03 November 2008

Goal of Econ, Goal of US Const, Goal of America

Imagine you are in charge of all the goods, resources, and services in the US. Now, you are charged with the task of allocating those goods among all the people subject to the condition that after you allocate, you could not make any one person better without making another worse. This conditions is a little stronger than making sure you allocate all the goods, its called the Pareto Condition. Consider the following reason.


One of your resources is Lake Michigan, and there is a factory located on its shore. It costs the factory $10 more to discard of its byproducts cleanly than to disperse them into the lake. On the other hand, the factory polluting the lake costs the fishermen $30 of lost fish. If you had allocated the goods such that you gave the water rights to the factory, you did not satisfy the Pareto condition. You could have allocated the water rights to the fishermen and then taken $11 from the fishermen to give to the factory. Under this reallocation you would have made everyone better without anyone worse off. The fishermen get $19 instead of zero. The factory disposes its byproduct cleanly, and makes $1.


Economics literally means "the study of the allocation of limited resources." Finding optimal allocations is not the difficult part of the process. The famous mathematician LaGrange gave us a very powerful tool for finding optimal allocations under constraints. If we had a benevolent social planner, he or she could take all the peoples' preferences and the resource constraints facing our country, simply apply Lagrange's method, and achieve the social welfare maximizing allocations.


Although some dictators claim they are benevolent social planners, no country truly has a benevolent social planner with access to a detailed Social Welfare Function, a hypothetical description of all peoples' preferences. Is it possible to achieve the same allocations that a perfectly intelligent and benevolent social planner would have chosen without such a social planner and without access to everybody's preferences?


Believe it or not, the answer is a glorious yes. The great Scottish economist Adam Smith conjectured that allowing potential buyers and sellers to freely meet in the market place and trade their goods until content results in Pareto allocations. Smith's conjecture was studied greatly. Finally, in the middle of the 20th century, it was proven that, with the exception of a few named market imperfections, free markets do achieve Pareto allocations without a social planner and without access to everyone's preferences: The Fundamental Welfare Theorem of Economics. To all but econ grad students, this may sound impossible, but it's true. To me, this theorem's characterization of market allocations is awesome.


With this useful Theorem in hand, and recognizing that omniscient and benevolent Social planners do not exist, countries faced a decision. Do they institute social planners, and give them powers to dictate to their citizens in hopes of eventually achieving social planner-like allocations; or 2) learn how to correct the market perfections, leave all freedoms and liberties in the hands of the citizens, and allow the marketplaces to flourish.


Many nations chose the former option. It was a formidable challenge. With teams of brilliant physicists, mathematicians, and economists studying optimal allocations they still often fell short. Those of you in my generation may recall images on TV of ultra-long lines at Soviet bakeries. First the USSR had under allocated baking ovens, under allocated distribution venues for the bread, and sometimes hadn't grown the proper combinations of flour and yeast to make bread efficiently. They suffered surpluses in some commodities, and shortages in other. Dictating all the commodities in an economy is an overwhelming task. There is no doubt that the soviets tried very hard, but also that politics and personal preferences also get in the way efficient planner allocations. Today many nations continue to try the command economy. Some have realized it is absolutely impossible to govern all commodities, and so they have decentralized some, but retain control over as many as possible. These countries are characterized by large governments, high tax rates, and few small businesses: examples include, Cuba, Venezuela, North Korea. China is an example of a country which has persevered and is actually realizing decent allocations for their people, although their people still do not enjoy all the freedoms and liberties of a decentralized economy.


Alternatively, some nations chose option 2, learning how to correct market imperfections subtly. The objective for these nations was to have a government that stood only to correct the market imperfections. With markets corrected, individuals can go to their marketplaces, trade and acquire Pareto allocations, all while preserving individual liberties and freedoms (no extraneous government dictations over their actions). This was the idealistic goal of the United States who led the charge and supported other nations who wanted to participate in the glamorous experiment. The US has definitely not been perfect in their implementation of this ideal. Politics and breakdowns in our system of government has ignored some of our citizens and over represented others. The result of these political breakdowns has often been imperfect market solutions biased for the over-represented special-interest contributors, and has held our country back from achieving the destined goal of Pareto allocations.


I do not intend to insult our form of governance, only suggest that there is some work left to do. Our constitution, in my mind, is the greatest document of all time. It has bound our diverse and challenged nation for hundreds of years. It is the longest standing charter of any nation, and also the shortest in length. It was written in 1789 by the polymath James Madison, before Adam Smith's auspicious conjecture. It has had to be amended (27 times in fact), and therefore is a working document for us to improve upon as new economic discoveries are made, but the constitution itself is what authorizes it to be amended. Let us not shirk on our responsibility to continue the journey of crafting the constitution so that US citizens can enjoy Pareto allocations all while fully enjoying individual liberties and freedoms.






Anonymous said...

I hate to be a nitpicker, but the Wealth of Nations was written in 1776, before the US constitution. (I'm also not sure if it's fair to say that Smith is conjecturing what Arrow is proving, but that's another story.)

mastro said...

right on, Madison wrote the Constitution (1789) following the Wealth of Nations (1776). Madison likely was familiar with Wealth of Nations content while structuring our government to govern markets.

second point also fair, i agree that Smith never formally conjectures the FWT, but does ruminate about the efficiency of markets.
to be fair, i should say that Arrow formalizes Smith's treatment of the efficiency of markets.