Perfect Market Assumptions
A perfect market is defined by the following assumptions:
No Differences in Information Everyone holds the same opinion. How can this assumption be violated? Here is one example. If your bank believes that there is a 50% chance that you will go bankrupt and default, and you believe that there is only a 0.1% chance, then your bank will lend you money only if you pay a much higher expected interest rate than it will pay you if you deposited your money with it.
This is why our perfect markets assumptions includes one that everyone has the same information and agrees on what it means. (It does not mean that there is no uncertainty, however. The important point in a perfect market is that everyone interprets the uncertainty identically.)
A Deep Market You can easily find a buyer or a seller. How could this assumption be violated? Say there is only one bank that you can do business with. This bank will exploit its monopoly power. It will charge you a higher interest rate if you want to borrow money from it than it will pay you if you want to deposit your money with it—and you will have no good alternative. (There is one nitpick qualification: if a project is worth more if it is owned or financed by a particular type—e.g., if a golf range is owned by a golf pro—then there must be a large number of this type of owner.)
This is why our perfect markets assumptions includes one that there are infinitely many buyers and sellers.
No Transaction Costs You can trade without paying any transaction costs. How can this assumption be violated? If it costs $1,000 to process the paperwork involved in a loan, you will incur this cost only if you need to borrow, but not if you want to save. This will make your effective borrowing interest rate higher than your effective savings interest rate. This is why our perfect markets assumptions includes one that there are no transaction costs.
No Taxes There are no tax advantages or disadvantages to buying or selling securities. Specifically, there are no asymmetric tax treatments to the seller divesting or to the buyer purchasing. How can this be violated? If you have to pay taxes on interest earned, but cannot deduct taxes on interest paid, your de facto savings rate will be lower than your borrowing rate.
This is why our perfect markets assumptions includes one that there are no taxes. We will soon tackle each of these issues in detail. However, the effect of violating any of these assumptions is really the same. Any violation that breaks the equality between the borrowing and the savings rate also breaks the link between value and one unique price (or cost). In fact, the value of a project may not even have meaning in imperfect markets—a project may not have one unique value, but any from among a range of possible values.