The Most Important Economic Theorem You’ve Never Heard Of

October 14, 2011 at 11:52 am

Have you ever been accused by a conservative of being against “economic freedom”?

One of my friends posted this the other day:

It’s impossible to be anti-capitalistic and pro-freedom at the same time. If you’re against capitalism, you’re against freedom.

My gut reaction was: Really?

But before getting into an argument over who could piss the most freedom, I thought I’d do some research on the economics behind this school of thought.

What I found out was actually quite surprising.

You’ve probably heard all the conservative talking points: deregulation, let the markets work, or make the markets more competitive.

And if you’ve taken Economics 101, you probably recognize Adam Smith’s Invisible Hand theorem from The Wealth of Nations:

A perfectly competitive market is perfectly efficient.

What Smith is saying is that in a perfectly competitive world, the market will regulate itself if you leave people free to trade and more value will be delivered to society through the individual pursuit of profit than through any centralized planning method.

In Smith’s words:

By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it.

Here’s the key phrase: perfectly competitive market.

Economists (including Adam Smith himself) understand that a perfectly competitive market is impossible.

It’s like a world without friction: a model used to better understand how the real world works.

But that’s ok, you say. We can get close to perfection and close to perfection is what we want.

This is the belief of economists like Milton Friedman and Alan Greenspan and many of our public policy makers over the last 30 years in Washington.

Get as close as possible to ideal markets. Deregulate, get government out of the way, let the markets “work”.

Is this starting to sound familiar?

Conservative economic ideology is based entirely on the premise that getting as close to ideal markets as possible will produce the best outcomes for society.

Stay with me because here’s where things get interesting.

In 1956, Canadian economist Richard Lipsey and Australian economist Kelvin Lancaster published a paper called “The General Theory of the Second Best” in The Review of Economic Studies.

The General Theory of the Second Best states:

If there is introduced into a general equilibrium system a constraint which prevents the attainment of one of the Paretian conditions, the other Paretian conditions, although still attainable, are, in general, no longer desirable.

In layman’s terms this means that if one condition can’t be attained than an optimum situation can only be achieved by departing from the other optimum conditions.

In other words, if you can’t have a completely frictionless world, trying to get as close as possible will do more harm than good.

Joseph Heath describes it this way in his book Economics without Illusions:

It’s as if a travel agent offers you a reduced fare ticket that will get you 98% of the way to Hawaii when you can’t afford the full fare.

The ideal flight lands you in Hawaii. The next best flight lands you in the ocean.

That’s how economics works. Trying to get as close as possible to ideal will land you in the ocean. And ideal, as economists admit, is impossible.

In Lipsey’s and Lancaster’s words:

If one of the Paretian optimum conditions cannot be fulfilled a second best optimum situation is achieved only by departing from all other optimum conditions.

This means if you can’t get to ideal, your second best option is achieved by not trying to reach ideal, but through some type of intervention or inefficiency.

The thought is that it is often welfare enhancing to let market imperfections cancel each other out rather than attempt to address them to try to attain a completely efficient market.

When the theory was first published, conservative economists spent a great deal of time trying to disprove the General Theory of the Second Best.

They couldn’t. So they found that the best strategy was to ignore it. This seemed to work as few outside of the field of economics seemed to understand the concept, and, more importantly, how it undermined the ideology driving our national policy.

You may find it taught in some college-level graduate classes, but it is never given the religious attention that is given to attaining ideal markets.

Think of all the people who are trying to sell us on the idea of “economic freedom,” that letting the markets work in as close to a frictionless way as possible is the best approach to national policy.

According to the General Theory of the Second Best, this approach is more likely to be a recipe for disaster than for an optimal economy.

Instead of striving towards ideal markets, what we should be arguing for is the freedom to introduce the market imperfections necessary to make markets perform best.

I’d insert a poll here, but if you’re like me, at this point your mind is blown because even as a liberal I’d always assumed that it would be a good thing to get as close as possible to efficient markets. I never suspected that economics would actually support the view that we need market imperfections for an optimal economy.

I’m going to have to go back and thank my conservative friend.

Cross posted at: Daily Kos.