Economic Theory does not Predict that Markets Produce Efficient Outcomes

Ingrid Robeyns (h/t Steve Waldman) in Economics as a Moral Science questions economists’ use of Pareto efficiency arguing that it is not value-neutral, but I actually think that adding normative analysis to economics is of distinctly secondary importance to simply insisting that economists and those who make policy on the basis of economic principles get their positive analysis of economics right.

First, in most real-world economic environments economic theory very clearly fails to predict that market trade will produce efficient outcomes. The prediction of efficient prices as a market outcome relies fundamentally on the assumption that all participants in the market are “price-takers” — in other words, all market participants must honestly reveal their private information about the their inventories and their desires, or economics does not predict efficient prices. As soon as the issue was clearly framed, economic theorists determined that efficient market equilibria are incentive compatible for the participants in the market when there are very many (technically infinite) market participants on both sides of every single market, but in general makes no predictions about efficiency in other circumstances. (See, e.g., John Geanokoplos “Arrow-Debreu Model of General Equilibrium” p. 122.) In short, because there is no reason to believe that efficient market equilibria are likely to be incentive compatible with real-world behavior except when all market participants are very small relative to the size of the market, game theory is extremely popular among economic theorists.

Second, the concept of Pareto efficiency divides social states into only two categories: states where the allocation is efficient and states where it is not. Thus, once we have reason to believe that the market is unlikely to produce an efficient outcome, the whole set of Pareto efficient outcomes comprises an appropriate target for government intervention.  For this reason, Pareto efficiency states that if we can design a policy that takes everything (or something or nothing) away from the rich, but ends up at an allocation where nobody’s welfare can be improved without reducing the welfare of someone else, then the government policy is an improvement over the market. In short, the second theorem of welfare economics makes it crystal clear that government policies that have redistributive aspects are entirely consistent with economic efficiency.

Overall, the problem with economics is not the use of Pareto efficiency, but the failure to acknowledge the implications of economic theory for the importance of the structure of our markets. Economics predicts efficient prices only when markets are carefully structured to make the revelation of private information incentive compatible. (See Mechanism design and  Auction theory.) An ill-defined concept of a “market” is not predicted to produce the same result, but instead to induce strategic behavior about when and how to reveal information.  When market participants are behaving strategically in an environment not designed like an auction to induce the revelation of truthful information, economic theory does not predict that the outcome will be efficient.

The fundamental problem with modern economics does not lie in the use of Pareto efficiency, but in the failure of both the broader economics profession and policy-makers to incorporate the implications of economic theorists’ formal economic analysis into their intuition about how the economy works.

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