Miscellany Philoeconomica

An Economics of False Advertising

The first fundamental theorem of welfare economics states conditions under which any price equilibrium with transfers, and in particular any Walrasian equilibrium, is a Pareto optimum. For competitive market economies, it provides a formal and very general confirmation of Adam Smith’s asserted “invisible hand” property of the market. A single, very weak assumption, the local nonsatiation of preferences . . . , is all that is required for the result. Notably, we need not appeal to any convexity assumption whatsoever.

Andreu Mas-Colell et al., Microeconomic Theory 549 (1995).

Wow. So there is a mathematical proof that a “competitive market economy” is always efficient? And all that is required is “[a] single, very weak assumption, the local nonsatiation of preferences,” which translates into the reasonable assumption that people always tend to want more?

If only.

Page forward 70 pages and you encounter the following proviso:

We have, so far, carried out an extensive analysis of equilibrium equations. A characteristic feature that distinguishes economics from other scientific fields is that, for us, the equations of equilibrium constitute the center of our discipline. Other sciences, such as physics or even ecology, put comparatively more emphasis on the determination of dynamic laws of change. In contrast, we have hardly mentioned dynamics. The reason, informally speaking, is that economists are good (or so we hope) at recognizing a state of equilibrium but are poor at predicting precisely how an economy in disequilibrium will evolve. Certainly, there are intuitive dynamic principles: if demand is larger than supply then the price will increase, if price is larger than marginal cost then production will expand, if industry profits are positive and there are no barriers to entry, then new firm will enter, and so on. The difficulty is in translating these informal principles into precise dynamic laws.

Andreu Mas-Colell et al., Microeconomic Theory 620 (1995).

So, that great proof of the efficiency of competitive markets applies only to an economy in “equilibrium,” but economics has no idea how any economy would actually get into equilibrium?

Yes, that is exactly right.

Economics has shown that if buyers and sellers happen to trade at competitive prices in all markets, then the invisible hand will work great. But economics has never been able to show that buyers and sellers will actually bargain their way to competitive prices, even in “competitive market economies,” and even if they are rational profit-maximizers and all that.

Actually, even this proviso is false advertising. Because economics has actually gone and nearly proved the opposite of the proposition that buyers and sellers will always bargain their way to competitive prices: that buyers and sellers in competitive market economies can bargain their way to almost any set of prices—not just competitive prices—and, moreover, that they can bargain prices in circles forever, never achieving any equilibrium set of prices at all, much less the efficient competitive equilibrium set.

The entire project of free market economic theory is, in other words, a failure, and has been since these results appeared in the 1970s.

But you wouldn’t know it from reading the canonical graduate textbook in economics.