The fundamental theorems of welfare economics indicate that markets can be extremely effective ways of determining social production and allocating goods. It should follow that interfering with the market mechanism can be quite costly.
For example, consider price controls. Superficially, it looks like price controls -- "artificially-generated" lower prices -- benefit consumers and hurt firms. However, in a state of disequilibrium supply does not meet demand and consumers will find that they are not able to consume as much as they would like at the fixed price. This creates a rationing problem that needs to be solved in some way. Some consumers will certainly become worse off due to the restriction on trade that they face.
Or consider sales taxes. Say watches cost $6 each in a "free market." Consumers who would gain more than $6 in value from consuming an additional watch will purchase one; firms who can produce an additional watch for less than $6 will do so, and they will engage in mutually beneficial transactions. But if the government charges $1 tax on each watch sale, then a transaction will only occur if the consumer values the watch at least $1 more than its cost. So some parties lose out. Indeed, the loss to the parties is greater than the gain to the government -- this is the deadweight loss of taxation.
If we assume that all parties are identical -- a "representative consumer" or "representative firm" shall we say -- then it follows that everyone in general is hurt by price controls and sales taxes. However, if parties have sufficiently different, then it may be possible that price controls or sales taxes benefit certain parties at the expense of others. The exposition followed so far has not focused on differences.
Monday, December 11, 2006
Monday, December 4, 2006
The Theorems of Welfare Economics
We model a "free market" consisting of consumers, firms, and goods. To keep things simple, we will focus on a single good, butter, and lump all other goods together under "wealth."
Butter can be bought and sold at the market at a single price. Firms produce butter and then sell it to consumers. Consumers seek to maximize the "utility" they enjoy from having wealth and consuming butter, but they can only consumer more butter by giving up some of their wealth. Firms seek to maximize profits by producing butter at a cost and then selling butter to consumers. (Firms are coincidentally also owned by consumers, whose wealth is partly dependent on the profits generated by the firms they own.)
What determines the "single price" in the market? An unspecified process known as "reaching equilibrium." If the price of butter is too high, then producers will be encouraged to produce lots of it, but then will not be able to sell all of it at this price. If the price of butter is too low, then consumers will want to buy lots of it, but producers will not produce enough to meet demand. In either of these cases, there will be "pressure" to move prices in one direction or the other. At the equilibrium price, this pressure disappears -- the market clears.
There are two questions to consider: 1) how much butter is produced and 2) how much of the produced butter is allocated to each consumer.
For consumers, more butter is better, although the gains in utility from more butter decrease as more butter is consumed ("diminishing marginal utility"). The consumer faces a tradeoff in enjoying more butter and paying for it. The first unit* of butter is likely to bring in a lot of utility, worth more than the price of butter, but as additional units of butter are consumed this eventually becomes untrue. So the consumer's consumption is determined by
Marginal Utility of Butter to Consumer = Cost of Butter to Consumer (= Market Price)
For firms, the cost of producing butter typically decreases with the initial production of a few units, due to fixed costs; it later eventually rises. Because they want to maximize profits, firms increase production until the gain from selling more butter (market price) no longer exceeds the cost of making more butter. So the firm's production is determined by
So the market determines the total amount of butter produced, and how it is allocated to consumers.
We next compare the performance of the "free market" to the performance of an Omniscient Planner who selects how much butter is to be produced by each firm and how much butter is to be consumed by each consumer. To avoid getting too bogged down with normative comments, we only compare outcomes if one is at least as good as the other for every consumer.
1. If the planner wants to produce the same amount of butter as the market solution, it is impossible to do it cheaper than the market solution.
2. If the planner decides to produce more (less) butter than the market solution, then it is possible to select a better outcome.
3. If the planner produces the same amount of butter as the market solution, but distributes it differently, then it is possible to select a better outcome.
The basic argument is that if one consumer would prefer cash to butter, and another would prefer butter to cash, then they could each made better off at no cost to anyone else by simply trading butter for cash. This will be the case when we are not at the market equilibrium.
From this reasoning we have the two Fundamental Theorems of Welfare Economics:
1. Market equilibria are Pareto optimal.
2. All Pareto optimal outcomes can be achieved through market equilibria (and the redistribution of initial wealth).
*Being able to define butter in "units" is one of a myriad of assumptions used here. Some more important assumptions are: 1. being able to assume away the equilibrium process; 2. firms lacking any sort of market power and being easily undercut by competition; 3. consumers' utility functions are completely independent; 4. optimal outcomes are described with minimal reference to the distribution of wealth.
This post will be modified again in the future, but I need to move on now.
Butter can be bought and sold at the market at a single price. Firms produce butter and then sell it to consumers. Consumers seek to maximize the "utility" they enjoy from having wealth and consuming butter, but they can only consumer more butter by giving up some of their wealth. Firms seek to maximize profits by producing butter at a cost and then selling butter to consumers. (Firms are coincidentally also owned by consumers, whose wealth is partly dependent on the profits generated by the firms they own.)
What determines the "single price" in the market? An unspecified process known as "reaching equilibrium." If the price of butter is too high, then producers will be encouraged to produce lots of it, but then will not be able to sell all of it at this price. If the price of butter is too low, then consumers will want to buy lots of it, but producers will not produce enough to meet demand. In either of these cases, there will be "pressure" to move prices in one direction or the other. At the equilibrium price, this pressure disappears -- the market clears.
There are two questions to consider: 1) how much butter is produced and 2) how much of the produced butter is allocated to each consumer.
For consumers, more butter is better, although the gains in utility from more butter decrease as more butter is consumed ("diminishing marginal utility"). The consumer faces a tradeoff in enjoying more butter and paying for it. The first unit* of butter is likely to bring in a lot of utility, worth more than the price of butter, but as additional units of butter are consumed this eventually becomes untrue. So the consumer's consumption is determined by
Marginal Utility of Butter to Consumer = Cost of Butter to Consumer (= Market Price)
For firms, the cost of producing butter typically decreases with the initial production of a few units, due to fixed costs; it later eventually rises. Because they want to maximize profits, firms increase production until the gain from selling more butter (market price) no longer exceeds the cost of making more butter. So the firm's production is determined by
Marginal Cost of Butter to Firm = Market Price
So the market determines the total amount of butter produced, and how it is allocated to consumers.
We next compare the performance of the "free market" to the performance of an Omniscient Planner who selects how much butter is to be produced by each firm and how much butter is to be consumed by each consumer. To avoid getting too bogged down with normative comments, we only compare outcomes if one is at least as good as the other for every consumer.
1. If the planner wants to produce the same amount of butter as the market solution, it is impossible to do it cheaper than the market solution.
2. If the planner decides to produce more (less) butter than the market solution, then it is possible to select a better outcome.
3. If the planner produces the same amount of butter as the market solution, but distributes it differently, then it is possible to select a better outcome.
The basic argument is that if one consumer would prefer cash to butter, and another would prefer butter to cash, then they could each made better off at no cost to anyone else by simply trading butter for cash. This will be the case when we are not at the market equilibrium.
From this reasoning we have the two Fundamental Theorems of Welfare Economics:
1. Market equilibria are Pareto optimal.
2. All Pareto optimal outcomes can be achieved through market equilibria (and the redistribution of initial wealth).
*Being able to define butter in "units" is one of a myriad of assumptions used here. Some more important assumptions are: 1. being able to assume away the equilibrium process; 2. firms lacking any sort of market power and being easily undercut by competition; 3. consumers' utility functions are completely independent; 4. optimal outcomes are described with minimal reference to the distribution of wealth.
This post will be modified again in the future, but I need to move on now.
Sunday, December 3, 2006
More Soros on Market Fundamentalism
Page 143:
He points out that markets take existing distributions of wealth as given; that common interest does not find expression in market behavior; and that financial markets are inherently unstable. Therefore political processes, despite their flaws, are necessary.
Market participation and rulemaking are two different functions. It would be a mistake to equate the profit motive that guides individual participants with the social considerations that ought to guide the setting of rules... How can [market fundamentalists] get away with it? Their first line of defense is that they are simply modelling how people behave: "People may talk about right and wrong, but when the chips are down they act according to their interests."...Soros questions both the existence of equilibrium and claims that "it is not the tendency to equilibrium that creates wealth, but the release of creative agencies... [which] does not ensure social justice." Emphasis added, because I am not sure what he means.
But... they are not modeling actual behavior; rather, they are building models on a peculiar assumption of rationality. Second, values are reflexive, and market fundamentalism tends to reinforce self-serving behavior in politics... Third, even if their models corresponded to reality, that would not make their argument right. Economic actions have social consequences that cannot be dismissed on the grounds that people are selfish.
That is where the market fundamentalists' second line of defense kicks in: "Markets tend toward equilibrium, so the pursuit of self-interest also serves the public interest." ...
He points out that markets take existing distributions of wealth as given; that common interest does not find expression in market behavior; and that financial markets are inherently unstable. Therefore political processes, despite their flaws, are necessary.
Soros on Values
Pages 112-115:
People have bemoaned the lack of shared social values throughout history, but there is one factor at play that makes the present different from other times: the spread of market values that give precedence to self-interest over the common interest... lasting relationships have been replaced by individual transactions... national economies have been superseded by an international economy, but the international community, insofar as it exists, shares few social values...Page 125:
We are inclined to take social or moral values for granted... "intrinsic" or "fundamental"... Nothing could be further from the truth... Social values are reflexive. They are influenced by social conditions and, in turn, play a role in making social conditions what they are...
Social values express a concern for others. They imply that the individual belongs to a community... whose common interest takes precedence over individual self-interests... [M]arket fundamentalism... maintains that the common interest is best served by everyone pursuing her own self-interest. That gives the pursuit of self-interest a moral blessing. Those who adopt the creed tend to come out ahead because they are not encumbered by moral scruples in a dog-eat-dog world -- and such success can be reinforcing...
[Humans] tend to reach out for values that extend beyond their narrow selves. Even when they pursue their self-interest, they seem to have a need to justify their behavior by appealing to principles that go beyond themselves. As Henri Bergson pointed out, morality can have two sources: tribal belonging and the universal human condition.
Although social values and moral precepts are in doubt, there can be no doubt about the value of money. That is how money came to usurp the role of intrinsic values.
Soros on Types of Socities
Pages 106-108:
Instead of a dichotomy between open and closed society, I now envisage open society occupying a precarious middle ground, where it is threatened by dogmatic beliefs of all kinds -- some that would impose a closed society, others that would lead to the disintegration of society...
...many things are possible in revolutionary situations that are inconceivable in normal times... When I was fourteen, in 1944, the Germans occupied Hungary and engaged in genocide against the Jews; I might not have survived had it not been for my father. He realized that this was a far-from-equilibrium situation in which the normal rules did not apply... I learned that the same rules do not apply at all times... Bureaucratic institutions, in particular, are constitutionally ill-suited for the task. That is why they tend to break down and collapse if the dynamic disequilibrium becomes too severe...
The fact that I had to revise a dichotomy and replace it with a tripartite division should warn us how precarious these divisions are. That does not detract from the values of the insights they provide, but it reminds us forcefully that the categories have been introduced by us and are not found in reality.
Soros and Social Science
Page 48:
Page 82:
In my opinion, there is a better way to protect scientific method than the one Popper suggests. All we need to do is declare that the social sciences are not entitled to the status that we accord the natural sciences. This would stop pseudoscientific social theories from masquerading in a borrowed suit of armor; it would also discourage the slavish imitation of natural science in areas where that is not appropriate. It would not prohibit the scientific study of human behavior, but it would help scale down our expectations about the results. My suggestion would also constitute a major loss of status for social scientists, so it is unlikely to be very popular among them.
Page 82:
Economists such as Robert Solow reject my interpretation because it does not provide any determinate explanation or prediction of market behavior. They are right, of course. My contention is that reflexivity injects an element of uncertainty that renders financial markets inherently unpredictable. I claim that recognizing this fact puts us in a better position to anticipate and react to market moves than does a supposedly scientific theory; but I have not produced a scientific theory.
Soros and Self-Criticism
Page 33:
I sought out a number of politicians who had served in previous governments and asked them how they would handle the situation. To a man, they said they would apply the same policies they had followed when they were in power. Rarely had I met so many people who had learned so little from experience.Page 35:
But other charismatic personalities have not arrived at their leadership positions following the same route... They probably remember that they always tried to get others to believe in them, and eventually they succeeded. They are not consumed by self-doubt, and they do not need to repress the urge to express it... People do not want their leaders to be fallible. That is one of the worst defects of our contemporary democracies.
Soros and Reflexivity
Soros, "Open Society," page 7:
On the one hand, the thinking participants seek to understand the situation in which they participate. I cal this the passive or cognitive function. On the other hand, they participate in the situation that they seek to understand. I call this the active or participating function. Instead of a one-way street, there is a two-way interaction... The intererference introduces an element of indeterminancy into both functions that would be absent if the two functions operated independently of each other. That is what I call reflexivity.Page 13:
Karl Marx claimed that the material conditions of production determined the ideological superstructure; Sigmund Freud claimed that human behavior was dictated by the unconscious; and classical economic theory was based on the assumption of perfect knowledge... In accordance with the standards prevailing in the nineteenth century, the explanation had to be deterministic in order to qualify as scientific.Page 15:
The paradox of the liar was for the longest time treated as an intellectual curiosity and was neglected because it interfered with the otherwise successful pursuit of truth. Truth was defined as the correspondence of statements to external facts.Page 21:
We should remember, however, that our fallibility is liable to create a gap between intentions and outcomes. Instead of the futile pursuit of the perfect design -- whether in the form of communism or in the form of markets that tend toward equilibrium -- we should content ourselves with the next best thing: a society that holds itself open to change and improvement. This is the concept of open society.
Saturday, December 2, 2006
George Soros and Market Fundamentalism
In the Introduction to "Open Society," (page xxiv), Soros writes:
In "Milton Friedman Was Right: 'Corporate Social Responsibility' Is Bunk," Henry Manne argues that while he once thought that laws against corporate social responsibility (CSR) were ill-advised -- after all, corporations might easily dress up the pursuit of private profit as social responsibility -- it turns out that he was wrong, and the late Milton Friedman was right. The bottom line: the notion of CSR has been used to turn Coca-Cola and Wal-Mart into "crypto-public enterprises that are the essence of socialism."
Since even the largest corporation starts out as an idea in someone's head, and grows through a vast number of voluntary contractual agreements, Manne wonders when exactly the public gains a stake in the private property. "If one apple is a fruit, even a billion apples do not become meat."
Manne also views the stakes as very high: "Our laws against extortion do not function effectively when it comes to corporations." And he views responsible business officials as being too afraid to contradict the notion of CSR publicly -- "for fear of financial ruin, even though the practice continues to cost shareholders and society enormous amounts."
And: "The origins of this transformation lie in the minds of people who do not like or appreciate the genius of capitalist success stories, including always politicians, who will generally make any argument in order to control more private wealth."
Market fundamentalists believe in individual freedom, which is the cornerstone of open society, but they exaggerate the merits of the market mechanism. They believe that efficient markets assure the best allocation of resources and that any intervention, whether it comes from the state or from international institutions, is detrimental. Since market fundamentalism has become so influential, it today constitutes a greater threat to a global open society than communism or socialism, because those ideologies have been thoroughly discredited.
In "Milton Friedman Was Right: 'Corporate Social Responsibility' Is Bunk," Henry Manne argues that while he once thought that laws against corporate social responsibility (CSR) were ill-advised -- after all, corporations might easily dress up the pursuit of private profit as social responsibility -- it turns out that he was wrong, and the late Milton Friedman was right. The bottom line: the notion of CSR has been used to turn Coca-Cola and Wal-Mart into "crypto-public enterprises that are the essence of socialism."
Since even the largest corporation starts out as an idea in someone's head, and grows through a vast number of voluntary contractual agreements, Manne wonders when exactly the public gains a stake in the private property. "If one apple is a fruit, even a billion apples do not become meat."
Manne also views the stakes as very high: "Our laws against extortion do not function effectively when it comes to corporations." And he views responsible business officials as being too afraid to contradict the notion of CSR publicly -- "for fear of financial ruin, even though the practice continues to cost shareholders and society enormous amounts."
And: "The origins of this transformation lie in the minds of people who do not like or appreciate the genius of capitalist success stories, including always politicians, who will generally make any argument in order to control more private wealth."
December Goals
Questions for December 2006:
1. What are the fundamental theorems of welfare economics?
2. How do externalities affect the outcomes generated by market processes?
3. What are public goods?
4. How does market power affect the outcomes generated by market processes?
5. How do asymmetries of information affect the outcomes generated by market processes?
Core Reading List
Mas-Collell et al, Chapters 10 through 14
Additional Reading:
George Soros, "Open Society"
A.J. Ayer, "Hume"
Mark Ridley, "Mendel's Demon"
Scott Atran, "In Gods We Trust"
1. What are the fundamental theorems of welfare economics?
2. How do externalities affect the outcomes generated by market processes?
3. What are public goods?
4. How does market power affect the outcomes generated by market processes?
5. How do asymmetries of information affect the outcomes generated by market processes?
Core Reading List
Mas-Collell et al, Chapters 10 through 14
Additional Reading:
George Soros, "Open Society"
A.J. Ayer, "Hume"
Mark Ridley, "Mendel's Demon"
Scott Atran, "In Gods We Trust"
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