Abstract

Although we generally teach economics as if markets formed a perfect system, in reality, there are many instances of partial and complete market failure in the real economy. Imperfections complicate models and analyses. Therefore, it is better to first introduce students to the model of the ideal-typical perfect system. In addition, in many circumstances, equilibrium and partial equilibrium models derived from the ideal-typical system have yielded good insights and results. However, ignoring imperfections carries several costs, including neglect of the role of institutions, and probably too much confidence in the self-correcting power of markets by policy makers.
The Review of Regional Studies 2009, Vol. 39, No. 1, pp. 1–7
2009 SRSA Presidential Address
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Imperfection as the Norm
Peter V. Schaeffer
*
Abstract. Although we generally teach economics as if markets formed a perfect
system, in reality, there are many instances of partial and complete market failure
in the real economy. Imperfections complicate models and analyses. Therefore, it
is better to first introduce students to the model of the ideal-typical perfect system.
In addition, in many circumstances, equilibrium and partial equilibrium models
derived from the ideal-typical system have yielded good insights and results.
However, ignoring imperfections carries several costs, including neglect of the
role of institutions, and probably too much confidence in the self-correcting
power of markets by policy makers.
1. Introduction
The current economic downturn is a reminder that our economies depend on a complex
system of interlinked markets, supported by formal and informal rules and organizations, and
physical infrastructure. These economies are resilient in the sense that they can absorb minor
shocks themselves and somewhat larger shocks with the help of appropriate interventions. Every
once in a while, however, we encounter a shock that challenges the ability of business leaders
and policy makers to respond adequately because of the magnitude and complexity of the shock,
and because its causes and effects span multiple policy regions. This is our current situation.
The post-WWII generations have until now been spared a deep and long world-wide
economic downturn. Growth and development, though occasionally interrupted for a short time,
has been steady in almost all countries and the socio-economic well-being of the world is much
better today than what it was fifty or even twenty-five years ago. Thus, some began to ask if we
were witnessing the end of the business cycle (Weber, 1997). The long expansion in the 1990s
generated enough such talk that The Economist (1999) felt compelled to publish a caution against
too much optimism. We are used to think in terms of steady progress in knowledge and well-
being, but we do well to remember that the idea of progress is itself a relatively recent
phenomenon (Bury, 1960).
Performance and the likelihood of progress depend in large part on the quality of human
systems and institutions. But economic systems are manmade and as such differ in quality of
“construction” of the institutions, rules, and infrastructures that define and enable them. In
addition, those institutions, rules, and infrastructures require maintenance (for example in the
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Presented at the Southern Regional Science Association 48th Annual Meeting at the Marriott Plaza, San Antonio, Texas, April
4, 2009.
*
Division of Resource Management and Regional Research Institute, West Virginia University, P.O. Box 6108
Morgantown, WV 26506-6108. Phone: 304-293-4832, ext. 4459. E-mail: peter.schaeffer@mail.wvu.edu
© Southern Regional Science Association 2010.
ISSN 1553-0892
SRSA, 1601 University Avenue, PO Box 6025, Morgantown, West Virginia 26506-6025, USA.
The Review of Regional Studies, Vol. 39, No 1, 2009 2
© Southern Regional Science Association 2010.
form of consistent enforcement of the law). When maintenance is neglected, the efficiency of
some or all of the markets in the economic systems will be affected.
This address will make a case for teaching economic theory from the perspective that
imperfection is the norm and not the exception, which is almost the exact opposite of how we
currently teach economics. The perfectly competitive economy is an ideal-typical system that
serves at least three useful purposes. First, it is an effective tool for introducing students to
economics. Second, research using partial and general equilibrium models has yielded useful
results, particularly for short and medium term policy analysis and forecasting, as well as for
insights into the workings of individual markets. Third, the ideal-typical system provides an
important benchmark against which to judge our current system and policies. It is, however, not
a description of the reality we live in, which is characterized by imperfections. Imperfection as
the term is used here is to be understood as any deviation from the ideal-typical perfectly
competitive model.
2. The Prevalence of Imperfection in the Real World
Imperfection is usually presented as the result of flaws in the economic system, referred
to as externalities. Externalities arise because of institutional arrangements that separate the
benefits of an action from its costs. They can be the result of poor institutional design or of the
practical impossibility of matching costs and benefits of an action. Both aspects have been
widely explored since the publication of Coase’s seminal work (1960). However, externalities
are not a necessary condition for the perfectly competitive system to yield socially suboptimal
results.
Land is a critical input in production and all human activities occur somewhere in space.
Although a great deal of economic theory can be formulated without explicit consideration of
space and the input land, this is not the case in regional science. In our multi and inter-
disciplinary field, space and distance cannot be ignored. Hotelling (1929) demonstrated that the
locations chosen by sellers may not be socially optimal. Of course, this result depends on special
assumptions and need not be generally true. The result is nevertheless theoretically significant
because it shows that, even in the absence of market imperfections, distance may cause socially
suboptimal outcomes. Work on competition for geographical market share resulted in spatial
pricing models (Greenhut and Ohta, 1975; Ohta, 1988). From these models we conclude that if
suppliers are separated from each other, then the costs of overcoming distance create limited
local monopolies. Therefore, the spatial economy, that is, the real world, is characterized by
monopolistic rather than perfect competition (Fujita, Krugman, and Venables, 2001).
Even in a perfectly competitive environment a market may fail to form altogether,
although social benefits exceed social costs. As Waldfolgel (2008) demonstrates, this may
happen when firms differentiate their products in response to different preferences of consumers.
If production is lumpy because of significant fixed costs, then it is possible that in a perfectly
competitive market a good or service will not be provided even if the total social benefits exceed
total social costs. (The commodity will be provided, however, if the producer is able to
discriminate to appropriate the consumer surplus.) This has implications for how responsive the
market is to consumer preferences. As Waldfolgel (2008) shows, it is possible that preference
minorities could be underserved, depending on the fixed cost relative to the size of the market.
Another implication is that, contrary to conventional wisdom and intuition, depending on
SCHAEFFER: 2009 PRESIDENTIAL ADDRESS —IMPERFECTION AS THE NORM 3
© Southern Regional Science Association 2010.
circumstances, trade can result in reduced rather than enhanced consumer choices. In summary,
lumpy markets may lead to market failure (prevent socially desirable markets from forming).
In the first introduction to economics and market, we usually explain to our students that
firms have to be responsive to consumers or the latter will leave and buy from someone else. As
Hirschman (1970) recognizes, this implicitly assumes that different firms supply perfect
substitutes because, if there is product differentiation, then consumers may use voice to effect
change in the firm’s behavior, rather than exit from the market. In a related argument, Scitovsky
(1978) notes that consumer complaints affect product quality. However, because only those who
complain bear the cost, but all consumers benefit, the number of complaints (Hirschman’s voice
option) will be socially suboptimal. This is another source of imperfection (inefficiency) in the
market.
The point of discussing the preceding sources of imperfection is to show that we do not
have to rely on conventional externalities—or natural monopolies—to explain market failures.
There are many sources, with space and distance being important factors.
3. Disadvantages of Over-reliance on Perfectly Competitive Static Models
One characteristic that sets capitalist economies apart from other economic systems is
their dynamic nature (Hayek, 1994; Marx, 1990; Schumpeter, 1950). In a capitalist society,
entrepreneurs are constantly in search of new opportunities and exploring new ideas (Atkinson,
2004). Governments also seek to change conditions; I know of no political party that campaigns
on the platform of preserving the status quo. In a dynamic economy, producers face
uncertainties they would not encounter in a static society, namely the possibility that a currently
profitable product will be replaced by something even better. When that happens, consumers
who bought that product will be left with a devalued asset and producers with a smaller or no
market and possibly obsolete production facilities. Some workers may lose their jobs and have
difficulties finding a new one because their skills have become obsolete. The search for
innovation makes capitalism a productive economic system, but it also generates uncertainty and
winners and losers.
In a static system, we can ignore the institutions that govern markets because there is no
need for them to change and adapt. We can take them as given and unchanging and invoke the
ceteris paribus assumption in our modeling efforts. Unfortunately, the reliance on static models
that assume stable economies, and on comparative static analysis in teaching economics,
particularly to undergraduates, allows us to ignore institutions that are critical to the efficient
functioning of markets. We just experienced what can happen when institutions do not keep pace
with product developments in financial markets. The result was a severe world-wide economic
crisis. Thus, if we want to analyze change, we cannot ignore institutions (Roemer, 2009).
Many of us working in regional science are interested in the development of models with
policy implications, that is, we are interested in providing ideas how to effect change. In most
instances, since the change we help bring about is gradual, the ceteris paribus assumption about
institutions still holds approximately in the short and possibly the medium run; it is far less likely
to be justified in the long run, however, or if we consider the cumulative effects of several
policies.
A few years ago I had the opportunity to work on a regional development project in the
People’s Republic of China. Change in that country has been so rapid that not only should we not
The Review of Regional Studies, Vol. 39, No 1, 2009 4
© Southern Regional Science Association 2010.
assume that institutions are constant, but changing existing and developing new institutions may
be among the most important tasks for development to avoid many pitfalls. Liebenthal (2008)
illustrates institutional problems with respect to the protection and management of water
resources in China that are at least partially the result of poor coordination between regulatory
agencies. When growth was slow they had time to react and poor coordination did not become a
critical issue. But China’s economy has grown several-fold over the last two decades, and lack of
an institutional design that allows appropriate measures to be taken quickly has caused severe
water problems. While other cases may be less dramatic, the relative lack of research into the
role of institutions in development and the success of economic policy leaves us short of tools to
advise policy makers.
I stated in the Introduction that partial and general equilibrium models serve at least three
very useful purposes. Therefore, I am not proposing a sudden change in how we teach economics
to our students. In addition to the fact that the models we teach are useful and successful in many
instances, it would be didactically unwise to start with more realistic and hence more complex
models. However, I believe that neglecting the roles of institutions has led not only to a relative
lack of knowledge, but worse, to a lack of awareness of their importance.
To illustrate my point I compare the United States and Switzerland because of my
familiarity with both countries. Although Switzerland’s constitution was modeled in the 19
th
century after that of the United States, in details these two sister republics have found different
solutions. Multilingual Switzerland would have broken apart had it insisted on a strong central
government. Instead, the Swiss government structure gives even more taxing power and
delegates more public expenditures to the state and local levels than is the case in the United
States. As a result, sub-national governments in Switzerland collect a higher percentage of total
taxes (40.8 percent compared to 4.8 percent in the United Kingdom and 34.4 percent in the
United States) than in any other industrialized country (OECD, 2009). As a consequence, the
actions of Swiss sub-national governments carry much more weight in counteracting the current
world-wide economic slump than those of sub-national governments in most other OECD
countries. In terms of macroeconomic modeling, it makes much more sense to treat government
as a single entity
1
in the case of an economy like that of the United Kingdom than in the cases of
Switzerland or the United States. Failure to take account of such institutional differences will
result in suboptimal policy recommendations.
4. The Challenge and its Rewards
Krugman (1991, p. 4) explains that “The neglect of spatial issues in economics arises for
the most part from one simple problem: how to think about market structure.” The difficulty of
incorporating space in mathematical models may also have contributed to its neglect. Again from
Krugman (1992, p.4):Indeed, as standards of rigor in economics have risen over time, the study
of location has been pushed further and further into the intellectual periphery.” The sources of
imperfection mentioned earlier also complicate mathematical models, making them more
difficult and less tractable, and model development more challenging. If we want to contribute to
long term policies, or consider the impact of policies over the long term, we have to account for
imperfections and institutions. In fact, if we ignore the role of institutions, we rob the set that
contains our tools for policy analyses of an important dimension.
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For example in the equation C+I+G=S+T+M-X in simple macroeconomic models.
SCHAEFFER: 2009 PRESIDENTIAL ADDRESS —IMPERFECTION AS THE NORM 5
© Southern Regional Science Association 2010.
The following are difficult challenges, and it will take time to properly address them. In
my opinion, however, the rewards are worth the effort.
1. Market conditions are determined by rules and regulations. Who gets to make the rules
(Schmid, 2004)? In equilibrium there is no incentive for rule changes and we therefore (can)
ignore this important question. By including institutions in our analyses, we add an important
dimension to our tool box. By focusing on who gets to make the rules, we are also forced to
deal with fairness ex ante.
2. If we assume that, in general, markets are perfect, then policy making will be on the
defensive and has to first prove that market failure exists. By contrast, if we accept that
imperfection is the norm, then we “only” have to demonstrate that intervention would lead to
a Pareto improvement.
3. Markets are great institutions. In most cases they efficiently coordinate the actions of large
numbers of participants, and the prices they generate provide useful information about
scarcity to consumers and producers. Furthermore, they are compatible with individual
autonomy and democratic decision making (Friedman, 1962; Hayek, 1944). This is a
stronger justification of markets than claiming that they bring about Pareto optimal
outcomes, when it is so obvious that most markets are not perfect and we cannot even be sure
that leaving them alone will result in a second-best outcome (Lipsey and Lancaster, 1957).
4. Utilitarian ethics provides the philosophical foundation of modern economics. This ethic is
outcome-oriented. By contrast, a rule-bound ethic, such as one incorporated in the Golden
Rule or advocated by Emmanuel Kant, is process-oriented. Thus, Simon (1986) alerts us to
the different meaning of rationality in economics and psychology. Branco (2009) explains
how the difference between a utilitarian and a rule-bound ethic matters when we deal with
positive rights, that is, with entitlements rather than commodities (wants). His work suggests
potential boundaries for the application of an economic approach based on a utilitarian
framework.
5. More attention drawn to dynamic behaviors. In a static system, we can ignore stock
variables; in a dynamic system the stock variables link the past, the present, and the future
and cause the dynamic behaviors.
6. More attention drawn to dynamic interdependencies. In economies with stocks that are
mobile between regions, the dynamics of one region influence the dynamics of other regions.
7. More systematic attention paid to market failures. At present we do not know how prevalent
and how serious most market failures are, and are not well aware of causes other than
externalities. Would not these questions be worthy of policy research?
8. Finally, considering policy intervention as something reasonable when market outcomes
leave us dissatisfied might renew interest in Tinbergen’s Principle. This principle states that
we need at least as many policy instruments as we have policy objectives (Tinbergen, 1952).
If we pay attention to the Tinbergen Principle, we will avoid policy overreach—trying to
reach more objectives than we have tools for—and maybe pay more attention to the
development of new policy tools.
The Review of Regional Studies, Vol. 39, No 1, 2009 6
© Southern Regional Science Association 2010.
5. Summary and Conclusions
Markets are human creations. The rules and regulations that govern them are formulated
by people and play a significant role in determining market outcomes, that is, how and to what
extend different groups benefit (Schmid, 2004). Unless we find a way to make interpersonal
utility comparisons, we cannot know if one set of reasonable rules yields a Pareto superior
outcome to an alternative set of rules. More generally, I have argued that market imperfections
are the norm, not the exception. Therefore, objections against market interventions because they
supposedly disturb a Pareto optimal resource allocation are unfounded. I am not advocating that
we therefore should open the door to policy interventions. This could lead to a heavy handed
government that undermines individual decision making. Policy intervention must always be
justified by demonstrating that doing something significantly improves outcomes. My main point
is to show that market imperfections are the norm and that, therefore, systematic research in the
nature of imperfections is desirable, as well as systematic research into policy and policy
instruments.
References
Atkinson, Robert D. (2004) The Past and Future of America’s Economy: Long Waves of
Innovation that Power Cycles of Growth. Edward Elgar: Cheltenham, UK.
Branco, Manuel C. (2009). Economics versus Human Rights. Routledge: New York.
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Publications (originally published 1932 by Macmillan): New York.
Coase, Ronald H. (1960) “The Problem of Social Cost,” Journal of Law and Economics, 3, 1–44.
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Fujita, Masahisa, Paul Krugman, and Anthony Venables. 2001. The Spatial Economy: Cities,
Regions and International Trade. MIT Press: Cambridge, MA.
Greenhut, Melvin and Hiroshi Ohta. (1975) Theory of Spatial Pricing and Market Areas. Duke
University Press: Durham, NC.
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Hirschman, Albert O. (1970) Exit, Voice, and Loyalty. Harvard University Press: Cambridge,
MA.
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MA.
Krugman, Paul. (1991). Geography and Trade. MIT Press: Cambridge, MA.
Liebenthal, Andres. (2008) “Critical Needs in China’s Water Resources,” In Peter V. Schaeffer,
(ed), Commodity Modeling and Pricing: Methods for Analyzing Resource Market
Behavior. John Wiley: New York, pp. 228–248.
Lipsey, R.G. and Kelvin Lancaster. (1957) “The General Theory of the Second Best,” Review of
Economic Studies, 24, 11–33.
SCHAEFFER: 2009 PRESIDENTIAL ADDRESS —IMPERFECTION AS THE NORM 7
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Marx, Karl. (1990) Capital, Volume I. Trans. Ben Fowkes. London: Penguin (first published in
German in 1867).
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Policy and Administration, Economics Department, Public Governance and Territorial
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operation and Development: Paris.
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Press: College Station, TX.
Roemer, John E. (2009) “Changing the Social Ethos Is the Key,” The Economist’s Voice, July.
http://www.bepress.com/ev/.
Schmid, A. Allan. (2004) Conflict and Cooperation: Institutional and Behavioral Economics.
Blackwell: Malden, MA.
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edition. Harper: New
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65–82.
... Instead, many economists warn of government intervention into the economy, which is taught to students as perfect and resulting in Pareto optimal outcomes. Even if this were so, there is still the question of how the starting distribution underlying the outcome was obtained, but more importantly, the system is not perfect (Schaeffer, 2009). It has always puzzled me how many of my fellow economists are confident that natural systems are resilient enough to deal with often dramatic interventions but see the man-made economy as relatively fragile and unable to fully recover from government interventions. ...
... To counter such an attitude, let us acknowledge that imperfections are the norm (Schaeffer, 2009). In fact, one imperfection is widely acknowledged as important to the success of modern economies. ...
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The success or failure of economic actors depends on a variety of factors, which I sort into three groups: attitudes and values, endowments, and rules. Of these three, we only fully control for factors in the first group. Factors in the other two groups are determined by luck, though through individual effort we may enhance them, particularly endowments such as talent or inherited resources. As individuals, most of us have no or very little influence on rules. Rules depend on power, and most people exercise power only indirectly as members of a group or groups. In this address, I focus on the rules, which also means that I focus on power, a neglected topic in economic development, and in modern economics in general.
... (Isserman, 1993a, p. 38) He reminded us that ability is one thing, but willingness and readiness to tackle the complex, dynamic problems that society faces is another. 2 Peter Schaeffer, in his presidential address to the SRSA in 2009, reminded us that imperfections, such as externalities, monopolistic competition, market failures, and inefficiencies, complicate models and analyses but also suggested that rising to the challenge of incorporating these complexities into our efforts is worth it in the context of policy relevance (Schaeffer, 2009). Again, long-term success of the association will require working together for change through individual and collective action. ...
... His comprehensive list reminds us that our work is far from complete. In concert with the list of challenges for future research found in Schaeffer (2009), there are several career's worth of research questions, few of which can be resolved by one regional scientist, one regional science method, or even one "parent discipline" within regional science. A transdisciplinary, systems thinking approach along with suggested areas for future research from past presidents and improved public engagement efforts should provide regional scientists with a problem-oriented research agenda, the results of which are fit for both academic journal articles and policy reports, for years to come. ...
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... The role of regional science scholars in guiding public choice decisions is not often discussed. Peter Schaeffer (2009) explains why we should pay more attention to ethical issues in regional economic development. Rule-making questions are ethical issues because they concern the distribution of costs and benefits of public decisions. ...
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