Crawl Across the Ocean

Tuesday, December 15, 2009

31. Moral Conditions of Economic Efficiency, Part 2

Note: This post is the thirty-first in a series. Click here for the full listing of the series.

Chapter 2 of 'The Moral Conditions of Economic Efficiency', by Walter Schultz, sets out to answer the question, "Can a population of strict rational egoists achieve efficient allocations of commodities in the absence of moral normative constraints?"

To answer this question, Schultz first constructs a social situation that depicts ' Strict Rational Egoism'. It is defined by 9 parameters.

The first 2 parameters describes the preferences held by agents (people who are strict rational egoists) in this model:

(p1) Each agent's preferences range over alternative social states defined solely in terms of their own consumption bundles

(p2) Agent's preference relations are stable. rational and locally non-satiated

The first basically says that people prefer one situation to another based on how much stuff they get (and not based on how much stuff other people get, or what people think of them, etc.)

The second basically just says that, whatever they have, they want more (and also that their preferences 'make sense' - they don't prefer apples to bananas, bananas to pears and pears to apples, and they don't prefer chicken to steak one minute and steak to chicken the next)

The next 3 parameters define how agents make decisions:

(p3) Agents' goals are selected according to a utility maximization criterion (i.e. the more the better)

(p4) Agents' beliefs depend only on information (and not on, for example, force of habit)

(p5) Agents are sufficiently and instrumentally rational (i.e. people try to get the most results for the smallest effort/expenditure of resources, think back to Patience saying how she never gives out money she doesn't have to).

The next two parameters define the positive (physical) limits of the situation.

(p6) Agents are constrained by a perfectly competitive market: numerous participants, homogeneous products, freedom of exit and entry, and perfect information (I covered perfect competition back here)

(p7) Agents control finite resources (seems reasonable)

The last two parameters define the social, or normative limits of the situation

(p8) There are no moral rules (that's what makes strict rational egoism 'strict'!)

(p9) There are conventions to equilibriate supply and demand (in other words, there is a mechanism for setting prices)

After setting out his 9 parameters, Schultz launches into a multi-page proof of the first welfare theorem, namely that the equilibrium result of perfect competition will be a pareto-optimal allocation of resources (i.e. nobody can be made better off without anyone being made worse off). The proof basically comes down to pointing out that if two people could make a trade that would benefit both of them (give them more satisfaction), they will, since they want more (by definition) and there is nothing stopping them from making the trade.

The reason Schultz goes through the proof in detail is to note that it relies on some elements that go beyond his 9 parameters defining strict rational egoism. In particular, it relies on 'price-taking' behaviour by people (i.e. people make no effort / have no ability to influence prices) and it also relies on specifying that externalities do not exist.

Schultz goes on in chapter 3 to explain how we can't assume that people act as 'price-takers' (externalities are covered in a later chapter and a later post) because they choose to trade at a given price even when they could take some alternative action (e.g. just take stuff from people, or trick them into giving it to you) because one of the given parameters (p5) says they wouldn't act that way, and if we remove (p5) then that will make the proof of the first theorem fail as well (if people aren't trying to get all they can, the market won't lead to a Pareto-efficient final outcome). So the only way out is to assume that people are not capable of committing acts of fraud or force that would let them get what they want. But the physical reality of markets means that people will have these opportunities.

Schultz explains how in a market where prices are set by an auctioneer (a common economic model of how prices are set), even if people refrain from using force and outright fraud, they can simply misrepresent how much they are willing to pay for certain items and this will benefit them at the expense of others (much in the manner that one seldom enters a negotiation by stating up front just how much they would be willing to pay for an item), causing the outcome not to reach a Pareto optimal outcome.

Another way out would be to assume some sort of Leviathan style referee who prevents/punishes force or fraud - but if the referee is a strict rational egoist (and everybody is in this model) then they will logically use their superior force to simply take everything they want.

Finally, the only solution left is a normative constraint, either directly on the market participants, or on the referee. People must decide for themselves not to take advantage of opportunities for force and fraud where they inevitably arise.

In a nutshell, what Schultz is saying is that when proofs of the economic efficiency of trade assume that people are 'price-takers' they are assuming a certain moral behaviour (restraint from force and fraud even where this would be beneficial to the person in question) that is inconsistent with people being strict rational egoists.

Note that *if* people could read each others minds so that they could never be fooled, and *if* there were not just a large, but an infinite number of buyers and sellers in the market and *if* everyone was capable of effortlessly defending possession of all their goods against any attempts at theft, and *if* we similarly assumed away any other possibilities for non-price taking behaviour, then we could agree that strict rational egoists could reach pareto-optimal outcomes.

The point is that once we take into consideration real factors that affect almost all real markets (people can't read minds, people *can* steal things and deceive others), the 'invisible hand' notion that people can achieve a good outcome (economic efficiency) by pursuing their own interests (via strict rational egoism) fails, unless supplemented by moral rules.

In the language of the previous post, in a world of people like Patience, economic efficiency will fail because Patience lacks a willingness to act as a price-taker, whereas in a world of people like Mal, it will succeed, and the difference between them is a difference in morals - Patience is a strict rational egoist, Mal is not.

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