The invisible hand needs a hand

November 28, 2007 | By | 32 Replies More

Adam Smith argued that everyone will ultimately benefit when each person acts out of self interest.  For a long time now, economists have now shown that Smith’s view was naïve, and that even rational people will act in ways that leave everyone worse off.  This dysfunctional process leads to an over-exploitation and destruction of common resources known as the Tragedy of the Commons:

Free access and unrestricted demand for a finite resource ultimately structurally dooms the resource through over-exploitation. This occurs because the benefits of exploitation accrue to individuals or groups, each of whom is motivated to maximize use of the resource to the point in which they become reliant on it, while the costs of the exploitation are distributed among all those to whom the resource is available (which may be a wider class of individuals than that which is exploiting it). This, in turn, causes demand for the resource to increase, which causes the problem to snowball to the point in which the resource is exhausted.

The October 19, 2007 issue of Science (available only to subscribers online) contains a short article about three economists (Leonid Hurwicz, Eric S. Maskin and Roger B. Myerson) who have recently been awarded a joint Nobel Prize in economics for their work regarding “mechanism design theory.”  This theory

aims to find schemes, or mechanisms that in sure that acting in self-interest will indeed lead to benefits for all.  Today, its applications range from how best to auction broadcast rights and other public resources to contract negotiations and elections.

How does mechanism design theory work?  It starts with the recognition

that unbridled self-interest doesn’t always lead to the greater good.  For example, if the people of the town were asked to chip in to build a bridge, each person would benefit by underestimating his or her share and letting others bear the cost.  So for lack of funds, the bridge would never get built.  That’s sort of a logically unavoidable lose-lose situation is known as a Nash equilibrium.

Hurwicz explored ways of tweaking the rules “so that the most beneficial state and the inevitable equilibrium state are one and the same.”  It seems undeniable that the free market, if allowed to run amok, is destructive to our long-term societal needs.  I was concerned about this issue in an earlier post, although I was perhaps melodramatic with my title.  What kind of tweaks does mechanism design theory offer to the markets?

“It’s a little Machiavellian,” says Gabriele Demange of the Paris school of economics.  “You design a game so that in the end the Nash equilibrium comes out to be what you want.”  For example, each person could be required to pay what others think the bridge is worth, thus eliminating the incentive to lie.

The article in Science suggests that mechanism design theory has promising applications in areas such as climate change.

Unrestricted free-markets are a proven method of depleting valuable resources.  It has happened over and over.  One of the most dramatic examples is the lack of commercial fishing in the North Atlantic Ocean, formerly teeming with fish.  Nonetheless, it is commonly argued among conservatives that government is incompetent and destructive whenever it intervenes in the economy, and that the freewheeling and unrestricted efforts of individual independent entrepreneurs are our only hope.  This blind faith in the “free market” often takes on a religious fervor.

I don’t dispute that entrepreneurs are great at some things, such as stocking the shelves with goods and services demanded by consumers. It is equally clear, however, that a society with long-term ambitions needs to somehow hook its energies to those long-term aims. 

The unregulated free market reminds me of the way natural selection works.  Neither unregulated markets nor natural selection “see” into the future or “try” to achieve any particular at long range end. That which ultimately evolves from either process is not necessarily “sought” by the real-time actors.  The result, again, is often the destruction of valuable resources upon which those short-term actors (and others) critically depend.

With notable and relatively few exceptions, corporations are short-term, shortsighted self-interested amoral entities seeking immediate high profit at the expense of preserving public resources.  When they are not regulated, corporations have repeatedly functioned to destroy valuable public resources.  They are especially pressured to run toward short term profit by the unregulated hedge funds that essentially run them.

I am not familiar with the nuts and bolts of “mechanism design theory” beyond the sketch presented in Science, but it sounds intuitively correct that free markets need to be tamed and tweaked in order to maintain some focus on critically important long-term needs.

Share

Tags: , , , , , , ,

Category: Consumerism, Economy

About the Author ()

Erich Vieth is an attorney focusing on consumer law litigation and appellate practice. He is also a working musician and a writer, having founded Dangerous Intersection in 2006. Erich lives in the Shaw Neighborhood of St. Louis, Missouri, where he lives half-time with his two extraordinary daughters.

Comments (32)

Trackback URL | Comments RSS Feed

  1. Erich Vieth says:

    I've decided that I need to learn more about the American libertarian movement. There are quite a few sincere and articulate people out there who swear that our societal problems would simply dissolve away if we intentionally weaken government. As I understand that assertion, I reject it, for the reasons I've stated above. In short, power can be asserted in many ways, only some of those through government. And I do find it ironic that so many libertarians act as though the court system will be pure and above it all once they cripple the legislative and executive branches.

    Here's a Wikipedia excerpt on Libertarianism:

    Many libertarians view life, liberty, and property as the ultimate rights possessed by individuals, and that compromising one necessarily endangers the rest. In democracies, they consider compromise of these individual rights by political action to be tyranny of the majority, a term first coined by Alexis de Tocqueville, and made famous by John Stuart Mill, which emphasizes the threat of the majority to impose majority norms on minorities, and violating their rights in the process. "…There needs protection also against the tyranny of the prevailing opinion and feeling, against the tendency of society to impose, by other means than civil penalties, its own ideas and practices as rules of conduct on those who dissent from them…"[14]

    Having weak state executive control means libertarian societies are more dependent on the courts for conflict resolution. An impartial judiciary can thus be of paramount importance, for without it wealthy and collective interests might run roughshod over the private citizen.

    An example often cited by Republican Texas congressman Ron Paul[citation needed] is the disrespect for property rights during and soon after the industrial revolution. Many factories were allowed to pollute their neighbors' property with impunity as the courts cast a deaf ear to the cries of individual property owners.[citation needed]

    Some libertarians favor Common Law, which they see as less arbitrary and more adaptable than statutory law. The relative benefits of common law evolving toward ever-finer definitions of property rights were articulated by thinkers such as Friedrich Hayek, Richard Epstein, Robert Nozick, and Randy Barnett. Some libertarian thinkers believe that this evolution can define away various "commons" such as pollution or other interactions viewed by some as externalities. "A libertarian society would not allow anyone to injure others by pollution because it insists on individual responsibility."

    http://en.wikipedia.org/wiki/Libertarianism

    I do want to make sure that I'm not missing something big here. Therefore, I've subscribed to receive one year of a magazine: Reason: Free Minds and Free Markets. I received my first issue today. Here's the focus of Reason (from the Reason website):

    Founded in 1968, Reason advances a free society by developing, applying, and promoting libertarian principles, including individual liberty, free markets, and the rule of law.

    Reason produces respected public policy research on a variety of issues and publishes the critically acclaimed monthly magazine, Reason. Together, our top-tier think tank and political and cultural magazine reach a diverse, influential audience, advancing the values of individual freedom and choice, limited government, and market-friendly policies.

    Reason Foundation's nonpartisan public policy research promotes choice, competition, and a dynamic market economy as the foundation for human dignity and progress. Reason produces rigorous, peer reviewed research and directly engages the policy process, seeking strategies that emphasize cooperation, flexibility, local knowledge, and results. Through practical and innovative approaches to complex problems, Reason seeks to change the way people think about issues, and promote policies that allow and encourage individuals and voluntary institutions to flourish.

    Reason is the monthly print magazine of "free minds and free markets."

    I'll report on the progress of my Libertarian education periodically.

  2. Grumpy said:

    —True, many products don’t make it to market for safety reasons, but this is true for all competitors. Seen from the vantage point of the consumer, forcing ‘bad’ products off the market creates opportunities for innovators who can build a ‘good’ product to satisfy the need, thereby benefitting the consumer in the long run.—

    Oh, I agree entirely. But as far as the producers are concerned, they are already in competition with each other, and the additional "burden" of meeting government regulation is viewed as an unwelcome impediment in that competition.

    Another way to look at it, from the commercial viewpoint, consumers exist solely to benefit the producer. From the consumer viewpoint, producers exist only to benefit the consumer. The reality is that neither group could function without the other and both are producers AND consumers. But the ideological distinction (aritificial to be sure) is akin to the rejection by certain people that each individual has both a masculine and a feminine aspect. It only makes sense, but we've all talked to people, I'm sure, who simply won't accept that. (Okay, so it's a stretch, but it's the only simile I could think of this early 🙂 )

  3. Erich Vieth says:

    Both parties are convinced that government is exceptionally skilled at doing things they want more of, and entirely incompetent when it comes to things they don't like. http://www.tonywoodlief.com/archives/001312.html#

  4. Erich Vieth says:

    From Marty Kaplan at Huffpo:

    [T]he second 9/11 — the slow-motion collapse of the American, and maybe the global, economy — has been caused by a catastrophic failure of intelligence about Wall Street rapacity. If the now five-year-old Iraq war was the inevitable, tragic consequence of the neoconservatives' Project for the New American Century, then the subprime mortgage quagmire, the Bear Stearns bailout, and the foreclosure fiasco are the foreordained outcome of the Republican ideology which holds that regulation of corporate financial behavior is the domestic equivalent of Islamofascism.

    The economic meltdown is the new 9/11, and it's George W. Bush's fault — his, and the fundamentalist free-marketeers who have been living high on the hog, feeding at the public trough, intimidating Democrats, and getting away with capitalist murder ever since Ronald Reagan made "government" a dirty word.

    http://www.huffingtonpost.com/marty-kaplan/my-goa

  5. Niklaus Pfirsig says:

    If I had a mil (1 tenth of a cent) for everyone that honestly believes that a free market economy means unregulated capitalism, I would be a very wealty man.

    A free market is a theoretical economy drivent entirely by consumer demand. It is the total antithesis of what most people think of as capitalism.

    Small pockets of free market economy exist for short periods around the country. The best example is the farmers's market. The farmers are selling the same things, and the price is a direct function of consumer demand. If the customers on't like the quality or price from one vendor, they just move on to the next until they find what they want for a price they are willing to pay.

    The second any vendor runs out of an item, however, the free market ceases to be because the consumerslose a choice. If one vendor out of twenty fails to offer all items, it becomes a near free market. If only one vendor offers an item, it is a monopoly.

    Pure unfettered capitalism favors monopolies and cartels, which result in low quality and high prices for the consumers. Monopolies and cartels manipulate the supply to maximize profit, and by doing so harmsthe consumer.

    This is why one of the most important functions of government is to regulate the suppliers and level the playing field between the well established suppliers and the new ones entering the market. However since the introduction of the voodoo theory of "Trickle down economics", we have seen an ever increaseing percentage of the nations wealth becoming concentrated in a greadually shrinkg percentage of the population.

    It could be argued that we are seeing a repetition of history going on. A major cause of the great depression was the lack of regulation of the financial institutiions, but the extreme disparities in income is often overlooked as an important factor by mainstream historians. The economy had grown top-heavy with managment and middlemen, and when disaster hit the source of production, and the poorest of the poor could no longer pay for their needs, it all came crashing down.

    It was the poorest of the poor who were least affected by the great depression, as they had already adapted to a lifestyle with little or no money.

  6. Erich Vieth says:

    Here's a story about how the "free market" works when it comes to coal-burning electrical plants;

    Steve Susman, the Houston lawyer who donated his time to the cause, also alluded at the screening to deregulation's shortcomings.

    "The free market system simply does not work in this area," he said.

    Of course, we don't really know. Deregulation hasn't given us a free market, it's given us a market mash-up that's both free and fixed.

    Our legislators were quick to buy Ken Lay's deregulation sales pitch, but promises that it would lower our electric bills proved as accurate as an Enron balance sheet.

    http://www.chron.com/disp/story.mpl/business/stef

  7. Erich Vieth says:

    Some are now suggesting the end of capitalism:

    [T]he hands-off brand of capitalism in the United States is now being blamed for the easy credit that sickened the housing market and allowed a freewheeling Wall Street to create a pool of toxic investments that has infected the global financial system. Heavy intervention by the government, critics say, is further robbing Washington of the moral authority to spread the gospel of laissez-faire capitalism.

    http://www.msnbc.msn.com/id/27112481/

Leave a Reply