Thursday, August 20, 2009

Perfect markets

I've not been blogging for the past few weeks as I've been taking a break - vacation etc. Anyhow, the fall semester is up and running and its time to get back at it!

A recent article in the New Scientist (a UK publication) really illustrates how people - even very smart scientists just don't get economics.

In the article "Falling out of love with market myths", Terence Kealey (vice chancellor at the University of Buckingham, UK) attacks the economics concept of a perfect market.

I'd like to take a moment to explain why he is completely wrong.

In financial economics, we frequently talk and think about things in terms of perfect markets. Usually a perfect market is one with full information to all participants and no frictions (such as trading costs or taxes).

Mr Kealey argues that perfect markets are "bizarre" and that the theory, and the efficient market theory are "false".

Unfortunately, Mr Kealey just doesn't understand what the purpose is of a perfect market. In finance, we don't think for a minute that markets are perfect. They are not, there are taxes, trading costs, regulation, information asymmetries etc. But by starting with an idea of what a perfect market would look like, we are able to more fully understand the distortions that market imperfections are likely to play. Perfect markets are used as the foundation of more complex theories that attempt to explain how the world really is, and more importantly, how it will change if we change the imperfections in the market.

Students might note that in introductory MBA finance, we start with perfect markets when considering capital structure and also asset pricing.

Notwithstanding this fairly poor article, the New Scientist is an excellent publication.