Classical and Keynesian Schoools of Thought in Market Imperfections

The market mechanism can also be interpreted as the free market system, this refers to the ability to buy or sell as much as you want or choose to do nothing in that given market, you are free to make decisions. Economic efficiency means how scarce economic resources are utilised to make economic outputs. Alfred Pareto was the first economist to define efficiency, and accordingly we define optimality in terms of Pareto efficient states. According to Pareto, “a Pareto efficient state of affairs is when no one can be made better off without making someone worse off” ... The classical school of thought and the Keynesian school both had different views on the market mechanism, the classical school have always suggested the idea that maximisation of the private sector, the adjustment of relative prices to equate supply and demand, and the efficient of unregulated markets. However later on in history came The Keynesian school of thought that went against these ideas. Keynesian school believes that to understand these economic fluctuations involves not just learning the details of general equilibrium but also acknowledge the possibility of market failure on a grand scale. Therefor this essay will firstly aim to examine the different notion and ideas of the classical school of thought for market efficiency and then examine the Keynesian school of thought on the market imperfections, respectively. Finally, this essay will reference the role of governments and real- life application for the financial crash in 2007-2008.

Classical economists emphasise the efficiency of the market mechanism, this stems from rationality as being one of the key factors to achieve efficiency, classical economics belief of rationality comes from two approaches the philosophical approach and the methodical approach. We begin by examining the philosophical approach, Jevons explains that “every person will choose the greater apparent good” (1957, p. 18). Meaning Economic decisions are made independently and individually not collectively or under certain economic decisions. The methological approach for rationality as Menger notes being "the principle that leads men to exchange is the same principle that guides them in their economic activity as a whole; it is the endeavour to ensure the fullest possible satisfaction of their needs." decisions being made individually these decisions are in pursuit of their own economic interest (profit and wealth) this is known as the utilitarian process. For the market mechanism to be efficient this requires that each agent to act in these ways, reviewing the theory it can be said that these early formulations of the rationality principle are a bit fluctuating: classical economists reference to action or to choice which align to the maximum satisfaction or greater good both not being stated clearly. However, the principle is still key to classical economists’ view of efficiency and allows economists to draw conclusions about recent economic events that take place. 

On the other hand, Keynesian school of thought emphasise imperfections of the Market mechanism this is depicted by limit to human rationality. Keynes (1936) argues economic agents are not rational or consistent which is assumed by the classical school of thought. Due to human nature and animal spirits there is an instability of rationality. Economic agents will make decisions based on the outcome being good enough and rule of thumb instead of economic gains versus losses or weight average of quantitative probability’s multiplied by quantitative probabilities. Because economic agents choose to make a decision on these variables how can the market mechanism be efficient if decisions aren’t made rationally?

Keynes idea of imperfections arising from the limit to human rationality has evolved in recent times to what is now known as Prospect theory. Prospect theory as developed by Kahneman and Tversky (1979) One of the basis, people rely on when making decision is loss aversion, overweighing small probabilities to guard against losses. For example, we would rather agree to a small certain loss than a risky unlikely large loss. This theory presents a more effective depiction of the classical utility theory, this imperfection at the individual decision making level can hold some explanation to the financial crash. Economic agents would rather bet/ choose the guaranteed safe option, before the 2008 this was known to be the housing market. Bankers had the idea that the housing market will never fail because of this safe option Banks invested heavily on this idea and assumed prices to make sense in 2006, because of prospect theory this would explain why so many bankers choose the certain choice and why no one betted against the housing crisis. Maybe if we choose the weight average of quantitative probability’s multiplied by quantitative probabilities between the housing market will never fail and will fail the Crash could have been prevented?

As spoken above Classical school of thought view individual rationality as essential to achieving market efficiency, but this was not sufficient to achieving the Pareto social optimality. Other mechanisms were proposed in order to facilitate exchanges through markets with each agent. Examples include perfect information, private property rights and perfect competition. These mechanisms are known as the market decision making level. Turning back to Keynesian school of thought ‘they believed that to understand economic fluctuations meant to examine the details of the market mechanism but also to appreciate the possibility of market failure on a grand scale” (Snowdon, 2005) such market failure Keynes would express is imperfect information. Imperfections in the market mechanism would come from economic agents having imperfect information, the reason this affected the market mechanism is simple with buyers and sellers not having perfect information about the market they may be discouraged to participate in such market. Buyers would be faced with the problem of not knowing what they are buying and the quality of such economic good, whereas sellers with high quality goods won’t participate if it becomes difficult for to demonstrate such quality to buyers. 

Keynesian’s suggestion that imperfection of the market mechanism arises from imperfect information can be linked to asymmetric information, this refers to situations, in which some agent in a trade possesses information while other agents involved in the same trade do not (World Bank, 2003). Also known as adverse selection. Adverse selection can help explain the market failure of the 2008 financial crash, many buyers were confident in purchasing US housing bundles for the prices that the market gave. Under classical theory the market should be efficient and react accordingly to buyers and sellers, however one thing the buyers didn’t know was these housing bundles were toxic and complex. Because of the complexity of such bundles only the seller possessed better information than the buyer. Creating a market full of lemons (Arkerlof, 1978) This asymmetric information in the market of housing bundles is what lead to the wrong price valuation of such, leading to the market failure and the start of the financial crash in 2008.

Classical school’s idea that the market mechanism is efficient was improved by the New classical school with their idea of efficient market hypothesis, the theory was developed by Eugene Fama (1970) explaining that stock prices reflect all available information and that market prices will only react to new information. Fama changed the classical view of buyers having perfect information due to his belief that for investors to make a higher rate of return they will chance buy or choose a riskier investment. One the other hand empirical evidence by Dreman (1995) suggests that prices do not reflect these conditions as his study expressed how P/E stocks have greater returns going against Fama theory.

Furthermore, Efficient market hypothesis doesn’t explain the phenomenon ‘herding behaviour’ this is the effect when economic agents act collectively on investments on what they perceive everyone else is doing and not going on their own analysis. This behaviour goes against classical theorist idea of humans acting rationally, herding behaviour can be increased by various factors such as fear (Economou et al, 2018) or a shared identify of economic agents (Berger et al., 2018). which helps explain the reasoning why so many investors were continuing to buy housing bundles, people ignored the risk that these bundles may be overpriced/overvalued because everyone else was pilling into the stock making the idea the majority must be right. The herding effect therefor brings a stronger case to Keynesians view that the market mechanism isnt efficient and has many imperfections. It is also perhaps to simple to evaluate the financial crash all being down to herding behaviour of the market, (Economous et all, 2018) evidence suggests herding behaviour is documented in the UK market during 2007-2009 but not all global markets during the financial crash. Nevertheless Famas argument to the financial crash in 2008 is this was the effect of a onset recession rather than a burst in the US sub-prime mortgage market, the change in prices reflected updated information about economic prospects.

Classical school’s idea of efficiency in the Market mechanism is again challenged by new Keynesian school with the idea of moral hazard. (Krugman, 2009) any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly. By economic agents taking on more risk without bearing the cost this goes against the classicals thought of humans acting rationally, (Zandi, 2009) claims Moral hazard to be the root cause of the US subprime mortgage crisis, he explains the risk involved in mortgage lending became so dispersed no one had to worry about the quality of the mortgage bundles. This sort of irrational behaviour is evidence of moral hazard within the mortgage lending industry showing Keynesians view of imperfections in the market mechanism, with mortgage companies transferring their risk to larger pools their responsibility for these assets are undermined making them behave irrational leading to the inefficiency of the market. On the other hand, the example of Lehman Brothers collapse and mortgage company Citibank who share price plunged from 513.40 to 25.30 in the height of the financial crisis could suggest government bailouts do not encourage riskier spending behaviour (moral hazard) due to there being no actual guarantee that a bailout would occur.

Whether the market mechanism acts efficiently or contains imperfections all depends on the ability for humans to act rationally. The controversial theory around rationality have been discussed throughout this essay, with different viewpoints from classical school and Keynesian school of thought. Although the classical school believe humans act rationally making the market mechanism efficient this essay has shown many arguments against the theory from Keynesian and new Keynesian school of thought. The imperfections have been discussed at the individual decision making level and market level, giving key references to the limit of human rationality and the 2007-2009 financial crisis. despite the compelling evidence of imperfections in the market mechanism it’s important to note classical theorists believe economic agents behave rationally, at least on average over time and across various agents and not in the short term.

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