm’s pro-rata share of the market excess
demand at Po is the horizontal difference between it’s marginal cost at Po and that intersection, read in quantity
off the horizontal axis. To use simple illustrative numbers, if there are 10,000 suppliers and the market excess
3
This is a good example because there are very few lines of business that more closely approximate the perfectly competitive
model than retail gasoline sales.
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MARKET EXCESS DEMAND: Firm Signals and Adjustments
Consider first the case of an increase in consumer demand or decrease in supply, or some combination of the
two shocks, in a competitive market that was formerly clearing. The market level excess demand (Qd - Qs) thus
generated at the former equilibrium price Po is shown in the right graph of Figure 1 below. The higher price
that it would now take to clear the market, Pn, is also shown, and read across to the left graph, which contains
the marginal cost curve of the representative firm. The owner/manager of the firm does not know what the new
market-clearing price will be, but he will certainly experience and observe effects of his firm’s proportional
share of the market excess demand.
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demand at Po is a million units, the excess demand felt by the typical firm is 100 units per time period. The firm
may be too small in equilibrium to affect market price when alterations in its rate of production are uncorrelated
with those of other suppliers, so that it experiences heavy
consumer substitution as it does, but it is not too small in disequilibrium relative to its own share of market
excess demand, particularly given that its actions will be correlated with those of other firms in its market area
facing the same conditions.
In the simplest imaginable case, all competing firms make the same production and price increases
simultaneously and by the same magnitude. No firm loses sales to any other since their prices do not change
relative to one another, and they all gain information. They feel out their marginal cost curves for the higher
production rates, and they discover the elasticity of their demand curves as they observe the incremental decline
in sales and of the shortages they face (which together sum to the market excess demand remaining at each
price). Since they are raising price on all units they produce and sell (both the inframarginal and the marginal),
the marginal revenue they gain is above price, and it pays each firm to keep increasing output and raising price
to cover the higher marginal cost (or raising price and increasing output until p = mc) as long as that is so.
In the more realistic case in which some highly competitive and entrepreneurial firms start raising output and
unit price early, and some others follow later, price dispersion and relative price differences appear by
definition, but in a ‘perfectly’ competitive industry the statistical variance of such dispersion should be small.
The firm that acts early will reduce its excess demand both from the increase in quantity supplied and from the
reduction in quantity demanded it experiences. Some of those customers priced out, however, will ‘switch
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Given the market excess demand, that line, marked dr, shows the actual demand curve for the representative
firm’s output between those two points, and the horizontal summation of those line segments over all firms
constitutes the market demand segment over that range of price. This is the demand side analogue to the fact
that, on a p = mc rule, the firm’s marginal cost curve running between the point at which it equals Po and that at
which it equals Pn is the firm’s supply function over that range of price, and that the horizontal summation of all
firm mc functions over that price range yields the actual market supply segment over that range. Of course the
firm could deal with the excess demand at Po by increasing its rate of production enough to supply the
additional units demanded without changing price. The firm has the physical capacity to do so. It’s decision
maker will not generate the additional units at that price, however, because they would all be sold at less than
marginal cost, thus reducing the profitability of the firm. Instead, the owner/manager will use a form of the
price equals marginal cost rule. Sensing the generality of excess demand across the competing suppliers, the
decision maker will suspect (sooner or later) that his/her firm’s own unit price can be raised without losing
much, if anything, in sales to other firms, because, facing the same problem, they will likely be doing the same
thing. Thus, the firm will increase its rate of production by one or more units and raise the price on all units
sold to equality with the increased marginal cost (or raise price and increase output until marginal cost rises
enough that p = mc again).
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queues’ so to speak, as they try to buy output from a firm with a relatively lower price. That lengthens the late
adjusting firm’s queue until the opportunity cost of waiting for the marginal customer is just high enough to
offset the firm’s lower price. Graphically, that means that the demand curve segment of the late adjusting firm
will rotate to the right at the bottom, increasing it’s excess demand and raising pressure on that firm’s
owner/manager to increase output, raise price, and move up the firm’s marginal cost curve along with the others.
When the firms finally raise their prices and outputs to Pn = mc, excess demand goes to zero at both the market
and firm levels. Any further price changes by particular firms are once again completely uncorrelated with
those of other firms, and consequently result in massive consumer substitutions as their relative prices change.
In short, the infinitely elastic demand curve prevails and firms are once again price takers in the market, with no
ability to set price above Pn and no desire to set it below. Each firm could sell as much as it wants at that price,
but of course, the amount it ‘wants’ to produce is that amount at which Pn = mc. All relevant information has
been discovered and assimilated, both by producers and consumers, in the process of reaching the new
equilibrium, and the typical firm is doing the best it can financially and productively under the existing technical
and economic conditions. The market, as Hayek (1984, pp. 254-265) put it, is a discovery process, in which
prices, profits and losses, shortages, and surpluses, transmit information and provide motivation for action. In
the case just discussed, once this has all worked itself out, the conditions of perfect competition prevail.
One way to think about this adjustment is in terms of a moving frequency distribution of prices, as illustrated in
figure 2. Initially the distribution of prices charged by the firms is symmetric with a very, very small variance of
prices around Po. When the market shock generates excess demands for all of the firms, the left tail of that
distribution extends upward as the more foresighted and entrepreneurial firms begin feeling their way up toward
Pn before the others. The mean of prices itself shifts up as more firms adjust, and so does the right tail
(deviations below the mean), which remains very short. As the rising mean of prices in the market approaches
Pn, the left tail of high (above the mean) prices shortens, until, when the mean of prices equals Pn, the
distribution of firm prices is again symmetric, with a very, very small ongoing deviation of prices on the high
and low sides as various firms make pricing errors, adjust inventories, or ‘test’ the market.
p
Pn
pi
Po
f(p)
Of course we do not know that the market is in long-run equilibrium at Pn. Having been concerned only with
explaining how the observations, actions and interactions of firm decision makers and other market actors move
price and quantity back to market clearing values following a demand and/or supply shock, I have deliberately
neglected to place the typical firm’s average cost function anywhere in the left graph of figure 1. So at the new
equilibrium the firms may be making economic profits or losses, resulting in a new round of adjustments as
entry or exit occur. Or, firms might just be making a normal rate of return on their invested capital, precluding
such adjustments until some other demand or supply shock occurs, which, in a dynamic and innovative market
economy, will probably not be long coming. Indeed, those who argue that not only do we never reach a state of
general equilibrium, but that complete equilibrium is seldom reached in any market, may be right, though that
state is still analytically useful.
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Figure 2
Shifting Frequency Distribution of Prices
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MARKET EXCESS SUPPLY: Firm Signals and Adjustments
Now consider a case of a disequilibrating shock (whether in the same initially perfectly competitive market as
the prior case or some other) due this time to decreased demand, increased supply, or some combination of the
two. An excess supply, or surplus results at the initial price, Po. The magnitude of the surplus at the market
level is illustrated in the right graph of Figure 3. The lower price that it would now take to clear the market, Pn,
is also shown, and is read across to the left graph, which again shows the marginal cost curve of the
representative firm. As in the opposite case, the owner/manager does not know what the new market clearing
price will be, but he/she experiences observable effects of the firm’s proportional share of the market excess
supply.
If the product is a physical good, the decision maker observes over time that the firm’s rate of sales at Po is
below its rate of production (if it is a manufacturer) or of wholesale delivery (if it is a retailer), resulting in an
inventory buildup. Money spent on costly variable inputs to produce those units in excess of sales (or to
purchase them wholesale) is not being recovered, plus the firm is incurring storage costs. Indeed, if the good is
a perishable item, say lettuce, the excess units being acquired will, if kept for long, decay and be thrown out, and
the costs of acquiring them will never be recovered, in whole or part. If the market is for a service, firm
resources for providing the service are sitting idle (barber chairs are empty and barbers are reading magazines
and waiting for customers much of the day, or bookings for cleaning service firms fill only part of the available
time). Sooner or later the owner/manager of the firm will note these phenomena, recognizing that they are
persisting beyond the normal day-to-day random demand fluctuations, and be impelled to take action.
In the left graph of Figure 3 the firm’s rate of sales at the initial (formerly equilibrium) price, Po, is shown
where it’s former horizontal demand curve intersects a line running down to an intersection with the firm’s
marginal cost curve at what will be, eventually, the new equilibrium price, Pn. The firm’s pro-rata share of the
total market surplus is read off the horizontal axis as the difference between the quantity demanded at Po and the
amount offered for sale where Po = mc. The surplus may be a small or a large fraction of the firm’s total output,
as the case may be, but clearly, by being discrete and finite, it indicates immediately that the elasticity of the
firm’s demand has become finite. Just as clearly, the larger the surplus the more the firm’s earnings are being
hurt, and the greater the decision maker’s incentive to take action.
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Here the condition existing at equilibrium that the firm has no incentive to sell at a price below Po no longer
exists, and information has become imperfect. Consumer and producer intentions have diverged, and neither
knows about the other. Both have incentives to find out, interpreting and acting on observable signals. Now the
owner/manager has both the incentive and the capacity to reduce price and adjust its output, and his/her actions
will be correlated with those of competitors (particularly the local ones) in the market. The firm’s formerly
infinitely elastic demand curve to the right of qd at Po is now irrelevant. The firm’s demand has ‘kinked’ down
toward intersection with it’s marginal cost curve at the new equilibrium price, though the decision maker is as
yet ignorant of the particulars of it’s shape and elasticity.
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Given the market surplus, the inverse line marked dr again shows the actual demand curve for the representative
firm’s output over that range of price. The horizontal sum of those firm demand segments across all suppliers
would yield the market demand curve over that range, just as the horizontal sum of the marginal cost functions
of all the firms in the market at each price over that range constitutes the market supply function segment over
that range. And as in the prior (excess demand) case, the firm may be too small to affect market conditions
materially by any change in its own price or output, but it has sufficient capacity to affect the state of its pro-rata
share of the market excess supply. This is true no matter how large the number of suppliers in the market is
assumed to be.
However, this case is a bit more analytically difficult than the excess demand case discussed above. Suspecting
that the condition of excess supply is general, so that his/her competitors will be responding similarly, and hence
that there will be something much less than an infinitely elastic demand response to any price reduction, there
are two ways the typical firm’s owner/manager could adjust in response to his observable surplus and losses due
to inventory buildup or perishable product waste (or waste of labor time waiting for services to be demanded).
The first would be to reduce his firm’s rate of production by one or more units in sequence, reducing price to the
new (lower) marginal cost observed, and feel out demand by observing the increase in quantity demanded and
watching the diminishment of it’s surplus.
Note that with this strategy, the firm will still be adding to inventory (and hence to storage costs) or
experiencing some added perishable good waste, right down to the point at which the new equilibrium price Pn
is reached when the firm’s share of the market surplus goes to zero. The rate of inventory buildup or perishable
good waste will decline, however. In short, the manager could use a p = mc rule to determine it’s operating rate
all the way down. If the firm is a durable good producer or retailer, it might then actually wish to go to a price
below equilibrium for a brief time (hold a sale), in order to clear out the excess inventory accumulated over the
periods of surplus production.
An alternate strategy seems available to durable goods producers, however: instead of producing at the rate
given at which p = mc, the firm could reduce it’s use of the variable input(s) enough to just supply the amount
demanded by it’s customers at each price (as it reduces price below Po in sequential adjustments), so that it
stops adding to inventory. The firm would be operating at a mc < p such that it paid to increase output, and in
this case, keep lowering price as it does, eventually reaching the new equilibrium when Pn = mc and it’s pro-rata
share of the market surplus goes to zero. It might even be possible, and beneficial, for the firm to operate at a
little less than the quantity demanded at each price, supplying the extra units needed out of it’s excessive
inventory, thus working that excess down to the levels necessary to handle the normal day-to-day random
fluctuations in sales that exist even in equilibrium.
It should only be possible to do this, however, if the firm’s price reduction occurred ahead of most other firms,
and that condition is likely to be temporary. The increase in the firm’s quantity demanded would partly come
by consumer substitution that would increase the surpluses experienced by the other firms (causing their inverse
demand function segments to rotate counterclockwise at the top), raising the pressure on them to reduce price
also. As the firms do so essentially together, thus reducing the “market” (average) price, and the market and
firm surpluses diminish, the kink itself slides down and shortens the segment of inverse, less-than-perfectly
elastic demand for each firm. As it does, so does any marginal revenue curve below the firm’s demand
function. When Pn is reached, Pn = mr = mc for all of the firms, including any that had been trying to follow
that third strategy, and excess demand is zero at both the firm and market levels. 4 After that, firm price
movements are uncorrelated. All relevant information needed by both consumers and suppliers has been
4
This argument, which I regard as an unlikely case for the reasons given, is where my discussion most closely approaches
that of Arrow (1959). Oddly, Arrow applies his version of it in the excess demand case, where it cannot apply because, as I
made clear above, marginal cost exceeds price for that entire range of output necessary to find any hypothesized mr = mc
solution on an mr curve falling below the firm demand segment.
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Even a third strategy seems possible, though it may be ephemeral. Given the ‘kink’ in the firm’s demand at Po
yielding an inverse segment showing the limit on the firm’s output demanded for all prices from Po down to Pn
under conditions of market surplus, there must be a declining marginal revenue function below the firm’s
demand curve line segment, also having it’s origin at the kink. Conceivably, the firm could set it’s rate of
production where mr = mc on this marginal revenue function, and set price on it’s demand curve segment
directly above that output rate. That would also stop the firm from accumulating additional inventory, incurring
more perishable product waste, or additional waste of costly employee’s time waiting for service delivery.
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discovered and assimilated, the intentions of sellers and buyers have been spontaneously coordinated, and the
demand functions of firms are once again perfectly elastic.
Here again, a good way to think about this market adjustment is in terms of a moving frequency distribution of
prices. Initially the distribution of prices charged by the firms is symmetric with a very, very small variance of
prices around Po. When the market shock generates an excess supply for each of the firms, the right tail of that
distribution extends downward as the more foresighted and entrepreneurial firms begin feeling their way down
toward Pn before the others. The mean of prices itself shifts down more rapidly as more firms adjust price
down, and so does the left tail (deviations above the mean), which remains very short. As the falling mean of
prices in the market approaches Pn, the right tail of low (below the mean) prices shortens, until, when the mean
of prices equals Pn, the frequency distribution of firm prices is again symmetric, with a very small ongoing
deviation of prices on the high and low sides as various firms either make pricing errors, deliberately adjust
inventories, or ‘test’ the market.
SUMMARY AND CONCLUSIONS
The main insights and arguments of this paper are simple and few, as Occam’s razor mandates. Two of the key
assumptions of the orthodox model of ‘perfect’ competition, price taking by firms and perfect information, are
conditions that, even if the other defining conditions are given, can only appear when such a market is clearing.
A disequilibrating supply or demand shock by definition makes information imperfect. Consumer and producer
plans and intentions have diverged. However, both consumers and suppliers experience observable effects of
the market disequilibrium. Suppliers in particular have signals in various forms, such as divergence between
their production and sales rates generating queues, inventory buildup or drawdown, over or under booking, etc.,
providing them with both information and motivation to alter price and output through marginal adjustments
aimed at improving their bottom lines.
Even if there exists an enormous number of suppliers in the market, the owner/manager of each will not only
have the information and motivation, but the productive capacity, relative to their pro-rata share of whatever
market excess demand or supply exists, to alter price and output as necessary given that the conditions facing
them are common and their rationally self-interested adjustments of price and output are consequently
correlated. That correlation is further regulated, in the sense that deviations from the mean of firm prices and
price movements are kept relatively small even under disequilibrium. This occurs by operation of the same
forces of consumer search and substitution between and among suppliers – made more necessary by the
variation itself and the random character of who leads and lags the price adjustments toward the new
equilibrium at various points in time – that generate the ‘single’ price once the new market equilibrium is
reached and the price mean stops moving.
In short, individual firm demand functions will not be infinitely elastic when the market is in disequilibrium, and
their own excess demands will be within their capacity to affect through alteration of their price and output. The
consequences of such actions will feed additional information back to them concerning their costs, demand,
inventory buildup or drawdown, perishable good waste, changes in observable queues, over or under booking
for service delivery, etc., that will be relevant for further price and output adjustments by each firm, until their
own excess demand or supply goes to zero, collectively ending the market disequilibrium condition.
When that state is reached all relevant information needed by suppliers and demanders has been acquired and
acted upon. This is as close as the participants in the market can come to ‘perfect’ information. The signal has
been extracted and all that is left is noise. Individual consumer preferences for the particular good or service
may change, but randomly on the part of different persons, in both directions and by various magnitudes,
canceling in the aggregate. Thus the state of complete informational entropy assumed but not explained by the
theory of perfect competition is seen here as one final outcome of the equilibrating price adjustments by firms
that the perfectly competitive model also ignores. The connecting model – no longer missing - actually
complements and helps complete the model of perfect competition.
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Once equilibrium is restored (assuming no further disequilibrating demand or supply shocks emerge) any further
price changes by particular firms are random and uncorrelated, causing clear relative deviations from the
‘single’ price and thereby generating massive consumer substitutions that will quickly discipline the firms
involved. Variation around the mean of prices narrows further. Individual firm demand curves approach
infinite elasticity and each firm becomes a price taker for the duration of any such (almost certainly transient)
state of market equilibrium.
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On the other hand, it might be thought that the present theory, despite its basic simplicity, is quite revolutionary
in reducing perfect competition to a triviality. The Austrian and Marshallian adjustment processes now take
priority and the Walrasian elements are subordinated. Price-taking and perfect information are now seen to hold
only under transient states of equilibrium which may seldom be reached or long persist. Nevertheless, as long
as we analytically let such adjustments go unimpeded to their logical culmination, it provides for the main
outcomes for which the model of perfect competition is needed. It allows, when all such adjustments have been
made, for perfect allocative efficiency to emerge in resource use, and it validates market supply relations as
functions of relative price.
The present model relies on thick market dynamics to explain the divergence from and convergence – through
entrepreneurial price and output adjustments – toward competitive equilibrium (CE) conditions in ‘perfectly’
competitive markets. Research going forward should focus on solving Vernon Smith’s conundrum, that in so
many economics lab experiments the equivalent of CE outcomes emerge from the market price and output
adjustment process in concentrated or even oligopolistic market structures lacking price-taking firms or
participants with perfect information. Answering how and why that occurs and why markets thus work so much
better than orthodox theory predicts, might then move us toward a more unified theory of competitive market
dynamics and equilibrium outcomes.
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Hayek, Friedrich A. 1945. “The Use of Knowledge in Society,” American Economic Review 35(4): 519-530.
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Kirzner, Israel. 1976. “Equilibrium versus Market Process.” In Edwin G. Dolan, ed., The Foundations of
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___________. 1981. “The Austrian Perspective on the Crisis.” In Daniel Bell and Irving Kristol, eds., The
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