Thursday, June 11, 2015

Perfect Markets and the Beauty of B School Economics

Don Boudreaux at Cafe Hayek has written several posts recently that are related to some of the themes I've been focusing on lately. (See his posts here, here, and here.) I'll quote from the first one and provide some of my thoughts.
The market process is chiefly one of entrepreneurs spotting market failures and sub-optimal situations – spotting problems that have yet to be ‘solved’ adequately by market (or non-market) forces – and then experimenting with actions to address such problems.  The discipline to ensure that such experiments work as well as possible over time is supplied by (1) the fact that those who do the experimenting in private markets put their own money and effort on the line (rather than money and effort forcibly commandeered from others), (2) consumers’ freedom to buy or not to buy the resulting products, and (3) the actual and potential competing experimenters who do, or might, arise along side of the initial entrepreneurial experimenter.  And this on-going process is indeed just that: a process that, as much as it improves market performances over time, never comes close to creating any situation that deserves the name “perfect market.” 

If you learned economics while in business school this will all make a lot sense to you. Conducting a SWOT analysis or analyzing a business with Porter's Five Forces implicitly teaches the market process view. The world around the firm is always changing; that's why SWOT is important. A manager needs to be able to see potential profit opportunities before other firms in the industry do precisely because markets are always changing.

Porter's Five Forces helps make sense of the effects of the preponderance of substitutes on demand for the firm's product. It can help students understand how barriers to entry impact the relationships of firms up and down the supply chain. Implicitly in this analysis is the question: "How can the managers avoid this potential problem or pounce on this opportunity?" Again, this is a good way to think of markets as constantly changing.

As I noted in a previous post, VRIO analysis allows students to see the difference between barriers to entry that are simply imperfections in the real world around us and those which are favors artificially created by government through rent seeking. Firms in the real world have to undertake a series of steps to establish sustained competitive advantage. VRIO is an analytical tool that helps build the road map.

The bottom line is that, as Boudreaux notes, "this on-going process" that "improves market performances over time, never comes close to creating any situation that deserves the name 'perfect market.'" B-school frameworks (I hesitate to call them "theories.") can impart a realistic view of markets that avoids some of the problems of looking at economic phenomena as a series of equilibrium end-states. Further, learning principles and intermediate economics in the context of some of these key business school frameworks just might help students avoid the nirvana fallacy.

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