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I’ll try not to get my readers into the weeds on this question, but I would like to summarize it and make a larger point. First the larger point: this is a real argument. This is to be taken seriously. Waldman is doing here what I though college and academia and serious discussion was supposed to be all about. He understands very well the underlying theory he is talking about. He presents the underlying theory that he is about to criticize in a straightforward, transparent and well-articulated light. He points to where in the line of logic he finds something problematic. He discusses how this disagreement impacts the basic theory. And he leaves us with some very interesting and important implications of his thoughts. Notice what he does NOT do. He is not calling anyone stupid. He is not positing that unicorns exist or that scarcity isn’t real or that anyone is evil. It’s an excellent analytic argument and if someone wants to grapple with it, they cannot do so by saying he is a paid lackey of some industry, or that he is disingenuous or anything of the sort. This is why I enjoy reading him. I also enjoy reading him because I have no idea what his politics are, even after reading him for many years.

OK, so briefly onto the substance of his post. What he is arguing is that a market clearing price that equilibrates the quantity supplied and quantity demanded, while it may maximize the number of mutually beneficial transactions that occur in a marketplace, does not maximize overall well-being as postulated by the welfare theorems. Now this is either entirely obvious or entirely mind-blowing. I hope my micro students find this to be entirely obvious, since we spend nearly two full lectures that when we are doing micro theory we are HAVING to make some normative judgment about how to measure the “usefulness” of an economic outcome, and that the one we are choosing is to look at willingness to pay as our measure of value. We tend to call that “welfare” in economics, but this is only true insofar as it is definitional. If we want to use some other value as our measure of well-being, then it is not entirely obvious that the “welfare theorems” still hold. I don’t find that particularly revolutionary.

Furthermore, what IS more important is that “our way” of examining welfare is an analytic tool to help us look for ways to increase the size of the pie for EVERYONE and that were we able to actually get all parties in a room to negotiate in the presence of inefficiencies that there are things that they would ALL agree to that would be better than an inefficient outcome. So, if I steal an apple from the rich guy Chaci (whose WTP for an apple is large) and give it to a poor person Joni (whose WTP for an apple is low only because she is poor), she surely enjoys having the apple. But she is very likely to get more satisfaction from being able to sell that apple, for more than it is worth to her, right back to Chaci. In this case, we get the same outcome, with the apple in rich guy’s belly, which supposedly is the problem with inequality) but Joni is better off than she would be than if she were “forced” to eat said apple. When we say it would be inefficient for Joni to get the apple we are not saying she does not deserve it or that her willingness to pau for it wouldn’t be larger if she were richer, what we ARE saying is that there are ways SHE’D prefer to be made better off than by being asked to eat the apple itself.

However if you have not thought hard about the assumptions we are making when we draw supply and demand curves, and further when we start computing areas between them, then it indeed becomes a pretty revolutionary insight. This is why I absolutely abhor the mechanistic text-book approaches to economics.

Waldman also makes this argument:

But the goal of market exchange is to maximize welfare, not to generate trade for the sheer churn of it.

And for many that is indeed the goal of market exchange. As I tell my students, most of the study of economics not only requires an agreement on what normative criteria to be used, but also that it seems to comport well with a utilitarian one. I personally happen to NOT share that sentiment. I don’t think the goal of market exchange is to maximize welfare. I think the goal of market exchange is to allow people to be free in their economic lives, welfare maximization be damned. Furthermore, I dispute that there is any “goal” of market exchange, that is a convenient anthroporphizing of something that cannot be given human characteristics. Market processes emerge, they are not imposed or formally created, and it is not even clear WHY they emerge, though many great economists in history have provided their own reasons for why. It SEEMS like markets emerge because of people’s inherent desire to ease the burdens in their lives, but they could very well have emerged for a number of other reasons, conscious or otherwise.

OK, but the essence of his argument is this: market clearing prices maximize welfare if and only if the distribution of income between buyers and sellers is somewhat equal and his point is that economists, when making pronouncements about the inefficiency of price controls and the benefits of having markets clear, are implicitly making this equal distribution of wealth assumption. I personally don’t make that assumption, because I am a great economist (laugh laugh), but he does have a point. The insight is simply this: when we look at price controls and other interventions that cause welfare losses, we typically weight all of the willingnesses to pay and willingnesses to accept up with the same weights, which is why tautalogically ANY movement away from a market clearing price reduces welfare.

Take the case of a rent control. It is typically “bad” because the quantity of units is reduced, and this is bad because mutually beneficial transactions are prevented from happening – some would be buyers don’t get apartments and some would be sellers don’t rent them despite their mutual interest in doing so. And for the transactions that do happen (ignore rationing costs for now) sellers have to accept lower prices and buyers get to pay lower prices (and assume away the long term impacts of this and assume away the short term issues related to rationing too). So it would seem that sellers are worse off but SOME buyers are better off (ignoring that other stuff). And since there is diminishing marginal utility, and if the sellers are richer than the buyers, then the loss in welfare to the sellers must be less than the gain in welfare to the buyers, since a dollar of new income to a poor person creates more welfare than a dollar of lost income to a wealthier person.

Now, this is right as a theoretical matter, but then again, it is ONLY right as a theoretical matter and doesn’t take us very far. Here is one reason it does not take us very far – that even if we assume diminishing marginal utility it is not clear that a dollar lost to a rich guy causes less welfare loss than a dollar gain to a poor guy. But another reason is that in many cases where this might seem to matter, such as in the case of rent control and minimum wage legislation, it is not at all clear that the imbalances in “wealth” between buyers and sellers are all that apparent. Walmart pays more than the minimum wage. The people I worked for at a local golf range paid less. They were also quite poor and subject to massive swings in their income. It is not at all clear that had they been forced to pay me above minimum wage that the dollar increases to me improved my well being more than the loss of dollars hurt them. Not at all. The point here is not to dispute the insight, for it is correct, but it really boils down to an empirical question and furthermore, on its face, it is not as clear as me, a priori, that the distributional problems work the way that the conventional wisdom here claims they do.

Finally of course, such an insight is totally incomplete if we do not acknowledge several other important pieces of economic insight including the very serious public choice issues involved in actually setting prices “correctly” even if we wanted to take into account the initial distributional concerns, they also include the knowledge problem that is the very basis of support for an emergent price system – how do planners (ignoring their motives) even come about acquiring the knowledge about what the initial distributions look like, what the true welfare functional looks like and what actual prices should be set, and when and for how long, and so on. And of course such insights require us to be able to measure the kinds of distributional conditions that we are supposing are problems, and to take into consideration the long-term impacts of intervening in the price system in such a way. And this is just getting started.

I don’t think Waldman of course is suggesting that we actually act on this stuff, I think he is making a VERY GOOD point however that it should be clear what we are talking about when we are teaching the welfare theorems and understand the nuances that underly what seem to be very simple and rock-solid theories in microeconomics. Unfortunately, I think non-economists who read Waldman’s analysis are likely to go off the rails to suggest that the “whole entire apparatus” is a sham. And that’s not right. Finally, as Waldman makes pretty clear at the end, I think, is that nothing he says is inconsistent with the very principles of economics that are taught when covering this type of material. Go read about the “Second Fundamental Welfare Theorem of Economics” to see what I mean.

6 Responses to “Are Markets Internally Inconsistent?”

  1. Harry says:

    What clear writing. Thanks for the link, and I will study the subjects further, and if I have anything to argue with WC or the crickets, you bet I will point out fallacious reasoning.

    But I have read impenetrable prose all my life, wasting time to get to the end of an article that was worthless, and this includes not only academic socialists but also many writers in the WSJ and Barron’s.

    I too could not detect, with my sensitive dog whistle ears for calls from all dog whistles, any alarms. Through the first reading, I learned much. That was reading the piece and reading WC, who threw blood into the water, thinking that the crickets are sharks.

  2. Harry says:

    That is good writing worth reading, WC.

    I cannot calculate the time I have wasted reading impenetrable prose, often because the writer wants to disguise his or her lack of understanding, using jargon sprinkled with polysyllabic words. My colleague, when I asked for it, gave me research reports from a Smith Barney which consumed too much time.

    I was interested about the comment about people not having interest in trading just for trading among themselves, a wasteful activity. Then I thought about that worthless Smith Barney research, which was designed to stimulate trading. If one takes this BS seriously, one might seriously redistribute one’s income to someone else.

  3. Harry says:

    Sorry for the double posts on the same idea, Mike. You refer to many big ideas, all most interesting, but I meant to do a review of the writing.

  4. Harry says:

    Wintercow, our Socrates, has given his readers a whole summer assignment before he goes off to another mountain trip where he will hike and threaten us once again that he will blog never again. This was a great post, WC, but it reminds me of myself giving kids summer reading a half hour before I got to the golf course, this time in May, when the dogwoods were in full bloom.

  5. Harry says:

    Why, all of a sudden, are we arguing Marx? To enliven Fidel Castro, or to resurrect Che Guevata, Mao, Yang Yin, Stalin, Pol Pot, and the assorted Kim’s?

    Every single one of them, including Lenin, who is revered and taught by not just our universities, failed repeatedly, over and over, for more than a century, rivers of blood. That includes Hitler, with whom the Supreme Leader, the Ayatollah Khameni sympathasized about the Jewish problem. He was educated in Moscow, and is unlikely to understand anything WC has ever thought about.

    Khameni’s dream is not just the end of days, but inflicting harm upon everyone who did well since 800 AD, to blame it all on the Crusaders, who kept that sorry part of the world full of people who did not know whether tomorrow they will eat,

    So, who is the better philosopher, Hayek, or Rexford G. Tugwell?

    To those who are unequal, wake up at six, work smartly, and get a promotion.

  6. Harry says:

    “…the goal of market exchange is to allow people to be free in their economic lives…”

    An axiom worth repeating.

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