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Asymmetric Information about Perfect Competition:
The Treatment of Perfect Information in Introductory Economics Textbooks

Scott A. Beaulier
Assistant Professor of Economics
Stetson School of Business and Economics
Mercer University
Macon, GA 31207
Phone: [phone] [e-mail] URL: www.scottbeaulier.com

Wm. Stewart Mounts, Jr.
Professor of Economics
Stetson School of Business and Economics
Mercer University
Macon, GA 31207
Phone: [phone] [e-mail] September 2008

Acknowledgements: The authors thank David Prychitko for useful comments and suggestions. The standard disclaimer applies.
Asymmetric Information about Perfect Competition:
The Treatment of Perfect Information in Introductory Economics Textbooks

Abstract

The theory of perfect competition is the most fundamental core topic of economics. Deviations from its underlying assumptions offer the format for the development of all other aspects of economic theory. For example, reducing the number of sellers and blocking entry initiates the discussion of monopoly, deadweight losses, rent-seeking behavior, etc. This first presupposes that the underlying assumptions are present in some manner. This, however, is not the case for the assumption of perfect information. In many instances this is not even mentioned. Yet, the relaxation of this assumption has led to many recent innovations in both micro and macroeconomics. This paper looks at how market-leading introductory economics textbooks treat perfect information within the theory of perfect competition. From this examination it is clear that many textbooks gloss over, or completely avoid, perfect information. This matters greatly as students need to see that the current state of affairs in all of economics is based on the full understanding of perfect competition and deviations from its assumptions. In a more general sense, this omission suggests that principles texts need to rethink their approach to presenting microeconomics.

Asymmetric Information about Perfect Competition:
The Treatment of Perfect Information in Introductory Economics Textbooks

I. Introduction

The theory of perfect competition sets the frame of reference for all presentations of economic theory, both microeconomic and macroeconomic. As such, it serves as the efficiency benchmark when evaluating economic outcomes, both on the chalkboard and in the measurement of reality. In addition, it remains the starting point for discussions of the theory of the firm.[1] Among the faithful, the market structure of perfect competition requires five necessary assumptions: 1) Firms sell a homogeneous product; 2) There are a large number of small firms; 3) Firms are price takers; 4) There are no barriers to entry and exit in the long-run; and

(5) Firms and consumers have perfect information.

While we suggest there is general agreement in the profession that all five are necessary for the theory of perfect competition to hold, some textbooks only rely on two or three of them when telling the introductory story of perfect competition. Yet, an assumption that textbook authors often drop or, at the very least, treat fast and loose is that of perfect information. Take Mankiw’s (2004) treatment for example. He simply chooses not to mention it. This failure is problematic. For example, information economics, which most textbooks do cover within market failure, assumes imperfect information. How can students understand the importance imperfect information when the topic of perfect information has been largely omitted or treated lightly? In many cases, students are introduced to information-related problems in economics without having any clear benchmark against which to judge the problem. If the instructor wishes to speak clearly about information asymmetries,[2] lemons, and missing markets, imperfect information must be compared to the world of perfect information. In this paper we survey 11 of the market-leading micro principles textbooks by asking two different questions. First, do they mention perfect information anywhere in the text? And, second, do those that mention perfect information include it as an assumption when discussing perfect competition? From this survey it is clear that most textbooks lack a clear treeatment of perfect information. In most cases, the perfect information assumption has been omitted from the theory of perfect competition. Since the perfect information assumption plays a crucial role in discussions of imperfect markets, it is difficult then to understand why textbook authors treat the assumption of perfect information as they do.

II. The Heavy Lifting of Perfect Information within Perfect Competition

The theory of perfect competition and the general economic equilibrium analysis resulting from it remain the cornerstones of neoclassical welfare economics. If a perfectly competitive market structure exists, and if we make a few subsidiary assumptions about maximizing behavior and convexities, Pareto optimality can be attained, but more importantly, explained. When we model firms as perfectly competitive enterprises, all five assumptions must hold. The producer’s output must have no significant effect on the market price. The producer is producing a homogeneous product, which is in every way identical to other output being produced in the industry. If things change for the worse, the producer is free to get out of the market at any time; if things improve, other entrepreneurs will enter the industry (quickly). How does the firm owner know how much to produce at current market prices? Clearly, profit-maximizing behavior takes him or her to the place where marginal revenue equals marginal cost. Yet, he or she does not know how much to produce unless we make some kind of assumption about the nature of the information that is available. Consumers must have perfect information about all relevant prices. Resource owners, such as laborers and capital equipment providers, must know the current and alternative values of their resources. The individual producer is said to have perfect information about all relevant costs of production. In fact, the firm owner has perfect information about costs before production is ever undertaken. The firm owner also has perfect information about the market demand curve and the firm’s marginal revenue curve. Profit-maximizing behavior becomes an easy exercise for the well-informed firm owner. Without an assumption about information, well-informed decisions cannot be made. We cannot even begin to understand a firm’s decisions without making some kind of assumption about the knowledge available in the industry. Without perfect information, the decision to enter or exit an industry is not apparent to the profit seeker: the firm owner does not even know the shape of relevant cost curves; the owner also lacks information about future costs and prices. In fact, in the absence of perfect information, producers are not even sure whether their output levels are the profit maximizing points of production. It seems clear, then, that the theory of perfect competition requires the perfect information assumption for there to be consistent logic in presentation. In the end, the perfect information assumption does the heavy lifting when it comes to understanding individual decision-making within perfectly competitive firms. No other assumption is this far reaching as necessary to make the analysis logically consistent. As Stigliz (1997 [1994]: 110) puts it, “When information is imperfect - or in sectors of the economy where innovation is important - markets will essentially always be imperfectly competitive.”

III. From Perfect to Imperfect Information

If so much is dependent on the assumption of perfect information, then is seems reasonable to ask how economists present it in an introductory course. Principles classes are the places where potential majors are initially developed. Texts are complementary to this farming activity. More importantly, however, principles classes are the only place the overwhelming numbers college education citizens are exposed to the power of competition and competitive markets. For this purpose alone, economics text must present the argument that competition and competitive forces are all for the social good. In this context, how do texts present perfect information if they do at all? As shown in Table 1, only four of the 11 textbooks surveyed include perfect information as an assumption of the perfectly competitive market. In fact, only six of the 11 leading textbooks even make mention of perfect information anywhere in the text.

TABLE 1: MENTIONS OF PERFECT AND IMPERFECT INFORMATION IN LEADING TEXTBOOKS

|Textbook |Mention Perfect Information |Include Perfect Information in Perfect |
| | |Competition Assumptions |
|Ayers and Collinge | | |
|Baumol and Blinder | | |
| | | |
| |( |( |
|Case and Fair | | |
| |( |( |
|Gwartney, Stroup, et al. | | |
|Hall and Lieberman | | |
| |( | |
|Krugman and Wells | | |
|Mankiw | | |
|O’Sullivan and Sheffrin | | |
|Parkin* | | |
| |( |( |
|Ruffin and Gregory | | |
| |( |( |
|Stiglitz and Walsh | | |
| |( |( |

*Parkin (2005: 238) does not explicitly assume perfect information. He assumes that “[s]ellers and buyers are well informed about prices.”

Moreover, when we take a qualitative look at the actual discussions of perfect information, many of the textbooks gloss over perfect information rather quickly. Baumol and Blinder (2005: 156) provide one of the best definitions of perfect information when they write: Perfect Information. Each firm and each customer is well informed about available products and prices. They know whether one supplier is selling at a lower price than another” (italics in original).

While Baumol and Blinder point out that a firm owner knows the cost curves of other firms in the industry, they do not say a word about perfect information anywhere else in their textbook. In essence, perfect information is nothing more than a footnote when, in fact, it should be playing a central role in their discussion of perfect competition. Stiglitz and Walsh (2002: 228, 287) offer a more extensive discussion of perfect information. They list perfect information as a “key assumption” of the competitive model (2002: 228), and they provide readers with a nice intuitive explanation of an environment with perfect information when they write: …buyers know what they are buying, whether it is stocks or bonds, a house, a used car, or a refrigerator. Firms know the productivity of each worker they hire, and when workers go to work for a firm, they know exactly what is expected of them in return for the promised pay (228).

Case and Fair (2004: 103) provide the best treatment of perfect information. …households and firms possess all the information they need to make market choices. Specifically, we assume that households possess knowledge of the qualities and prices of everything available in the market. Firms know all that there is to know about wage rates, capital costs, and output prices.

Later on, they remind the reader of the complete information assumption when they begin their discussion of imperfect information (321). Their discussion of imperfect information explicitly compares imperfect information to perfect information. They tell the reader that [b]ecause the market handles many information problems efficiently, we do not need to assume perfect information to arrive at an efficient allocation of resources (323).

Baumol and Blinder (2005), Case and Fair (2004), and Stiglitz and Walsh (2002) handle the assumption of perfect information quite well. When discussing imperfect information, Hall and Lieberman (2005: 154) briefly note: [i]n our model, consumers are assumed to know exactly what goods they are buying and the prices at which they can buy them. But in the real world, we must sometimes spend time and money to get this information. (emphasis in original)

Hall and Lieberman’s treatment of perfect information tells readers nothing about the information assumptions economists make on the production side, and readers will find no other references to perfect information in the Hall and Lieberman text. Some mention of perfect information is probably better than no mention, however. At least Hall and Liberman (2005) compare an environment with imperfect information to one with perfect information. The six textbooks that completely fail to mention perfect information are more troubling when the extent of market share each holds is considered. Consider the ever popular Mankiw (2004: 480-484, 489-493). He concludes his textbook with discussions of asymmetric information and behavioral economics. After discussing the basics of asymmetric information, he concludes by saying, “[t]he study of asymmetric information gives us new reason to be wary of markets” (484). Nowhere does he note that asymmetric information is one extreme view of the world, which stands in stark contrast to perfect information—the alternate view of the world. Mankiw’s discussion of behavioral economics (489-493) is also frustrating. It contrasts a behavioral/satisficing individual against home economicus. Yet, a clear discussion of what economists mean by ‘well informed people’ cannot be found. Similar problems can be found in many of the other leading textbooks. Our purpose is not to engage in an exhaustive content analysis of all of the leading textbooks, but, rather, to show that different textbooks treat the theory of perfect competition differently. Some completely avoid the assumption of perfect information; others discuss it quite loosely; and some remain true to the original theory and its believers. In sum, there is a general lack of consistency in the way textbook authors deal with perfect information. Given the theory of perfect competition’s important place in microeconomic theory, the widely varying treatments of perfect information in the textbooks should be viewed as troubling. The loss of perfect information in the textbooks raises the question: why have textbook authors been dropping perfect information from their discussions of perfection competition and what can be done about it? Clearly, it is needed for a logically consistent presentation of the benchmark of all of economic theory.

IV. Why Wait?

Nearly every topic in intermediate microeconomics—whether it be consumer choice theory, elasticity, or the theory of the firm—was introduced to students in micro principles. Even indifference curves can be found in appendices of many principles textbooks. But, as we have pointed out above, information is a topic that is sidestepped or avoided entirely at the principles level. Since information is a topic that receives a good deal of attention at the intermediate level, it is interesting to wonder why there is an implicit opinion among the textbook industry and its economists that it is ok to wait. Why? Is information so different and so difficult that it is only meant for upper level economics students? It may be the case that a well-informed student only really needs to know certain things about competition. That is to say, there is an optimum amount of the theory of perfect competition that anyone needs to know. We agree that it is possible to tell people too much. In determining the optimal amount of coverage of perfect competition, the textbook industry has produced a competitive result that has left perfect information out of discussions of perfect competition. Another possibility is that there is a certain amount of inertia in the textbook industry. Principles textbooks have been slow to discuss information at greater length because the information revolution in microeconomics is relatively new and difficult to discuss. When faced with real page constraints, textbook authors have collectively chosen to stick with what has worked in the past rather than delve into new topics like perfect information. it is new and a subject anjust does not contain perfect information. In such a view, new things find it difficult to compete limited page space. Clearly, the recognition of the importance of perfect information is new to the timeline that is economic progress. It just might not be the time for a full presentation of its importance. Is its discussion just too complex? Certainly, a mention of ‘ratio’ , ‘tangency’, and ‘marginal rate of substitution’ creates fear enough with the average undergraduate not destined to be an economics major. In the end, we don’t know. I guess all we can hope for is that we get the interested reader to wonder for themselves.

V. Conclusion: Is There a Future for Perfect Information?

Perfect competition has withstood the test of time as a central idea in microeconomic theory. Central to perfect competition has been the assumption of perfect information. Without perfect information there can be no perfect competition. Given the fact that perfect information is crucial to understanding market processes, it is puzzling to see introductory textbooks dropping the perfect information assumption. The loss of perfect information is problematic for a number of reasons. Notions like efficiency, market coordination, and market failure do not make sense in the absence of perfect information. As Stiglitz (2000: 1460; emphasis in original) has correctly pointed out, if we completely abandon the perfect information assumption, the following outcomes could result: demand could differ from supply in equilibrium. Labor markets could be characterized by [involuntary] unemployment; credit markets by credit rationing…

If textbook authors wanted to be consistent, discussions of competitive markets, without concomitant discussion of perfect information, should lead to discussions of market failures and the inability of markets to clear. Instead, and much to Stiglitz’s discontent, we still find textbook authors talking about supply meeting demand in equilibrium, the market only producing voluntary unemployment.

Bibliography

Akerlof, G. (1970). “The Market for ‘Lemons’: Qualitative Uncertainty and the Market Mechanism,” Quarterly Journal of Economics 86: 488-500.

Ayers, R., and Collinge, R. (2005). Microeconomics: Explore and Apply. Upper Saddle River, NJ: Pearson Prentice Hall.

Barone, E. (1908). “The Ministry of Production in the Collectivist State,” in F.A. Hayek, ed. (1935) Collectivist Economic Planning. London: Routledge.

Baumol, W., and Blinder, A. (2005). Microeconomics: Principles and Policy, 9th ed. Mason, OH: Thomson South-Western.

Case, K., and Fair, C. (2004). Principles of Microeconomics, 7th ed. Upper Saddle River, NJ: Pearson Prentice Hall.

Gwartney, J., Stroup, R., Sobel, R., and Macpherson, D. (2006). Microeconomics: Private and Public Choice, 11th ed. Mason, OH: Thomson South-Western.

Hall, R., and Lieberman, M. (2005). Microeconomics: Principles and Applications, 3rd ed. Mason, OH: Thomson South-Western.

Hayek, F.A. (ed.). (1935). Collectivist Economic Planning. London: Routledge.

Krugman, P., and Wells, R. (2005). Microeconomics. New York: Worth Publishers.

Makowski, L., and Ostroy, J. (2001). “Perfect Competition and the Creativity of the Market,” Journal of Economic Literature 39 (2): 479-535.

Mankiw, N.G. (2004). Principles of Microeconomics, 3rd ed. Mason, OH: Thomson South-Western.

O’Sullivan, A., and Sheffrin, S. (2003). Microeconomics: Principles and Tools. Upper Saddle River, NJ: Prentice Hall.

Pareto, W. (1971 [1906]). Manual of Political Economy. New York: August M. Kelley.

Parkin, M. (2005). Microeconomics, 7th ed. USA: Pearson Addison Wesley.

Ruffin, R., and Gregory, P. (2001). Principles of Microeconomics, 7th ed. USA: Addison Wesley.

Stiglitz, J. (2000). “The Contributions of the Economics of Information to Twentieth Century Economics,” Quarterly Journal of Economics 115 (4): 1441-1478.

-------. (1997 [1994]). Whither Socialism? Cambridge, MA: MIT Press.

Stiglitz, J., and Walsh, C. (2002). Principles of Microeconomics, 3rd ed. New York: W.W. Norton.

Thaler, R. (1992). The Winner’s Curse. Princeton, NJ: Princeton University Press.
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[1] Makowski and Ostroy (2001) provide a nice contemporary survey of the main criticisms of perfect competition.
[2] In this case the pun is intended.

Bibliography: Akerlof, G. (1970). “The Market for ‘Lemons’: Qualitative Uncertainty and the Market Mechanism,” Quarterly Journal of Economics 86: 488-500. Ayers, R., and Collinge, R. (2005). Microeconomics: Explore and Apply. Upper Saddle River, NJ: Pearson Prentice Hall. Barone, E. (1908). “The Ministry of Production in the Collectivist State,” in F.A. Hayek, ed Baumol, W., and Blinder, A. (2005). Microeconomics: Principles and Policy, 9th ed. Case, K., and Fair, C. (2004). Principles of Microeconomics, 7th ed. Upper Saddle River, NJ: Pearson Prentice Hall. Gwartney, J., Stroup, R., Sobel, R., and Macpherson, D. (2006). Microeconomics: Private and Public Choice, 11th ed Hall, R., and Lieberman, M. (2005). Microeconomics: Principles and Applications, 3rd ed Hayek, F.A. (ed.). (1935). Collectivist Economic Planning. London: Routledge. Krugman, P., and Wells, R. (2005). Microeconomics. New York: Worth Publishers. Makowski, L., and Ostroy, J. (2001). “Perfect Competition and the Creativity of the Market,” Journal of Economic Literature 39 (2): 479-535. Mankiw, N.G. (2004). Principles of Microeconomics, 3rd ed. Mason, OH: Thomson South-Western. O’Sullivan, A., and Sheffrin, S. (2003). Microeconomics: Principles and Tools. Upper Saddle River, NJ: Prentice Hall. Pareto, W. (1971 [1906]). Manual of Political Economy. New York: August M. Kelley. Parkin, M. (2005). Microeconomics, 7th ed. USA: Pearson Addison Wesley. Ruffin, R., and Gregory, P. (2001). Principles of Microeconomics, 7th ed. USA: Addison Wesley. Stiglitz, J. (2000). “The Contributions of the Economics of Information to Twentieth Century Economics,” Quarterly Journal of Economics 115 (4): 1441-1478. -------. (1997 [1994]). Whither Socialism? Cambridge, MA: MIT Press. Stiglitz, J., and Walsh, C. (2002). Principles of Microeconomics, 3rd ed. New York: W.W Thaler, R. (1992). The Winner’s Curse. Princeton, NJ: Princeton University Press. ----------------------- [1] Makowski and Ostroy (2001) provide a nice contemporary survey of the main criticisms of perfect competition.