by Filip Palda
Cambridge economist Arthur Pigou, though a laissez-faire advocate, had doubts about efficient markets and was among the first to integrate the idea of market imperfections into a coherent economic model. He argued that markets were plagued by “externalities”, such as pollution, which led certain products to be underpriced. Efficient equilibrium could be restored by a tax on those underpriced products. The Ford vehicle that sold for $1,000 was underpriced because in building it, Ford’s Dearborn factory polluted the Rouge River. If the environmental damage, such as a reduced fish catch, was $100 per car, then a tax was needed to sensitize Ford to the true cost of the inputs to its production process. In an economic sense, the killing of fish was such an input. A tax of $100 a unit would restore Pareto efficiency by forcing Ford to take account of the cost it was imposing on anglers. Government could then compensate the anglers by transferring the tax to them.
Pigou did not reject market economics, nor the idea of a Pareto efficient equilibrium, but merely sought to devise some mechanisms by which government could patch up “market failures” that led away from Pareto efficiency. His protégé John Maynard Keynes went much further.
Keynes doubted that labor markets reached equilibrium in the demand for and supply of workers. An excess supply of workers, what non-economists call unemployment, may persist if wages do not fall in order to entice employers to hire idle hands. Workers might make irrationally high demands for salaries that could keep them unemployed for long spells. Government then had to step in, not to lower wages, but to stimulate demand for the excess labor through public works.
Keynes and those who followed him did not go so far as to completely reject the market model. They simply felt that markets could not respond to surpluses and shortages of output rapidly enough to keep the economy in equilibrium. Government had to intervene directly in markets and had to build “automatic stabilizers” into the economy that would stimulate private demand in times of recession and slow it in boom times. These ups and downs in the economy were signs of the inefficiency in markets. Governments needed to smooth them out.
Pigou and Keynes established the bridgeheads from which many an assault on the classical free market model would be launched in decades to come. Yet their assaults obeyed a sort of Geneva Convention of economic debate. Discussion took place within the social accounting framework of market equilibrium. So while free market skeptics launched assaults, they did so in a manner that generally respected the rules of intellectual engagement. These rules were based in the social accounting calculus of the mathematical model of market equilibrium.
Socialist free-marketers
WHILE FOR SOME time the Pigou-Keynes critique of free market economics became the dominant mode of thinking about social accounts, there was a short-lived but zestful assault launched on market equilibrium social accounting by a group of thinkers who called themselves “market socialists”. They have largely disappeared as a coherent movement but their ideas continue to ripple through economics.
The label “socialist free-marketer” may seem apt as “puritan lecher” but it did have a certain logic. Their assault on free market thinking was less accessible to mainstream economists than the Pigou-Keynes assault, but in some ways it was far more devastating than the cannonades of Pigou and Keynes. Economists still struggle with the issues market socialists raised.
A prominent market socialist was Oscar Lange. In the 1930s he achieved the unlikely distinction of being a favorite of Stalin’s while at the same time being a senior professor of economics at the University of Chicago. In two articles published in 1936, he argued that if planners in the central bureau of a socialist dictatorship had all the information they needed on supply and demand, they could dictate prices and people would produce and consume in such a manner as to bring about an efficient equilibrium. If the planners got the prices wrong they could check where there were surpluses and lower prices and increase them in markets where there were shortages. This was a straightforward transposition from the way free markets attain equilibrium to centrally planned markets.
Lange’s articles were remarkable not just for their appropriation of free market reasoning to socialist causes, but also for their sarcasm towards the free market advocate Ludwig von Mises. In mock gratitude for explaining free markets so well that socialists could adapt them to their needs, Lange wrote, “Both as an expression of recognition for the great service rendered by him and as a memento of the prime importance of sound economic accounting, a statue of Professor Mises ought to occupy an honorable place in the great hall of the Ministry of Socialisation or of the Central Planning Board of the socialist state” (1936, 53).
Even Frank Knight, the great defender of free markets, who in the 1930s trained future Nobellists Milton Friedman and George Stigler, agreed with Lange. Knight wrote that “the place of marginal economics in a collectivist economy is not essentially different from its place in an economy of ‘competitive individualism’ … the problems of collectivism are not problems of economic theory, but political problems… A collectivist society of any type would necessarily confront the same economic problems, in the formal sense, as an individualistic one” (1936, 255–256). There was no surprise in similar views coming from differently minded scholars. They followed directly from the conception of the market as offering up prices that attracted consumers and producers to a fixed point in which supply equalled demand.
As Knight indicated, making the best use of resources subject to material constraints involves making trade-offs that move resources to higher value uses until a reshuffling of resources just barely exhausts the possibility for gain and so makes you indifferent to where you invest your last unit of resource, be that your labor, or your consumption. By the first welfare theorem, this is why competitive equilibria are efficient. The socialist view was that the logic of the welfare theorem could be inverted. Instead of allowing prices to emerge from supply and demand tensions in a decentralized market, socialists would deduce the correct equilibrium prices from their knowledge of the economy and allow these prices to guide people toward equilibrium.
Economists of a Freudian mindset might have surmised that socialists were suffering from “capitalism envy” because it seemed they were trying to inject elements of decentralization into a centrally planned system. After all, prices are indicators of the value of privately held and exchangeable property. Market socialists were not put out by this evident contradiction between central control and the need for prices. Their view was that a factory manager could follow a rule dictated from the center which said that if the value of the factory’s product was above what it cost to pay its workers, then it should hire more of them until their value diminished to the point where their return just equalled their cost. It was not made clear why managers should do this without being compensated with some share of the company’s profits, and thus de facto becoming shareholders, and thereby violating central control. Similarly, consumers could be given some “tokens”, or money as we usually call it, and respond to prices set to equate demand and supply. Owning money was a violation of central control but it allowed central planners to “grope” towards an equilibrium by varying prices. Despite these violations of the central control principle, market socialists believed them to be trivial, and thought they had discovered a way of achieving economic efficiency without delegating authority to capitalists.
The absorption of free market equilibrium into socialist prescriptions for economic dictatorship took place many decades ago. Yet this appropriation left questions unanswered. How could socialist central control and capitalist free enterprise market equilibrium lead to the same result? And if they did, what was the whole debate between left and right all about?
Free market defender and future Nobellist, Friedrich Hayek (1945) argued that no central planning bureau could gather all the information on people’s tastes and productive abilities. Without such particular “knowledge of time and place” it would be impossible to know demand and supply
curves and thus to dictate efficient prices in a socialist centrally controlled economy.
Hayek argued that a free market dealt with this enormous quantity of information not by gathering it up in a central bureau but through the emergence of prices that moved up or down until supply and demand equalled each other without the aid of some all-seeing planner.
The equation of what people produced and what they consumed was a “coordination problem” of high order brought about by prices that adjusted to the particulars of everyone in the market, the realities “time and place”. Market socialists countered that the central planner did not need knowledge of time and place. All the planner had to do was post a price, see if it resulted in a shortage, then increase the price until demand and supply equilibrated.
The stalemate between Hayekians and market socialists over the best way to coordinate the actions of large numbers of people lasted until the union of game theory and information economics in the 1970s. Nobellist Roger Myerson (2008), who helped pioneer this fusion into a field called “mechanism design”, argued that there were some sorts of informational problems that in particular plagued capitalism and others that plagued socialism. In either system it is difficult to monitor how well managers perform their duties. Capitalist systems solve the problem by paying managers with company shares so as to align manager and firm interests without the need to constantly monitor what managers are up to. Socialism did not give managers shares in their factories and never quite figured out how to monitor performance. The result was that managers had power without responsibility. This is a recipe for what economists call “moral hazard”. The widespread shirking of duties and looting of enterprises was one of the reasons the Soviet system collapsed.
Capitalism was not without flaws. It had a particular informational problem called “adverse selection”. Job candidates for managerial posts may misrepresent their abilities in order to get hired. Or salesmen may lie about the quality of their product in order to make a sale. Socialism removes the incentive for misrepresentation by paying people in a manner that has little to do with their qualifications.
Mechanism design theory saw these strategic interactions between people as games that could be manipulated to make people act honestly and obediently once government implemented the proper rules and reward schemes. The only problem was that when government was designing the rules, the costs of getting everyone to behave could be higher than the benefits. Despite Myerson’s diplomatic clarification of the types of informational issues involved, the socialist calculation debate still rages, driven on the socialist side by the feeling that capitalism is unjust, and on the Hayekian side by the overwhelming real-world evidence of the inefficiency and corruption of socialist economies.
Political equilibrium
MARKET EQUILIBRIUM IS not the be-all and end-all of social accounting. A great deal of spending is determined not in private markets but by government. Demand and supply analysis is not directly applicable to government because of a fundamental difference in the way that private markets and governments work. Private markets are based on the consensus of every single person involved in a trade. The “decision rule” for how private resources are to be used is one hundred per cent unanimity. If you do not like a certain car you do not buy it. No one can force you into the purchase nor can the dealer be forced to sell to you. In private market equilibrium, price brings about a unanimous consensus by equating how much buyers want with the amount sellers provide. Market equilibrium tools such as supply and demand are easy to apply to situations such as these because the objectives of all parties are clear. Consumers wish to maximize well-being subject to the constraint of income and prices, whereas producers wish to maximize profits.
That is not the way it works with government. Whether in a dictatorship or a democracy, most people have no direct say in what government buys on their behalf with their money. The reason is sometimes political and sometimes technical. The entire rationale for having a government which coercively removes money from your paycheck is the presumed existence of goods and services which everyone would be willing to buy, but for which private firms find themselves unable to charge. Think of street lighting. It has huge benefits for almost everyone except night prowlers and back-door men. Yet private firms do not have the incentive to build a network of lamps. It is technically very difficult to charge someone every time he or she walks under a lamp in a public street at night. Private citizens might start a charitable collection, but the lights might not get built if some citizens shirked their contributions in order to “free-ride” on the contributions of others. The result is that a project that is affordable and good for everyone might falter because some users do not pay their share of the costs. The free riders in this story cripple society’s ability to coordinate itself for everyone’s good. In the end, because the project does not get done, even potential free riders suffer.
Most economists really do not like to think too deeply about scenarios such as how to build street lamps. That is “public stuff”. Their malaise stems from the lack of an accepted equilibrium model of group behavior to tell them whether the lamps will get built or not, or if they are built whether too many or too few will be installed. More generally, there is no accepted model of how groups of people will collectively decide how resources should be used. That does not mean there are no models. On the contrary, models proliferate. They blossom because no one can quite agree on what are the core incentives driving people who influence government. The field seems to be split into a naïve segment which takes government as a pure do-good institution serving the interests of the people, and a cynical segment which sees government as an impartial vehicle for a variety of extractive interests.
Duncan Black’s celebrated 1948 Median Voter Model can be considered a naïve model of political equilibrium. It proves that under very specific conditions the wishes of the “median” voter, whose income is right in between the income of the poor and the rich, will be the voter whose wishes politicians try to please. Under even more specific conditions the political equilibrium that results will lead to a Pareto efficient level of street lighting and other similar “public goods”. Black’s model presumes a true democracy with rulers who count votes honestly.
Nobellist Gary Becker’s 1983 model can be categorized as cynical. According to Becker, political equilibrium exists even in non-democratic societies. It arises out of a simple calculation that predatory interest groups and their taxpaying victims make: what return on my investment can I get by lobbying government? Becker’s insight is that the gains to predators are linear, but the losses to prey are exponential, thereby stiffening the resistance of victims as the aggression of predators plods on without similarly increased vigor. Think of a gang of robbers taking half the crop from peasants. They then return for the second half. The gain to the gang of the second half cut is the same as in their first extortion. Yet for peasants to lose the last half of their crops means possible starvation and the certain loss of seed corn. They can be expected to resist violently, as they did in the Hollywood movie The Magnificent Seven and in the Japanese movie on which it was based, The Seven Samurai.
Black and Becker are but two of many contending modelers of political equilibrium. They are joined by Gordon Tullock, Nobellist James Buchanan, and others who have launched a new school of economic analysis called Public Choice. It is geared towards modeling equilibrium in politics. In this quest to decide what is the basis of political equilibrium, a system of social accounts remains the basic datum of interest. And ultimately Pareto efficiency is the quest.
The example of politics highlights that equilibrium is more than an economic concept. It represents some ideal, efficient point towards which societies strive. If the ideal is inferior, as in the case of the Soviet Bloc, then these societies become inferior and eventually crumble. The US bankrupted the Soviet Union in the arms race of the 1980s. It was able to do so because American society was based on a social accounting system that encourage
d effort and innovation from its people.
The Russian system stifled initiative and failed to control looting of government resources on a massive scale by the very leaders who were supposed to guide the collective good. The social accounting of the free market was able to motivate Americans to produce arms far more efficiently than was the collectivist social calculus of communist Russia.
The dark matter of economics
DESPITE THIS STUNNING vindication of the benefits of decentralized control and the weaknesses of communist dictatorship, there is still much we do not know about how equilibrium arises. We may know what equilibrium is, but we have a harder time knowing how people attain it. This lack of knowledge makes it premature to judge based purely on economic theory whether a free market would have been better for Russia than a communist dictatorship.
We lack data that would allow us to make a comparison. In particular we lack the “counterfactual” experiment demonstrating what would have happened had Russia taken the free market path after 1917. Without such a comparison between what was and what might have been, we can at best use our models and notions to speculate on the superiority of one system of social accounting over another.
French writer Milan Kundera said much the same thing in his novel The Unbearable Lightness of Being in which he lamented that nothing could be learned from life because we could not rerun the experiment of our existence to see if different choices might have improved our lot. Soren Kierkegaard had a more statistical approach. He wrote that “Life has its own hidden forces which you can only discover by living.” Both have a point.
These challenges to equilibrium should be seen as calls to a treasure hunt rather than as obituaries. One of the great and fascinating mysteries of equilibrium lies in the pre-conditions for its emergence. Efficient market equilibrium is difficult to achieve without property rights protected by the rule of law. Harold Demsetz pointed out in his 2002 article that such rights can only arise if the costs of elaborating and maintaining property rights are lower than the benefits they generate.
