The God's-eye View of the Economy
A Background Essay
I studied economics in the late 20th century. The concepts of optimization and optimality were absolutely central. (I was born in 1954, went to college from 1971-1975, and finished grad school in 1980.)
In 1947, Paul Samuelson published the hubristically titled Foundations of Economic Analysis (based on his doctoral dissertation!). He argued for a conception of economic theory as the study of the mathematical properties of models in which consumers and firms optimized their uses of resources.
Academic economists took Samuelson’s formulation to heart. For mainstream economists, an optimizer of satisfaction is what a consumer is. As an individual, you or I can be represented mathematically as agents who maximize the utility (satisfaction) that we get from our choices of how much to work, how much to save, and what to buy.
Similarly, a maximizer of profits is what a firm is. From the local barbershop to Amazon, a firm can be represented mathematically as an agent that maximizes the difference between the revenues it obtains from outputs and the cost that it pays for inputs.
Mainstream economics also attempted what I call the God’s-eye View of the economy. Call this GV.
GV was represented mathematically as a Social Welfare Function.1 In theory, the goal of society was to attain the maximum value for this. Also in theory, the role of government would be to make this happen.
For the economy as a whole, economists have a criterion that they call Pareto Optimality. If resources are utilized in such a way that no one can be made better off without someone else being made worse off, then the allocation of resources is Pareto Optimal.
There are many allocations of resources that can be Pareto Optimal. For example, if I own everything and everyone else owns nothing, then nobody else can be made better off without taking something away from me.2 So that is Pareto Optimal. That sounds like a misuse of the term “optimal,” and it is.
When they are being more careful, economists distinguish between Pareto Efficiency and Social Optimality. Pareto Efficiency is the set of possible outcomes in which no one can be made better off without making someone else worse off. Social Optimality means that taking a God’s-eye view (GV again), society has chosen from that set the outcome that is best. GV probably does not result in the outcome in which I own everything and everyone else owns nothing.
In mid-twentieth century economics, government’s role is to move society toward the Social Optimum. This can be decomposed into two elements. One element is to correct “market failures.” The other element is to implement redistribution according to GV.
Market failures mean that the unregulated market will fail to achieve Pareto Efficiency. Market failures arise because ASSUMPTIONS are violated.
The ASSUMPTIONS undergird a basic theorem in economics. That theorem states that if there is a way to make one person better off without making anyone else worse off, the free market will find it. The intuition of this theorem is that the optimizing household will choose for itself the best consumption basket given market prices, while the optimizing firm will choose for itself the best mix of outputs and inputs given market prices. In the process of carrying out these optimizations, consumers and firms will take advantage of every opportunity to make someone better off without making someone else worse off.
The ASSUMPTIONS include some that are highly unrealistic. One assumption is that consumers are perfectly well informed about their choices. Obviously, this is not true. Another assumption is that there is no advantage to being a giant firm in any market. Again, this is obviously not the case, since we can see the advantage that Amazon or Wal-Mart have in negotiating with suppliers or the advantage that Facebook has relative to a smaller social network.
In the latter half of the 20th century, economists identified many market failures. A market failure means that either too little of a good gets produced or too much of it gets produced, relative to Pareto Optimality. The solution often takes the form of a subsidy or a tax. For example, because monopolies tend to under-produce, theoretically a solution is to subsidize the monopolist to produce more. This is obviously counter-intuitive, since it redistributes wealth away from ordinary people to the monopolist.
We are disinclined to subsidize monopolists because of the other role of government, concerning redistribution. Economists assume that the GV would have government redistribute wealth from the rich to the poor.
Mainstream economists in the latter half of the twentieth century treated government as if it would undertake economic policy by using the GV. They just assumed that government would be motivated to act in this way, and they assumed that government would, with the help of economists, would have the knowledge to act in this way.
Other economists do not think that government plays the role of correcting market failures and moving toward the GV amount of redistribution. The standard label for this negative view is “public choice theory,” but I prefer the term “political realism.” I will describe it in a subsequent essay.3
For several decades, many papers were written about the Social Welfare Function. One of the most important of these papers became known as Kenneth Arrow’s Impossibility Theorem. I leave it to the reader to explore this literature or not.
In fact, I would probably be better off letting other people have stuff, but ignore that. The point is that a very unequal distribution of wealth can be Pareto Optimal, but it would not be particularly attractive.
I wrote this essay to provide background for Claude in putting together a chapter of The Social Code
As an older student majoring in engineering, my first economics courses were "Engineering Economics" and "Operations Research," which focused on making optimal decisions. Later, as a "social science" requirement, I found Economic History and Economic Development fascinating, but they were light on math. I did start to see some economists using partial differential equations to describe specific economic dynamics and so-called business cycles, but that seems to have disappeared. In control system engineering, dynamics and time are critical; however, in economics, dynamics and the associated mathematics related to "market failure" appear to be missing, and market failure seems to be a matter of politics.
A supply/demand market can be described as a "feedback control system" where a change in demand drives a change in supply, and the response dynamics are referred to as elasticities. However, when you look at the dynamics of these equations, time delays are critical and the solutions involve complex math and imaginary numbers (-1)^.5 or (square root of -1). I didn't see many (or any) economists in my math classes who were dealing with complex math. The dynamics can be unstable, and the market fails because a bureaucratic delay was introduced in issuing permission. Economics doesn't seem to understand these instabilities and their causes in the same way engineers do. I often hear "market failure," but seldom "because of ......"
Similar to the housing market, where the actual construction period is only a year, but obtaining permission can take 5 to 10 years, the housing market can experience peaks and crashes, resulting in a "market failure," which is essentially a government-induced failure.
When I was a young man in LA, every time the demand for housing inched upward, someone would build a new city, such as Lakewood, and the market would inch down. However, this trend got out of control when we added the multi-year time delays from CEQA in the 1970s, and housing prices spiked. The mathematics from control systems shows why what was a stable market became unstable and a market failure, having nothing to do with the workings of a market and everything to do with bureaucratic power dynamics and the addition of time delays.
I find that government-hired economists often use math to obscure reality from the public by conducting benefit-cost analyses on 100-year projects with declining discount rates, which can significantly inflate the benefits of a benefit-cost analysis, while excluding alternatives that could render the project's benefits zero in the future. Consider the Delta Conveyance Project, also known as the "20 billion tunnel," and its cost-benefit analysis.
Excellent overview of the first year of Econ graduate school. A great deal of mathematics and almost nothing about how an actual economy functions. Government was assumed to be omniscient and selfless. Preposterous. Once you had contact with reality, you realized how deficient this view of economics was and how much people inhabiting Ivory Towers needed to learn.