Eighty years ago, on May 20, 1946, Austrian economist Friedrich A. Hayek delivered at Princeton University what, in my opinion, was one of his most important and insightful lectures, “The Meaning of Competition,” which was published two years later in his collection of essays titled Individualism and Economic Order (1948). He lays out the premises of his argument on the first page:What we should worry about, Hayek concluded, is the heavy hand of the government intervening in the economy with regulations and restrictions that prevent or inhibit the real world processes of dynamic market-based free competition
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It appears to be generally held that the so-called theory of “perfect competition” provides the appropriate model for judging the effectiveness of competition in real life and that, to the extent that real competition differs from the model, it is undesirable and even harmful. For this attitude there seems to me to exist very little justification. I shall attempt to show that what the theory of perfect competition discusses has little claim to be called “competition” at all and that its conclusions are of little use as guides to policy. (p. 92)
However, in spite of Hayek’s argument, perfect competition has remained a central analytical benchmark for much of microeconomic theory and policy over these eight decades, behind notions of “market failure” that result in calls for government intervention and regulation. A main criticism of “capitalism” or the free-market economy, from the perfect-competition perspective, is the accusation of persistent imperfect knowledge and asymmetric information that prevents the market from properly reflecting “efficient” outcomes or distributive “social justice.”
But before looking at Hayek’s argument, it would be useful to take a brief excursion in the history of economic ideas to understand how the theory of perfect competition emerged and why it became the rationale for much of the interventionist state.
Adam Smith and the hubris of the social engineer
If by imperfect knowledge and asymmetric information we mean that different people know different things about the same things and different things about different things, then since the time of Adam Smith (1723–1790) economists have known that knowledge is diffused, decentralized, and diverse among all those who associate in the marketplace. In fact, this asymmetry in the knowledge and information possessed by different people was a central element in the case for free markets over government regulation, control, and planning.
In one of the most famous passages in The Wealth of Nations (1776), Adam Smith said:
What is the specie of domestic industry which his capital can employ, and of which the produce is likely to be of the greatest value, every individual, it is evident, can, in his own situation, judge much better than any statesman or lawgiver can do for him….
The statesman, who should attempt to direct private people in what manner they ought to employ their capitals, would not only load himself with a most unnecessary attention, but assume an authority which can safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it. (p. 423)
The individual participant in the market process has a fuller and more detailed knowledge of his own circumstances and its profitable possibilities than anyone in government can possess or appreciate in the same way. It becomes a source of danger, in fact, for the well-being of the society as a whole when those in political authority presume to know best how any individual should apply himself and the resources at his disposal in the service of others in the social system of division of labor. Indeed, as Smith said, it is nowhere “so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it.”
Jeremy Bentham and the division of knowledge in society
The same emphasis on market actors possessing different knowledge than political agents was made by Jeremy Bentham (1748–1832) in his Manual of Political Economy (1793–1795), in which Bentham highlights the fact that both the knowledge between these two groups in society differ as well as the degree of personal interest in trying to wisely apply it:
The interest which a man takes in the affairs of another, a member of the sovereignty for example in those of the subject, is not likely to be so great as the interest which either of them takes in his own; still less where that other is a perfect stranger to him.
Judgement depends partly upon natural faculties, partly upon acquired faculties, partly on acquired knowledge; knowledge depends partly upon opportunity, partly upon measure of attention: measure of attention depends partly upon intensity of attention, partly upon the quantity of time bestowed upon it. Opportunity depends partly upon causes within the power of the man in question, partly upon causes out of his power.
In not one of these particulars is the statesman likely to be more than upon a par with the individual whose choice relative to the subjects in question he is so ready to control: in almost all of them he is constantly and necessarily inferior beyond all measure.
A first Lord of the Treasury for instance or other Member of Parliament, or a first Lord of Trade, is not likely to have so many opportunities of acquiring knowledge relative to farming as a farmer, relative to distilling as a distiller, relative to manufacturing of stuffs as a manufacturer of stuffs, relative to the selling of the produce of any of these trades at home or abroad as one who has made the selling of them the business of his life…. A first Lord of the Treasury, or of Trade, or any other Member of the Legislature, is therefore not likely to possess either so much knowledge or so much judgment relative to the business of farming as the farmer (or relative to the business of distilling as the distiller, and so on). (Jeremy Bentham’s Economic Writings [1951], pp. 229–230)
Thus, Bentham focused part of his arguments on the limits and undesirability of government interference in the market process precisely based on the knowledge asymmetries between private enterprisers, on the one side, and politicians and those in the bureaucracies, on the other side. The latter do not know and cannot know what all these different individuals in the market know due to their circumstances, opportunities, inclinations, and incentives to be alert to them in their respective corners of society. Thus, the knowledge possessed by the political intervener must always be inferior and more incomplete than what is known to the respective market actors themselves. Nor do the politicians and bureaucrats have the same motivations as the private actors have to take advantage in the same way of what they know precisely because of their own self-interest, their own betterment, and being so closely linked to whether they make a profit or suffer a loss. Hence, the wisest and most realistic policy was to leave the decisions and outcomes of the marketplace to the individual participants themselves, with government limited to the securing of each person’s life, liberty, and honestly acquired property.
John E. Cairnes and asymmetric information in the market
The economists of the nineteenth century understood that the same imperfect and asymmetric knowledge and information existed between buyers and sellers in the marketplace. For instance, John E. Cairnes (1823–1875), one of the last of the important classical economists, drew attention to this in his Some Leading Principles of Political Economy, Newly Expounded (1874), especially in retail versus wholesale market dealing.
Those dealing in the wholesale market are specialized buyers and sellers, who every day deal with the same circumstances and changing situations and are far less likely to have persistent informational advantages over each other. Plus, the market process will weed out those having significantly less skill in analyzing and anticipating future wholesale market conditions, such that they persistently suffer losses rather than earn profits compared to some of their rivals.
But in the retail market, the consumers are the buyers of multiple goods. The determination of whether any one good in question is being offered by any particular seller with whom he is interacting at the best price usually involves sufficient transaction costs of time and expense for the consumers’ knowledge to be different and less than that of the retail sellers. Hence, the consumer might not get the best deal that someone in the market might be able to offer. Cairnes was far from being an advocate of laissez-faire; however, his answer to this informational asymmetry was not to call for government regulation or control but rather a call for greater free-market forms of competition to increase the knowledge available to the consumer in the retail markets (pp. 113–116).
Jevons and Walras and the marginalist approach to perfect knowledge
What has come to be called the mainstream neoclassical tradition in economics that emerged out of William Stanley Jevons’s (1835–1882) and Leon Walras’s (1834–1910) mathematical “marginalist” approach in the 1870s gave little of the same attention to such issues of asymmetric information, other than to assume the problem away.
Jevons, for example, wanted to determine the mathematical conditions for “equilibrium” trades between buyers and sellers in the market. In his Theory of Political Economy (1871), he said, “A market is theoretically perfect only when all traders have perfect knowledge of the conditions of supply and demand, and the consequent ratio of exchange.” After all, he added, “it is a far more easy task to lay down the conditions under which trade is completed and interchange ceases, than to attempt to ascertain at what rate trades will go on when equilibrium is not attained” (pp. 85–87; 93–94). Thus, his decision to assume away imperfections and differences in knowledge by transactors in the market was to simplify his mathematical problem of determining equilibrium states between supply and demand.
In his Elements of Pure Economics (1874), Leon Walras’s answer to the problem of divided knowledge in the market economy was to also assume it away by imagining that there is an auctioneer, a “crier” as he calls him, who shouts out alternative prices to buyers and sellers and tabulates what the quantities that would be demanded and supplied at these prices until the auctioneer determines that set of relative prices that would ensure a general equilibrium across all markets simultaneously. Only when that equilibrium set of prices has been determined by the “crier” are buyers and sellers permitted to enter into actual trades to ensure against disruptive “disequilibrium” purchases and sales at nonequilibrium prices (pp. 164–170).
It is, perhaps, not too surprising that Jevons and Walras in their economic policy writings both took fairly paternalistic and interventionist views about the role of government in society precisely due to the fact consumers and producers do not possess the correct and “proper” knowledge or rationality to make “right” decisions in their respective roles in the market economy.
Vilfredo Pareto claimed logical action requires perfect knowledge
One other important economist to mention in this context is Vilfredo Pareto (1848–1923), who was an advocate of a fairly laissez-faire free-enterprise system. But after years of writing on Italian economic policy issues from a free-market perspective in a setting in which Italian politics and policies kept moving in interventionist directions, he concluded that most people are not open to rational and logic arguments.
Pareto concluded that people are consciously and unconsciously guided by what he called “non-logical” motives, such as superstition, wishful thinking, rationalizations, ideological biases, and psychological impulses. Economics as a discipline, on the other hand, is concerned with “logical” human action. For Pareto, logical meant reasoning and actions in which individuals have “rightly” understood the most appropriate ends and selected the correct means to achieve those ends. In turn, interpersonal exchange is “rightly” economic when transactors know all the relevant resource, price, and trade-off constraints to mutually achieve their respective goals through trade.
Thus, “pure” economic theory, as Pareto formulates it in his Manual of Political Economy (1909), focuses on the mathematically “objective” relationships reflected in states of general equilibrium. In such states, individuals possess all the correct information to never make mistakes or errors by not knowing the “objective” knowledge that ensures perfect equilibrium in terms of people’s “tastes” and the “obstacles” of physical limits in production and the tastes and demands and willingness to supply of others, as captured in Parato’s famous “indifference curve” approach.
Frank Knight formalized the perfect-competition model
This was all formalized by economist Frank H. Knight (1885–1972) in his book Risk, Uncertainty, and Profit (1921) into the theory of “perfect competition.” It is somewhat paradoxical that this formalization is what has, perhaps, become the most lasting legacy of Knight’s book. For Knight, the defining characteristic of a state of perfect competition was its use as a foil against which he analyzed the difference between measurable statistical risk, to which a probability and a price may be attached, and real “uncertainty,” defined as possible future events for which such probabilities could not be attached and from out of which entrepreneurial profit mostly arose.
Knight defined the market conditions for “perfect competition” in the following way:
First, individuals are guided only by their own self-interests and each takes the market prices they find as “given” and to which they respond by deciding on the respective amounts to buy and sell, while having no individual ability to change the market prices at what they find them.
Second, there are no physical or legal obstacles preventing a buyer or seller from immediately leaving one market and, instead, start buying and selling in some other, and to assure this, goods are bought and sold in infinitesimal quantities to prevent any difficulties in shifting instantly from one line of production to another.
And, third, all market participants possess perfect knowledge of all relevant information — “There must be perfect, continuous, costless, intercommunication between all individual members in society” — so that no buyer pays a higher price and no seller accepts a lower price that the “correct” information in the market would assure. (pp. 76–79)
In fairness to Knight, he only offered the requirements for “perfect competition” as an analytical foil and emphasized more than once the unrealism and even the absurdity of the perfect-competition assumptions. Thus, he once referred to “the impossible conditions of ideally perfect competition, where time and space are annihilated and universal omniscience prevailed.”
Yet, as the decades went by, Knight’s analytical foil to study the implications of a world without “universal omniscience,” became the benchmark by which the real world of imperfect knowledge, time, space, and inescapable hurdles to immediate adjustment to change was to be judged as falling short of what was expected of a market for it to work properly and acceptably for normative purposes.
Indeed, the perfect-competition model still holds center stage in virtually every economics textbook from which students learn the fundamentals of market demand and supply. And it most frequently serves as the basis for justifying the need for government regulation and intervention due to resulting “market failures.”
Frank Hahn and how imperfect knowledge equals market failure
As just one example, Frank Hahn (1925–2013) was one of the most eminent mathematical economists of the second half of the 20th century. In an article entitled, “Reflections on the Invisible Hand” (Lloyd’s Bank Review, April 1982), Hahn offered a popular summary of why Adam Smith’s analysis of the market economy was fundamentally flawed because any real market economy does not meet the standard and prerequisites of the perfect competition model! Individuals are not passive “price takers”; instead, they attempt to influence market prices and the profits they can make by attempting to move market prices in ways that benefit them. Thus, they inappropriately try to assert “market power” by changing the price offered for their product to the disadvantage of their competitors and consumers.
In addition, precisely because knowledge is imperfect and transactions are often costly in terms of time and resources, there may not be “contingency” contracts offered on the market to cover all conceivable situations in which without such a contract an individual may suffer a loss-making outcome that could be avoided if such universal and time-infinite contracts were available.
Finally, free markets “fail” because individuals possess asymmetric information about the qualities and characteristics of the goods they buy and sell, such that a buyer may misread the real value of something offered on the market and therefore not know for sure whether the price asked is telling the truth about the product and what it is worth. On the other hand, the seller, knowing more about the product than the buyer, may try to take advantage of this situation to his own benefit that is not consistent with the “objective” situation.
Notice how Hahn (and many other mainstream neoclassical economists) superimpose their chosen definition of the meaning of “competition” on Adam Smith and others who did not assume or utilize the perfect competition assumptions and declare that their earlier analysis of competitive markets is therefore shown to be flawed in the “real world.”
This leaves no answer to such “market failures” other than the visible and intervening hand of the paternalistic state that knows more than the individual participants in the marketplace. That, in fact, means that Frank Hahn and others like him know better what is good for others than those others know themselves. Presumably, this is because — somehow — Hahn and those other economists and policymakers have freed themselves from the imperfect and asymmetric information problems that plague the rest of us. As we saw, it was precisely because earlier economists like Adam Smith and Jeremy Bentham took for granted that asymmetric information existed in the division of labor that it was pretentious and arrogant on the part of those in government to presume to know enough to direct and plan the affairs of all the others in the marketplace. Hahn turns this on its head and asserts that because market actors have imperfect knowledge, those in politics, somehow, know enough to correct the mistakes and improve market outcomes.
Hayek on the real meaning of competition
This now gets us to Hayek’s important 1946 lecture on “The Meaning of Competition.” He asks us to take a moment and think about how we normally use the word “competition” in everyday speech and as what we usually understand it to mean in the marketplace. In the everyday common-sense meaning, we use the word competition as a “verb,” that is, individuals actively trying to do better than their rivals. In sports, one player or team tries to do better than another individual or team. For example, in a foot race, each tries to run faster and in shorter time than the others on the track. In tennis, a player attempts to lob the ball over the net and position it in a way that results in the opponent missing it or hitting it out of bounds. In a team sport like basketball, the task is to keep the ball or get it away from members of the rival team and pass the ball between your team members to enable one of them to gain a better position on the court to throw it successfully into the hoop.
The creative discovery process of competition
In the market process, competition is understood to mean the attempt by supply-side producers to discover, develop, produce, and offer new, better, and improved products so as to attract customers to their product or service; the goal is increased sales, greater market share, and larger net revenues to earn profits.
To do so, competition in the marketplace also entails devising ways to not only improve the quality of the product but also to creatively find ways to produce it for less costs to offer it to customers at a lower price than one’s competitors.
This requires entrepreneurs to decide on what to produce and where, how, in which quantities, and at what price to market it to potential buyers. In other words, to compete means not to take the market price or the existing ways of doing things as “given.” It means to go outside the current and existing knowledge about how to produce a product with various inputs (land, labor, resources, capital equipment) and to discover how all of this might be done less expensively and with the product having new and improved qualities that make it more attractive to the buying public.
Inescapably, this process means new knowledge and information, given that the discovery processes that bring about better products can only come through some people in the market learning and utilizing and applying that knowledge before others. After all, any new knowledge must come into someone’s head first, which means new knowledge and its use is invariably asymmetric. That is, some people know things that others do not, and they know it ahead of those others.
Perfect knowledge assumes away all the competitive problems
In the theory of perfect competition, one of the analytical goals of the economist is to determine which combination of resources may be utilized at their lowest cost “given” the prices for the input factors of production in relation to the “given” market demand and price for the consumer good in question. Assuming that both the market actors and the economic analyst already know what the combination is based on the perfect-knowledge postulate, it is merely a mathematical exercise to determine at which level of output marginal revenue (the extra money revenue from selling one more unit of the good) would be just equal to marginal cost (the extra money outlay to produce one more unit of the good) and at the same time ensures that total money revenues from sales equals total money outlays from producing the “equilibrium” quantity of the good: this also means that level of production, sales, and price at which sellers neither make profits nor suffer losses.
Thus, perfect competition presumes the necessary “data” to be already existing and known to determine and define what a state of perfect economic equilibrium would look like simultaneously within and across all markets. This would reflect the most optimal productions of all goods and at their least costs to get the most out of “the society’s” scarce means to service people’s desired ends.
Hayek stated that the theory of perfect competition assumes that all the information that would be needed to determine such a perfect equilibrium state is already known. Thus, the theory assumes away the very question of how such an equilibrium would ever come about because it already presumes the answer to the very question that needs to be solved:
The modern theory of [perfect] competition deals almost exclusively with a state of what is called “competitive equilibrium” in which it is assumed that the data for the different individuals are fully adjusted to each other, while the problem which requires an explanation is the nature of the process by which the data are thus adjusted…. Competition is by its very nature a dynamic process whose essential characteristics are assumed away by the assumption underlying the static analysis (p. 94)….
[It is assumed that producers] know the lowest cost at which the commodity can be produced. Yet this knowledge which is assumed to be given to begin with is one of the main points where it is only through the process of competition that the facts will be discovered. This appears to me one of the most important of the points where the starting point of the theory of competitive equilibrium assumes away the task which only the process of competition can solve….The second point on which the producers are assumed to be fully informed [are] the wishes and the desires of the consumers, including the kinds of goods and services which they demand and the prices they are willing to pay. These cannot be regarded as given facts but ought to be regarded as problems to be solved by the process of competition. (p. 96)
Only real competition can discover what needs to be known
Similarly, Hayek argued, the assumption that all sellers in a particular market are selling homogeneous (or perfectly interchangeable) versions of the same product begs the question of how producers and sellers would have discovered what the qualities and characteristics of the most desired goods are, such that, at the end of the day, all sellers end up in perfect equilibrium producing exact copies of what their rivals are also producing because there is no better version to offer. Hayek’s point was it is only by competitively experimenting and differentiating your product from that of your rivals that you and they discover what it is that consumers want and what some perfect equilibrium type of it might possibly look like. Yet by trying to do so, according to the perfect-competition theory, producers are no longer acting like “perfect competitors” are supposed to.
Neither the market actors nor the “observing” economic analyst can know what the least costs could be, or what the most attractive product qualities might be, or the lowest price at which the product might be offered other than through the discovery process of market competition, understood as that active “verb” rather than as a “noun” expressing some hypothetically perfect equilibrium state of affairs.
Real competition overcomes problems of asymmetric information
As for the presumption that asymmetric information may place the buyer at a disadvantage to the benefit of the seller, because the buyer cannot be sure the price alone is telling the truth about the product and it characteristics, Hayek responded that that was the very reason why markets develop “personal” relationships between buyers and sellers beyond merely the price at which you buy and sell. That is, markets offer the development of “trust” relationships, such as having confidence in the knowledge and advice offered and taken from a medical doctor or a lawyer.
Though Hayek does not use these terms, what he was getting at are brand-name reputations of the sellers with whom you end up doing repeat business. The offering of product warranties also act to reduce consumer concerns about knowing enough about the product they are purchasing compared to what the seller knows about that product. These relationships and forms of knowledge are trial and error processes, as well, in a world of inherently and inescapable imperfect and asymmetric information. But this is how the market solves the problem of imperfect and asymmetric knowledge and information.
There are a number of other facets to understanding the real nature of competitive processes and the limits of the perfect competition model that Hayek also discusses in this essay. However, “the practical lesson of all this, I think,” Hayek said, “is that we should worry much less about whether competition in a given case is perfect and worry much more whether there is competition at all.” What we should worry about, Hayek concluded, is the heavy hand of the government intervening in the economy with regulations and restrictions that prevent or inhibit the real world processes of dynamic market-based free competition; regardless of whether it based on an erroneous and misplaced notion of “perfect competition” or on behalf of self-interested groups using government because they do not want to face their creative and innovative rivals in pursuit of consumers’ business. This lesson is as true and important today as when Hayek wrote about it 80 years ago.
This article was originally published in the May 2026 issue of Future of Freedom.
