How the theory of second best destroys faith in freer markets

In Economics Without Illusions, Joseph Heath – who’s one of my absolute favorite philosophers – makes a seemingly startling argument that should shock many proponents of (free-market) capitalism. Here’s the key bit:

Markets are, in general, an invaluable tool for promoting human well-being. It’s very easy to forget that whenever two people enter into an economic exchange, it’s because they both expect to be better off as a result of this exchange than they would have been without it.

But it is false to claim, on this basis, that the more our society relies upon competitive markets to organize the production and distribution of goods and services, the better off we will be. Sometimes moving closer to the ideal of perfect competition will make us better off, but sometimes it won’t.

Not only does the Invisible Hand Theorem offer no guarantees in this regard, it doesn’t even generate a presumption in favor of the market pattern of organization [emphasis mine]. The argument for market solutions must be made on a case-by-case basis; it cannot be derived from an abstract model of how an ideal economy would function.

First, take a step back.

With the “Invisible Hand Theorem,” Heath means the mathematical statement that if you have a perfectly competitive market, you’ll achieve Pareto efficiency. In simpler terms, if the economy and people are set up in a certain way (like no market power and full knowledge of prices, etc.), then we automatically get to a desirable state where nobody’s welfare can be further improved without harming the welfare of at least one other person. All positive-sum interactions have been exhausted and nothing has been left on the table. We can rest easy knowing that resource allocation is efficient.1 The fun part is that we get that even if there’s no overseer consciously planning and guiding the individual moving parts of the economy (hence, the invisible hand).

Okay, most educated people know this already, and they’re also well aware of the obvious drawback of this way of defending, say, capitalist markets. The drawback is that the theorem (also known as the First Fundamental Theorem of Welfare Economics) doesn’t really work in practice. In the real world, we have some market power, only partial information, externalities, and so on. The many assumptions that generate the conclusion do not obtain in reality; they’re too demanding.

But, and I promise I’ll get back to Heath in a moment, I think many defenders of free markets usually shrug off this inconvenience. They point out that though real markets might not be perfectly competitive, they’re at least close to being so, which means that real markets are also close to being Pareto efficient. In other words, though we can’t say the invisible hand works in its totality, it does work approximately. And so even if we can’t totally defend real world markets on the theorem’s basis, we can still use it for an approximate defense of markets.

Sounds intuitive, right? If perfect competition is unattainable, the economy should at least be made as competitive as possible. More concretely, if one price cannot be corrected, the other prices should still be allowed to reflect marginal social costs. And if one market remains distorted by subsidies and overregulation, the other markets should be liberalized.

Heath says this is simply false. You can’t say that because perfectly competitive markets are Pareto efficient, almost perfectly competitive markets are almost Pareto efficient. Relatedly, we shouldn’t try to maximize competitiveness so as to move closer to the desired efficient state of the economy. The theorem just doesn’t do anything for you as a free market defender once you enter the real world.

Why? Because of the theory (or theorem) of the second best. In 1956, Lancaster and Lipsey published a paper in which they showed that once even one of the conditions required for the first-best optimum cannot be satisfied, satisfying the remaining conditions one by one is no longer guaranteed to improve welfare/efficiency. Because the conditions interact, the best feasible arrangement may even require additional departures from the first-best rules. Correcting one distortion while leaving another in place may improve welfare, but it may also reduce it. There is no universal mathematical guarantee that “as free markets as possible” are most efficient. The intuitive defense from approximation just doesn’t work, unfortunately.

Heath illustrates the approximation problem with a journey to Hawaii. Travelling 98 per cent of the distance to Hawaii is not necessarily 98 per cent as good as arriving there. It may leave the traveler in the Pacific Ocean! So, if Hawaii is unavailable, travelling in a completely different direction to Las Vegas may be preferable. The point is that proximity in one dimension does not necessarily imply proximity in the dimension that matters, meaning that a market can resemble the conditions of perfect competition more closely without producing an outcome closer to Pareto efficiency.

To move on from Heath’s toy example, consider a standard simplified case that combines monopoly with pollution. A monopolist normally restricts production and charges a price above the competitive level. Considered by itself, this is inefficient because some mutually beneficial exchanges do not occur; namely, consumers who value additional units more than their production cost do not receive them. Suppose, however, that producing the good also creates pollution that is not included in its market price (a classic case of externality). Now, a competitive market would produce too much of the good from the standpoint of social welfare, on account of the externalized pollution. So, the existing non-competitive arrangement (where a monopolist restricts output) might be inefficient when considered alone, but it might also partly offset the external cost of pollution, making the net outcome perhaps more efficient!

Put simply, if the monopoly is removed while the pollution remains unpriced, output will increase. Competition has been strengthened, and one first-best condition has been restored, but the additional pollution may be more harmful than the benefit created by the additional production. The economy has moved closer to perfect competition in an institutional sense but may have moved farther from the welfare optimum.

So:

1. you can’t say that the Invisible Hand Theorem shows real world, imperfectly competitive markets are approximately Pareto efficient,

2. you can’t use the theorem to argue for removing distortions in the real world and moving markets closer to perfect competition,

3. and you can’t use it to argue against government-induced distortions or characterize them as inevitably worsening efficiency when they move the economy further away from the perfectly competitive benchmark.

I get why Heath says that Lipsey and Lancaster have “handed the left one of the most powerful arguments against laissez-faire capitalism ever developed.”

Here’s how he puts it in the book at more length:

[T]he model was not entirely science fiction; it did represent some kind of an approximation of the real world. A debate immediately broke out among economists (and other interested parties) about whether the approximation was close enough to justify drawing any sort of “real world” conclusions from its results.

But in pursuing the debate on these terms, they overlooked an even more fundamental problem. Everyone assumed that if the assumptions of the model mapped onto the real world in some approximate way, then the results of the model could also be mapped back in much the same way.

This was the error diagnosed by Lipsey and Lancaster. As it turns out, the extent to which the model approximates the real world with respect to competition says nothing at all about the extent to which it maps onto the world with respect to efficiency. So even if it were incredibly realistic, it would still be completely useless when it comes to addressing public policy questions.

Okay, so the theory of the second best destroys one naive, simplistic defense of the free market. But does it really remove, as Heath puts it, the “presumption in favor of the market pattern of organization?” I don’t think so. Heath doesn’t discuss this in his book (though he indirectly gestures at some of it), but there also exists the theory of the third best.

Yew-Kwang Ng came up with this pushback. I was randomly reminded of him and thought of this issue a couple days ago as I was rereading David Friedman’s Hidden Order. Friedman doesn’t discuss Ng’s work in the book, but he mentions him on the dedications page among all the other, as he calls them, “co-conspirators living and dead, the colleagues from whom I have learned.” I thought that was pretty cool. Anyway, Ng provides an epistemic or knowledge-based pushback to what flows or doesn’t flow from the theory of the second best.

The theory begins with three different levels of policymaking competence. In a first-best world, the economist knows how the economy works and can satisfy all the conditions needed for the optimum. There are no immovable distortions, or they can all be corrected. The task would then simply be to identify the optimum and implement it.

In a second-best world, at least one distortion cannot be removed. Perhaps, as intimated before, monopoly is unavoidable or an externality cannot be measured. Lipsey and Lancaster indeed showed that the remaining first-best rules no longer have to be desirable one by one, so the best attainable policy may include additional distortions away from the free market, such that they compensate for the unavoidable one.

But, Ng points out, standard second-best analysis still assumes something very demanding, which is that the policymaker understands the economic system well enough to calculate the right compensating distortions. The policymaker knows which imperfections are present and how they interact, or how people will respond. But do they know all of that? Probably not, so Ng’s more realistic third-best world removes the assumption. Now, the policymaker not only faces an imperfect economy but also has an imperfect understanding of it. Of course, the theoretically correct second-best solution may exist, but it’s not likely anybody can identify it with confidence (there might also be implementation issues).

Consider the polluting monopolist again. Second-best theory says that the monopoly may reduce pollution by restricting production, which is obviously possible. But preserving monopoly as an environmental policy would require enormous confidence that the environmental benefit of lower production exceeds the costs created by market power. If the government has good evidence about all the relevant factors here (pollution damage, how much is produced, demand, etc.), then yes, second-best analysis could be useful. But if the government has very little evidence, it should not treat the monopoly’s possible environmental benefit as established. It might be better to encourage competition and also develop a direct way of controlling pollution, which sounds much more like the first-best “free market” situation.

In short, the third-best theory’s upshot is that governments should not confidently preserve nor introduce indirect distortions whenever they might in principle offset another imperfection. Under uncertainty, which is pervasive in the real world, simple and targeted corrections, and policies that are easy to revise, are probably better than any fine-grained Big Government attempts at engineering a second-best optimum.

Where does this leave us? Heath is clearly right that the Invisible Hand Theorem cannot settle real policy disputes in the abstract, as at least many right-wingers (among those who still find it in themselves to defend capitalism and the free market) falsely believe. But Ng gives us an important reason to think that the absence of such a theorem does not leave markets and complex intervention on an equal footing. I’d say we have a defeasible presumption in favor of market-oriented arrangements that economize on policymakers’ knowledge, combined, where intervention is necessary, with measures that address identifiable problems as directly as possible.