Adam Smith’s Perfectly Competitive Market Is Not Pareto Efficient: A Dynamic Perspective

Abstract

The invisible hand of a perfectly competitive market refers to the self-regulating behavior of the market where if each consumer and producer is allowed to freely make their own choices, the market settles at an e¢ cient outcome which is bene…cial to all the individual members of the society and hence to the society as a whole. Two well-known facets of the invisible hand are generally mentioned in the economics literature-the …rst one is a static picture of a perfectly competitive market, i.e., a competitive market is e¢ cient in an equilibrium; and the second one is that if the competitive market is disturbed from its equilibrium position, in the absence of a market failure and frictions, the market automatically settles at a new e¢ cient equilibrium. Existing literature does not consider the most important dynamic facet of the perfectly competitive market from perspective of Pareto e¢ ciency, i.e., how e¢ cient is a perfectly competitive market on the dynamic adjustment path after an economic shock in the absence of all kinds of frictions and price rigidities, and if all the ideal conditions are maintained. This research models the dynamic facet of the market and concludes that Adam Smith' s perfectly competitive market is not Pareto e¢ cient and coordinated actions of economic agents can result in a level of economic e¢ ciency on the dynamic adjustment path which is not achievable by a free market mechanism. (JEL D40, D41, D50, E32)