Market Process

Equilibrium Analysis

Neoclassical economists use a fundamentally different methodology. "The economist must first ascertain and gather the facts which are relevant to the consideration of a specific economic problem ... The economist then puts this collection of facts in order and summarizes them by 'distilling out' a principle" (McConnell, p. 3). Economics, like natural sciences, starts by gathering empirical data. "All sciences are empirical. All sciences are based upon ... observable and verifiable behavior of certain data" (McConnell, p. 4). Theories make assumptions to simplify reality, and are verified by comparing their predictions (conclusions) with empirical data.

Individual behavior is described by constrained maximization. Consumers maximize utility given perfectly known means and ends. In a similar manner, firms maximize profits faced with perfectly known cost and revenue curves. Uncertainty can be introduced by assigning probabilities to possible outcomes, but the range of possible outcomes is known. (See, for example, Pindyck and Rubinfeld, pp. 58-59,73,246-247.)

Neoclassical economists use several equilibrium models to describe various "market structures." These generally include one of perfect competition, one of pure monopoly, and others of imperfect competition. All of the models have certain assumptions in common -- most importantly the assumption of perfect information. They differ in other respects, such as the number of buyers and sellers.

Market participants make plans, many of which anticipate other participants' actions (for example, a plan to buy anticipates an offer to sell). Equilibrium occurs when all participants are aware of all market opportunities (so that their plans take full advantage of all possibilities, and that their plans are compatible, that is, can all be carried out.) Perfect knowledge of market data is not merely a precondition of equilibrium, but its defining characteristic.

Neoclassical economists measure the efficiency of market structures and government policies with producer and consumer surplus, benefits received from the quantity of a good that is bought or sold. Producer or consumer surplus within the market structure, or after the imposition of a government policy, are compared with the surplus within the 'perfectly competitive' market structure. (See, for example, Pindyck and Rubinfeld, pp. 289-325, and McConnell, p. 546.)

The assumptions of the perfect competition model are generally recognized to include product homogeneity, many buyers and sellers with no effect on price, free entry into and exit from the industry, and perfect knowledge of relevant data on behalf of all market participants. Any deviation from these assumptions, such as product differentiation, leads to a market structure of imperfect competition. Perfectly competitive firms face horizontal demand curves and receive zero economic profit. (See, for example, Pindyck and Rubinfeld, pp. 246,270, and McConnell, p. 545.)

Imperfectly or monopolistically competitive market structures assume highly substitutable but differentiated products and relatively easy entry and exit (as well as perfect knowledge). Firms face downward-sloping demand curves and have some monopoly power. Firms are able to achieve this deviation from perfect competition through competition: "Combination, conspiracy and cutthroat competition are all means of reducing competition" (McConnell, p. 81). Advertising also reduces competition, changing demand rather than the product. "Advertising expenditures as such are relatively unproductive, they add little or nothing to the well-being of society" (McConnell, p. 605).

The market structure of pure monopoly assumes a single seller of a product with no close substitutes and restricted entry. Monopolies face downward-sloping demand, set price above and output below that of perfect competition, leading to losses for society. Barriers to entry include economies of scale, patents, monopolized resource ownership, and unfair competition.