Non-existent and Incomplete Market:
It is to be noted that though the assumption of perfect knowledge about relevant prices seems very strong, it is possible to believe that some real world situations would approximate it sufficiently for a more or less unique equilibrium price for more or less identical products to emerge. But it is also possible to conceive of real world situations where the assumption of perfect knowledge is far too strong. Jn other words, even an economy solely consisting of perfectly competitive industries, at least some of which are not in equilibrium will not have allocation, which is Paretian optimal. Moreover, if perfect knowledge is not assumed, there is no necessary reason why each perfectly competitive industry should be in equilibrium.
The recognition of imperfect knowledge has important implication that the price mechanism. Working on its own it may not be sufficient to bring about the necessary conditions for technological efficiency which is likely to be relevant to most kinds of social welfare functions. One important reason for this is the recognition of the possibility of uncertainty introducing information as a good into the analysis. The marginal cost of transmiqing certain kinds of information is ofien low or even zero. To the extent that some information (e.g., about improvements in techniques and designs etc.) is a factor of production, technological efficiency requires its price be the same for all producers. This requires that the information should be available to all its potential users at the very low or zero marginal cost, at which it is available to its original possessor or discoverer. But if information once gained has to be transmitted so cheaply, there may be very little incentive for firms and individuals to engage in information seeking activity, i.e., research. On the other hand, with the grant of legal rights for restricting the use of newly discovered knowledge, the necessary conditions for reaching the economy's production frontier are violated; one might say this is because less than the 'maximum' use is made of the new knowledge. There is then a dilemma here.
Moreover, even the free or low cost availability of information about new techniques of a kind, which would pass a reasonable investment criterion sometimes, does not ensure that entrepreneurs will in fact utilise .that information. If that were certain, governments would have given extra inducements to bring this about. Attempts to look at. the underlying reason behind such a tendency involve ethical assessments. For, if entrepreneurs prefer a 'quiet life' and, according to the adopted social welfare functions of the society concerned are entitled to follow their own judgment in such things, then the technological efficiency for such an economy would have to be modified to include the constraint of a 'quiet life' among the other constraints.
If we ignore this rather special possibility, we have here an important reason for doubting the ability of the market mechanism working entirely on its own to take the economy to its production frontier or consequently, its Paretian utility ruontier.
Let us now examine the other way in which the existence of uncertainty might prevent the attainment of the economy's production frontier. An example may be helpful at this stage. Suppose the welfare function of some society and its economic circumstances are such that it is considered desirable to have an annual amount of a good called XI. So far, this good has been imported by some firms. Assume that X2 is an important component of X1. X2 is not produced at present at home because XI, its sole or main user, is produced abroad; and because transport costs prevent competitive sale of X2 abroad. Hence, if any firm is to undertake the manufacture of X2 at home it must know that XI will also begin to be produced at home. Now it may be that it would be more profitable to manufacture XI at home rather than to import if X2 were available at home. Hence, if it were known that X2 was going to be produced at home, then XI would also be produced at home. If both Xz and X1 were produced at home, then the society would get X1 cheaper by at least the transport costs. If there also happens to be some unemployment in the economy-structural or involuntary, whether it is disguised or not- then there is also a favorable employment effect. The example could be slightly altered by assuming that XI is neither produced nor imported; but that if X2 were produced at home, then it would become profitable for some firms to produce XI and that X2 is profitable only if XI is
also being produced.
Normally when the mutual repercussions on the profitability of any two (or a group of) industries are so strong we should expect integration between them or exchange of information through trade journals (or even monopolistic collusion-if the repercussions are along a horizontal relationship rather than a vertical one as in our example). But vertical integration is. sometimes uneconomical when a region is adopting a certain kind of industry for the first time: the necessary entrepreneurial and managerial skill for quite so large an enterprise may be lacking; and- to introduce an imperfection in the market- it might be difficult to raise the necessary finance for a large integrated undertaking, even it would otherwise be economically viable. As for tacit or overt monopolistic collusion, there may be legal prohibition to prevent that.
Exchange of information is the other possibility as mentioned above. Such exchange of information may actually take place. Assuming perfect knowledge implies that it may actually take place. But in fact, there is no absolute necessity about it, and it is possible that in economies with relatively few entrepreneurs, trade journals, or clubs where businesspersons might meet, such exchange of information often fails to take place. Such conditions of imperfect dissemination of commercial information then constitute another reason why the market working on its own may not be able to take the economy to its production frontier to attain optimum welfare. Moreover, even if competition were almost perfect in some economy, knowledge about changes in technology and about mutual profitability relationships would not necessarily be perfect. Indeed, the newer a certain kind of industry is to a region, and the less developed a region is the more important are the imperfections in business knowledge likely to be. It is worth mentioning that in situation of the kind discussed in our foregoing example, a mere provision of information about the mutual profitability relationships of XI and X2 may not always be sufficient to ensure that the two industries would get started. Depending on the kind and degree of risk- aversion prevalent among the entrepreneurs, it may sometimes be necessary, provided it is not overruled by some other considerations laid down by the social welfare function-also to provide some assurance to the entrepreneurs in each industry that the industry would also be starting. The assurance might take the form of subsidies and guarantees by an outside agency, in other words, it calls for government intervention.
However, even government-assisted coordination can ever abolish another kind of uncertainty, which concerns possible changes in tastes, technology, weather and so on. Uncertainty from these sources can never be abolished, no matter what amount of coordination takes place. This kind of uncertainty makes it impossible to be sure that any pattern of allocation, which is presently considered desirable, will still be considered so by the time it has been achieved. This is a kind of uncertainty conditioning human existence, which is another, factor causing the inability to attain optimum. Another field where there may be an important degree of uncertainty through the market interdependence is the consumers' saving decisions. A consumer's regarding the form and size of her savings is likely to be affected by her estimate of the future changes in the absolute price level and in relative prices; but what these changes will be, depends, to some extent, on others' saving decision which the consumer acting on her own has no way of knowing.