Pareto-efficiency

Responsible business owners support regulations

pnrj ethics, market failure, public policy , , , ,

Jun 27 JDN 2459373

In last week’s post I explained why business owners so consistently overestimate the harms of regulations: In short, they ignore the difference between imposing a rule on a single competitor and imposing that same rule on all competitors equally. The former would be disastrous; the latter is often inconsequential.

In this follow-up post I’m going to explain why ethical, responsible business owners should want many types of regulation—and that in fact if they were already trying to behave ethically and responsibly, regulations can make them more profitable in doing so.

Let’s use an extreme example just to make things clear. Suppose you are running a factory building widgets, you are competing with several other factories, and you find out that some of the other factories are using slave labor in their production.

What would be the best thing for you to do? In terms of maximizing profit, you’ve really got two possible approaches: You could start using slaves yourself, or you could find a way to stop the other factories from using slaves. If you are even remotely a decent human being, you will choose the latter. How can you do that? By supporting regulations.

By lobbying your government to ban slavery—or, if it’s already banned, to enforce those laws more effectively—you can free the workers enslaved by the other factories while also increasing your own profits. This is a very big win-win. (I guess it’s not a Pareto improvement, because the factory owners who were using slaves are probably worse off—but it’s hard to feel bad for them.)

Slavery is an extreme example (but sadly not an unrealistic one), but a similar principle applies to many other cases. If you are a business owner who wants to be environmentally responsible, you should support regulations on pollution—because you’re already trying to comply with them, so imposing them on your competitors who aren’t will give you an advantage. If you are a business owner who wants to pay high wages, you should support increasing minimum wage. Whatever socially responsible activities you already do, you have an economic incentive to make them mandatory for other companies.

Voluntary social responsibility sounds nice in theory, but in a highly competitive market it’s actually very difficult to sustain. I don’t doubt that many owners of sweatshops would like to pay their workers better, but they know they’d have to raise their prices a bit in order to afford it, and then they would get outcompeted and might even have to shut down. So any individual sweatshop owner really doesn’t have much choice: Either you meet the prevailing market price, or you go out of business. (The multinationals who buy from them, however, have plenty of market power and massive profits. They absolutely could afford to change their supply chain practices to support factories that pay their workers better.) Thus the best thing for them to do would be to support a higher minimum wage that would apply to their competitors as well.

Consumer pressure can provide some space for voluntary social responsibility, if customers are willing to pay more for products made by socially responsible companies. But people often don’t seem willing to pay all that much, and even when they are, it can be very difficult for consumers to really know which companies are being responsible (this is particular true for environmental sustainability: hence the widespread practice of greenwashing). In order for consumer pressure to work, you need a critical mass of a large number of consumers who are all sufficiently committed and well-informed. Regulation can often accomplish the same goals much more reliably.

In fact, there’s some risk that businesses could lobby for too many regulations, because they are more interested in undermining their competition than they are about being socially responsible. If you have lots of idiosyncratic business practices, it could be in your best interest to make those practices mandatory even if they have no particular benefits—simply because you were already doing them, and so the cost of transitioning to them will fall entirely on your competitors.


Regarding publicly-traded corporations in particular, there’s another reason why socially responsible CEOs would want regulations: Shareholders. If you’re trying to be socially responsible but it’s cutting into your profits, your shareholders may retaliate by devaluing your stock, firing you, or even suing you—as Dodge sued Ford in 1919 for the “crime” of making wages too high and prices too low. But if there are regulations that require you to be socially responsible, your shareholders can’t really complain; you’re simply complying with the law. In this case you wouldn’t want to be too vocal about supporting the regulations (since your shareholders might object to that); but you would, in fact, support them.

Market competition is a very cutthroat game, and both the prizes for winning and the penalties for losing are substantial. Regulations are what decides the rules of that game. If there’s a particular way that you want to play—either because it has benefits for the rest of society, or simply because it’s your preference—it is advantageous for you to get that written into the rules that everyone needs to follow.

Coase, extortion, and pay-to-skip

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Feb 9 JDN 2458889

The Coase Theorem states that under perfect property rights, perfect information, perfect contract enforcement, and negligible transaction costs, Pareto efficiency can be achieved even when there are large externalities. It was designed as an argument against Pigovian taxation, which tries to use taxes to create incentives against externalities such as pollution.

The usual argument against the Coase Theorem is that transaction costs are rarely negligible and contracts are often unenforceable, so the Pareto-efficient solution to externalities that it provides is unrealistic. (In fact, Coase himself agreed with this critique, and instead argued that regulation of externalities needs to be done on a case-by-case basis with attention to the detailed context.)

Yet this is not the real problem with the Coase Theorem. The real problem is the criterion of Pareto-efficiency: An arrangement can be Pareto-efficient without being fair, just, or even economically efficient in any real sense.

As a reminder, Pareto efficiency simply says that no person can be made better off without making some other person worse off. It doesn’t say anything about how well off people are relative to one another—inequality—or how they got what they have—justice. It doesn’t even really entail economic efficiency: Supposing that the marginal utility of wealth is always positive, if one man claims all the wealth in the world and lends it out to everyone else at interest, that does seem to be Pareto-efficient—we can’t make anyone else better off without taking something from His Majesty the Supreme Emperor—but it clearly isn’t economically efficient in any desirable sense.

And this is what’s wrong with the Coase Theorem: The kind of Pareto efficiency it generates allows for—indeed, in many cases demands—what we would ordinarily call extortion.

What is extortion, after all?

If a member of the mafia comes to your house and says, “What a nice place you’ve got here; what a shame if anything happened to it!” and then demands you pay him $500 a month, that’s extortion. He has the power to inflict a negative externality on you, and he promises not to as long as you pay him. (Here, the contract enforcement actually comes from the reciprocity in the indefinitely iterated game, and doesn’t require an outside enforcer.)

Extortion is when one party has the power to create a negative externality upon another (e.g. burn your house down, punch you in the face). They make a deal: They won’t create that negative externality, provided that you compensate them (pay them money). Is this Pareto efficient? Absolutely! They’re as well off as they would be if they hurt you, and you’re better off. But is this how we want to run a society? I don’t think so.

In the cyberpunk future in which we now live, there is a market emerging that fits the requirements of the Coase Theorem as well as any which has ever existed; and sure enough, in the absence of adequate regulation it is turning to extortion.

I am referring of course to the market for online advertisements. Perfect property rights? Not quite, but that intellectual property enforcement is very strong. Perfect contract enforcement? Not perfect, but highly reliable, like any mature market in a First World country. Perfect information and negligible transaction costs? As close as humanity has ever come.

What’s the externality? People don’t like seeing ads. Ads are annoying, distracting, and unpleasant. But businesses benefit from showing people ads (or at least think they do), and seek rents by trying to post more ads than their competition. I proposed a Pigouvian solution: Tax advertising.

What’s the Coase solution? Let people pay to skip ads. And indeed there are now sites that do this.

Note that there is a vital difference between this and, say, YouTube Premium. With YouTube Premium, you’re actually paying for the opportunity to use an ad-free version of the service. So instead of advertisers paying Google to run ads on the content you watch, you’re simply paying for the content you watch. That’s great. I have no objection to that. In fact, I strongly prefer it to the ad-supported model. Paying for content makes you the customer. Accepting ads in return for free content makes you the product.

No, I’m talking about businesses posting ads, and then offering you the chance to pay them to get rid of those ads. (Maybe a cut would go to the content provider, but that’s not really important here.) The key is that the people who make the ads get the chance to get revenue from you paying to skip them.

In Coase terms, that sounds great! Instead of me having to put you through a miserable ad that probably won’t lead you to buying anything anyway, you just pay me $0.25 or something directly. I’m better off, you’re better off, everyone’s happy.

But in fact, everyone is not happy, because here’s what I can do: I can go out of my way to make the ads as obnoxious as possible, so that you have no choice but to pay me to skip them. I’m not the first one to make this point: It’s the subject of an SMBC comic and a major plot point in a Black Mirror episode.

This is precisely the same process as extortion: Threaten a negative externality, demand compensation in return for not doing so.

I think what Coase missed in his original argument is that negative externalities aren’t always by-products of otherwise productive activities. We often—nay, usually—have the power to inflict negative externalities upon other people with no productive purpose. If externalities were always by-products, negotiation as Coase imagined it could allow us to achieve the productive benefit without the externality cost. But when externalities can be generated independently, they are a means of extracting rent from those too weak to resist you.

What’s the solution to this problem? It’s boring: We have to tax and regulate externalities after all.

“The cake is a lie”: The fundamental distortions of inequality

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July 13, JDN 2457583

Inequality of wealth and income, especially when it is very large, fundamentally and radically distorts outcomes in a capitalist market. I’ve already alluded to this matter in previous posts on externalities and marginal utility of wealth, but it is so important I think it deserves to have its own post. In many ways this marks a paradigm shift: You can’t think about economics the same way once you realize it is true.

To motivate what I’m getting at, I’ll expand upon an example from a previous post.

Suppose there are only two goods in the world; let’s call them “cake” (K) and “money” (M). Then suppose there are three people, Baker, who makes cakes, Richie, who is very rich, and Hungry, who is very poor. Furthermore, suppose that Baker, Richie and Hungry all have exactly the same utility function, which exhibits diminishing marginal utility in cake and money. To make it more concrete, let’s suppose that this utility function is logarithmic, specifically: U = 10*ln(K+1) + ln(M+1)

The only difference between them is in their initial endowments: Baker starts with 10 cakes, Richie starts with $100,000, and Hungry starts with $10.

Therefore their starting utilities are:

U(B) = 10*ln(10+1)= 23.98

U(R) = ln(100,000+1) = 11.51

U(H) = ln(10+1) = 2.40

Thus, the total happiness is the sum of these: U = 37.89

Now let’s ask two very simple questions:

1. What redistribution would maximize overall happiness?
2. What redistribution will actually occur if the three agents trade rationally?

If multiple agents have the same diminishing marginal utility function, it’s actually a simple and deep theorem that the total will be maximized if they split the wealth exactly evenly. In the following blockquote I’ll prove the simplest case, which is two agents and one good; it’s an incredibly elegant proof:

Given: for all x, f(x) > 0, f'(x) > 0, f”(x) < 0.

Maximize: f(x) + f(A-x) for fixed A

f'(x) – f'(A – x) = 0

f'(x) = f'(A – x)

Since f”(x) < 0, this is a maximum.

Since f'(x) > 0, f is monotonic; therefore f is injective.

x = A – x

QED

This can be generalized to any number of agents, and for multiple goods. Thus, in this case overall happiness is maximized if the cakes and money are both evenly distributed, so that each person gets 3 1/3 cakes and $33,336.66.

The total utility in that case is:

3 * (10 ln(10/3+1) + ln(33,336.66+1)) = 3 * (14.66 + 10.414) = 3 (25.074) =75.22

That’s considerably better than our initial distribution (almost twice as good). Now, how close do we get by rational trade?

Each person is willing to trade up until the point where their marginal utility of cake is equal to their marginal utility of money. The price of cake will be set by the respective marginal utilities.

In particular, let’s look at the trade that will occur between Baker and Richie. They will trade until their marginal rate of substitution is the same.

The actual algebra involved is obnoxious (if you’re really curious, here are some solved exercises of similar trade problems), so let’s just skip to the end. (I rushed through, so I’m not actually totally sure I got it right, but to make my point the precise numbers aren’t important.)
Basically what happens is that Richie pays an exorbitant price of $10,000 per cake, buying half the cakes with half of his money.

Baker’s new utility and Richie’s new utility are thus the same:
U(R) = U(B) = 10*ln(5+1) + ln(50,000+1) = 17.92 + 10.82 = 28.74
What about Hungry? Yeah, well, he doesn’t have $10,000. If cakes are infinitely divisible, he can buy up to 1/1000 of a cake. But it turns out that even that isn’t worth doing (it would cost too much for what he gains from it), so he may as well buy nothing, and his utility remains 2.40.

Hungry wanted cake just as much as Richie, and because Richie has so much more Hungry would have gotten more happiness from each new bite. Neoclassical economists promised him that markets were efficient and optimal, and so he thought he’d get the cake he needs—but the cake is a lie.

The total utility is therefore:

U = U(B) + U(R) + U(H)

U = 28.74 + 28.74 + 2.40

U = 59.88

Note three things about this result: First, it is more than where we started at 37.89—trade increases utility. Second, both Richie and Baker are better off than they were—trade is Pareto-improving. Third, the total is less than the optimal value of 75.22—trade is not utility-maximizing in the presence of inequality. This is a general theorem that I could prove formally, if I wanted to bore and confuse all my readers. (Perhaps someday I will try to publish a paper doing that.)

This result is incredibly radical—it basically goes against the core of neoclassical welfare theory, or at least of all its applications to real-world policy—so let me be absolutely clear about what I’m saying, and what assumptions I had to make to get there.

I am saying that if people start with different amounts of wealth, the trades they would willfully engage in, acting purely under their own self interest, would not maximize the total happiness of the population. Redistribution of wealth toward equality would increase total happiness.

First, I had to assume that we could simply redistribute goods however we like without affecting the total amount of goods. This is wildly unrealistic, which is why I’m not actually saying we should reduce inequality to zero (as would follow if you took this result completely literally). Ironically, this is an assumption that most neoclassical welfare theory agrees with—the Second Welfare Theorem only makes any sense in a world where wealth can be magically redistributed between people without any harmful economic effects. If you weaken this assumption, what you find is basically that we should redistribute wealth toward equality, but beware of the tradeoff between too much redistribution and too little.

Second, I had to assume that there’s such a thing as “utility”—specifically, interpersonally comparable cardinal utility. In other words, I had to assume that there’s some way of measuring how much happiness each person has, and meaningfully comparing them so that I can say whether taking something from one person and giving it to someone else is good or bad in any given circumstance.

This is the assumption neoclassical welfare theory generally does not accept; instead they use ordinal utility, on which we can only say whether things are better or worse, but never by how much. Thus, their only way of determining whether a situation is better or worse is Pareto efficiency, which I discussed in a post a couple years ago. The change from the situation where Baker and Richie trade and Hungry is left in the lurch to the situation where all share cake and money equally in socialist utopia is not a Pareto-improvement. Richie and Baker are slightly worse off with 25.07 utilons in the latter scenario, while they had 28.74 utilons in the former.

Third, I had to assume selfishness—which is again fairly unrealistic, but again not something neoclassical theory disagrees with. If you weaken this assumption and say that people are at least partially altruistic, you can get the result where instead of buying things for themselves, people donate money to help others out, and eventually the whole system achieves optimal utility by willful actions. (It depends just how altruistic people are, as well as how unequal the initial endowments are.) This actually is basically what I’m trying to make happen in the real world—I want to show people that markets won’t do it on their own, but we have the chance to do it ourselves. But even then, it would go a lot faster if we used the power of government instead of waiting on private donations.

Also, I’m ignoring externalities, which are a different type of market failure which in no way conflicts with this type of failure. Indeed, there are three basic functions of government in my view: One is to maintain security. The second is to cancel externalities. The third is to redistribute wealth. The DOD, the EPA, and the SSA, basically. One could also add macroeconomic stability as a fourth core function—the Fed.

One way to escape my theorem would be to deny interpersonally comparable utility, but this makes measuring welfare in any way (including the usual methods of consumer surplus and GDP) meaningless, and furthermore results in the ridiculous claim that we have no way of being sure whether Bill Gates is happier than a child starving and dying of malaria in Burkina Faso, because they are two different people and we can’t compare different people. Far more reasonable is not to believe in cardinal utility, meaning that we can say an extra dollar makes you better off, but we can’t put a number on how much.

And indeed, the difficulty of even finding a unit of measure for utility would seem to support this view: Should I use QALY? DALY? A Likert scale from 0 to 10? There is no known measure of utility that is without serious flaws and limitations.

But it’s important to understand just how strong your denial of cardinal utility needs to be in order for this theorem to fail. It’s not enough that we can’t measure precisely; it’s not even enough that we can’t measure with current knowledge and technology. It must be fundamentally impossible to measure. It must be literally meaningless to say that taking a dollar from Bill Gates and giving it to the starving Burkinabe would do more good than harm, as if you were asserting that triangles are greener than schadenfreude.

Indeed, the whole project of welfare theory doesn’t make a whole lot of sense if all you have to work with is ordinal utility. Yes, in principle there are policy changes that could make absolutely everyone better off, or make some better off while harming absolutely no one; and the Pareto criterion can indeed tell you that those would be good things to do.

But in reality, such policies almost never exist. In the real world, almost anything you do is going to harm someone. The Nuremburg trials harmed Nazi war criminals. The invention of the automobile harmed horse trainers. The discovery of scientific medicine took jobs away from witch doctors. Inversely, almost any policy is going to benefit someone. The Great Leap Forward was a pretty good deal for Mao. The purges advanced the self-interest of Stalin. Slavery was profitable for plantation owners. So if you can only evaluate policy outcomes based on the Pareto criterion, you are literally committed to saying that there is no difference in welfare between the Great Leap Forward and the invention of the polio vaccine.

One way around it (that might actually be a good kludge for now, until we get better at measuring utility) is to broaden the Pareto criterion: We could use a majoritarian criterion, where you care about the number of people benefited versus harmed, without worrying about magnitudes—but this can lead to Tyranny of the Majority. Or you could use the Difference Principle developed by Rawls: find an ordering where we can say that some people are better or worse off than others, and then make the system so that the worst-off people are benefited as much as possible. I can think of a few cases where I wouldn’t want to apply this criterion (essentially they are circumstances where autonomy and consent are vital), but in general it’s a very good approach.

Neither of these depends upon cardinal utility, so have you escaped my theorem? Well, no, actually. You’ve weakened it, to be sure—it is no longer a statement about the fundamental impossibility of welfare-maximizing markets. But applied to the real world, people in Third World poverty are obviously the worst off, and therefore worthy of our help by the Difference Principle; and there are an awful lot of them and very few billionaires, so majority rule says take from the billionaires. The basic conclusion that it is a moral imperative to dramatically reduce global inequality remains—as does the realization that the “efficiency” and “optimality” of unregulated capitalism is a chimera.

We do not benefit from economic injustice.

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JDN 2457461

Recently I think I figured out why so many middle-class White Americans express so much guilt about global injustice: A lot of people seem to think that we actually benefit from it. Thus, they feel caught between a rock and a hard place; conquering injustice would mean undermining their own already precarious standard of living, while leaving it in place is unconscionable.

The compromise, is apparently to feel really, really guilty about it, constantly tell people to “check their privilege” in this bizarre form of trendy autoflagellation, and then… never really get around to doing anything about the injustice.

(I guess that’s better than the conservative interpretation, which seems to be that since we benefit from this, we should keep doing it, and make sure we elect big, strong leaders who will make that happen.)

So let me tell you in no uncertain words: You do not benefit from this.

If anyone does—and as I’ll get to in a moment, that is not even necessarily true—then it is the billionaires who own the multinational corporations that orchestrate these abuses. Billionaires and billionaires only stand to gain from the exploitation of workers in the US, China, and everywhere else.

How do I know this with such certainty? Allow me to explain.

First of all, it is a common perception that prices of goods would be unattainably high if they were not produced on the backs of sweatshop workers. This perception is mistaken. The primary effect of the exploitation is simply to raise the profits of the corporation; there is a secondary effect of raising the price a moderate amount; and even this would be overwhelmed by the long-run dynamic effect of the increased consumer spending if workers were paid fairly.

Let’s take an iPad, for example. The price of iPads varies around the world in a combination of purchasing power parity and outright price discrimination; but the top model almost never sells for less than $500. The raw material expenditure involved in producing one is about $370—and the labor expenditure? Just $11. Not $110; $11. If it had been $110, the price could still be kept under $500 and turn a profit; it would simply be much smaller. That is, even if prices are really so elastic that Americans would refuse to buy an iPad at any more than $500 that would still mean Apple could still afford to raise the wages they pay (or rather, their subcontractors pay) workers by an order of magnitude. A worker who currently works 50 hours a week for $10 per day could now make $10 per hour. And the price would not have to change; Apple would simply lose profit, which is why they don’t do this. In the absence of pressure to the contrary, corporations will do whatever they can to maximize profits.

Now, in fact, the price probably would go up, because Apple fans are among the most inelastic technology consumers in the world. But suppose it went up to $600, which would mean a 1:1 absorption of these higher labor expenditures into price. Does that really sound like “Americans could never afford this”? A few people right on the edge might decide they couldn’t buy it at that price, but it wouldn’t be very many—indeed, like any well-managed monopoly, Apple knows to stop raising the price at the point where they start losing more revenue than they gain.

Similarly, half the price of an iPhone is pure profit for Apple, and only 2% goes into labor. Once again, wages could be raised by an order of magnitude and the price would not need to change.

Apple is a particularly obvious example, but it’s quite simple to see why exploitative labor cannot be the source of improved economic efficiency. Paying workers less does not make them do better work. Treating people more harshly does not improve their performance. Quite the opposite: People work much harder when they are treated well. In addition, at the levels of income we’re talking about, small improvements in wages would result in substantial improvements in worker health, further improving performance. Finally, substitution effect dominates income effect at low incomes. At very high incomes, income effect can dominate substitution effect, so higher wages might result in less work—but it is precisely when we’re talking about poor people that it makes the least sense to say they would work less if you paid them more and treated them better.

At most, paying higher wages can redistribute existing wealth, if we assume that the total amount of wealth does not increase. So it’s theoretically possible that paying higher wages to sweatshop workers would result in them getting some of the stuff that we currently have (essentially by a price mechanism where the things we want get more expensive, but our own wages don’t go up). But in fact our wages are most likely too low as well—wages in the US have become unlinked from productivity, around the time of Reagan—so there’s reason to think that a more just system would improve our standard of living also. Where would all the extra wealth come from? Well, there’s an awful lot of room at the top.

The top 1% in the US own 35% of net wealth, about as much as the bottom 95%. The 400 billionaires of the Forbes list have more wealth than the entire African-American population combined. (We’re double-counting Oprah—but that’s it, she’s the only African-American billionaire in the US.) So even assuming that the total amount of wealth remains constant (which is too conservative, as I’ll get to in a moment), improving global labor standards wouldn’t need to pull any wealth from the middle class; it could get plenty just from the top 0.01%.

In surveys, most Americans are willing to pay more for goods in order to improve labor standards—and the amounts that people are willing to pay, while they may seem small (on the order of 10% to 20% more), are in fact clearly enough that they could substantially increase the wages of sweatshop workers. The biggest problem is that corporations are so good at covering their tracks that it’s difficult to know whether you are really supporting higher labor standards. The multiple layers of international subcontractors make things even more complicated; the people who directly decide the wages are not the people who ultimately profit from them, because subcontractors are competitive while the multinationals that control them are monopsonists.

But for now I’m not going to deal with the thorny question of how we can actually regulate multinational corporations to stop them from using sweatshops. Right now, I just really want to get everyone on the same page and be absolutely clear about cui bono. If there is a benefit at all, it’s not going to you and me.

Why do I keep saying “if”? As so many people will ask me: “Isn’t it obvious that if one person gets less money, someone else must get more?” If you’ve been following my blog at all, you know that the answer is no.

On a single transaction, with everything else held constant, that is true. But we’re not talking about a single transaction. We’re talking about a system of global markets. Indeed, we’re not really talking about money at all; we’re talking about wealth.

By paying their workers so little that those workers can barely survive, corporations are making it impossible for those workers to go out and buy things of their own. Since the costs of higher wages are concentrated in one corporation while the benefits of higher wages are spread out across society, there is a Tragedy of the Commons where each corporation acting in its own self-interest undermines the consumer base that would have benefited all corporations (not to mention people who don’t own corporations). It does depend on some parameters we haven’t measured very precisely, but under a wide range of plausible values, it works out that literally everyone is worse off under this system than they would have been under a system of fair wages.

This is not simply theoretical. We have empirical data about what happened when companies (in the US at least) stopped using an even more extreme form of labor exploitation: slavery.

Because we were on the classical gold standard, GDP growth in the US in the 19th century was extremely erratic, jumping up and down as high as 10 lp and as low as -5 lp. But if you try to smooth out this roller-coaster business cycle, you can see that our growth rate did not appear tobe slowed by the ending of slavery:

US_GDP_growth_1800s

 

Looking at the level of real per capita GDP (on a log scale) shows a continuous growth trend as if nothing had changed at all:

US_GDP_per_capita_1800s

In fact, if you average the growth rates (in log points, averaging makes sense) from 1800 to 1860 as antebellum and from 1865 to 1900 as postbellum, you find that the antebellum growth rate averaged 1.04 lp, while the postbellum growth rate averaged 1.77 lp. Over a period of 50 years, that’s the difference between growing by a factor of 1.7 and growing by a factor of 2.4. Of course, there were a lot of other factors involved besides the end of slavery—but at the very least it seems clear that ending slavery did not reduce economic growth, which it would have if slavery were actually an efficient economic system.

This is a different question from whether slaveowners were irrational in continuing to own slaves. Purely on the basis of individual profit, it was most likely rational to own slaves. But the broader effects on the economic system as a whole were strongly negative. I think that part of why the debate on whether slavery is economically inefficient has never been settled is a confusion between these two questions. One side says “Slavery damaged overall economic growth.” The other says “But owning slaves produced a rate of return for investors as high as manufacturing!” Yeah, those… aren’t answering the same question. They are in fact probably both true. Something can be highly profitable for individuals while still being tremendously damaging to society.

I don’t mean to imply that sweatshops are as bad as slavery; they are not. (Though there is still slavery in the world, and some sweatshops tread a fine line.) What I’m saying is that showing that sweatshops are profitable (no doubt there) or even that they are better than most of the alternatives for their workers (probably true in most cases) does not show that they are economically efficient. Sweatshops are beneficent exploitation—they make workers better off, but in an obviously unjust way. And they only make workers better off compared to the current alternatives; if they were replaced with industries paying fair wages, workers would obviously be much better off still.

And my point is, so would we. While the prices of goods would increase slightly in the short run, in the long run the increased consumer spending by people in Third World countries—which soon would cease to be Third World countries, as happened in Korea and Japan—would result in additional trade with us that would raise our standard of living, not lower it. The only people it is even plausible to think would be harmed are the billionaires who own our multinational corporations; and yet even they might stand to benefit from the improved efficiency of the global economy.

No, you do not benefit from sweatshops. So stop feeling guilty, stop worrying so much about “checking your privilege”—and let’s get out there and do something about it.

Externalities

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JDN 2457202 EDT 17:52.

The 1992 Bill Clinton campaign had a slogan, “It’s the economy, stupid.”: A snowclone I’ve used on occasion is “it’s the externalities, stupid.” (Though I’m actually not all that fond of calling people ‘stupid’; though occasionally true is it never polite and rarely useful.) Externalities are one of the most important concepts in economics, and yet one that even all too many economists frequently neglect.

Fortunately for this one, I really don’t need much math; the concept isn’t even that complicated, which makes it all the more mysterious how frequently it is ignored. An externality is simply an effect that an action has upon those who were not involved in choosing to perform that action.

All sorts of actions have externalities; indeed, much rarer are actions that don’t. An obvious example is that punching someone in the face has the externality of injuring that person. Pollution is an important externality of many forms of production, because the people harmed by pollution are typically not the same people who were responsible for creating it. Traffic jams are created because every car on the road causes a congestion externality on all the other cars.

All the aforementioned are negative externalities, but there are also positive externalities. When one individual becomes educated, they tend to improve the overall economic viability of the place in which they live. Building infrastructure benefits whole communities. New scientific discoveries enhance the well-being of all humanity.

Externalities are a fundamental problem for the functioning of markets. In the absence of externalities—if each person’s actions only affected that one person and nobody else—then rational self-interest would be optimal and anything else would make no sense. In arguing that rationality is equivalent to self-interest, generations of economists have been, tacitly or explicitly, assuming that there are no such things as externalities.

This is a necessary assumption to show that self-interest would lead to something I discussed in an earlier post: Pareto-efficiency, in which the only way to make one person better off is to make someone else worse off. As I already talked about in that other post, Pareto-efficiency is wildly overrated; a wide variety of Pareto-efficient systems would be intolerable to actually live in. But in the presence of externalities, markets can’t even guarantee Pareto-efficiency, because it’s possible to have everyone acting in their rational self-interest cause harm to everyone at once.

This is called a tragedy of the commons; the basic idea is really quite simple. Suppose that when I burn a gallon of gasoline, that makes me gain 5 milliQALY by driving my car, but then makes everyone lose 1 milliQALY in increased pollution. On net, I gain 4 milliQALY, so if I am rational and self-interested I would do that. But now suppose that there are 10 people all given the same choice. If we all make that same choice, each of us will gain 1 milliQALY—and then lose 10 milliQALY. We would all have been better off if none of us had done it, even though it made sense to each of us at the time. Burning a gallon of gasoline to drive my car is beneficial to me, more so than the release of carbon dioxide into the atmosphere is harmful; but as a result of millions of people burning gasoline, the carbon dioxide in the atmosphere is destabilizing our planet’s climate. We’d all be better off if we could find some way to burn less gasoline.

In order for rational self-interest to be optimal, externalities have to somehow be removed from the system. Otherwise, there are actions we can take that benefit ourselves but harm other people—and thus, we would all be better off if we acted to some degree altruistically. (When I say things like this, most non-economists think I am saying something trivial and obvious, while most economists insist that I am making an assertion that is radical if not outright absurd.)

But of course a world without externalities is a world of complete isolation; it’s a world where everyone lives on their own deserted island and there is no way of communicating or interacting with any other human being in the world. The only reasonable question about this world is whether we would die first or go completely insane first; clearly those are the two things that would happen. Human beings are fundamentally social animals—I would argue that we are in fact more social even than eusocial animals like ants and bees. (Ants and bees are only altruistic toward their own kin; humans are altruistic to groups of millions of people we’ve never even met.) Humans without social interaction are like flowers without sunlight.

Indeed, externalities are so common that if markets only worked in their absence, markets would make no sense at all. Fortunately this isn’t true; there are some ways that markets can be adjusted to deal with at least some kinds of externalities.

One of the most well-known is the Coase theorem; this is odd because it is by far the worst solution. The Coase theorem basically says that if you can assign and enforce well-defined property rights and there is absolutely no cost in making any transaction, markets will automatically work out all externalities. The basic idea is that if someone is about to perform an action that would harm you, you can instead pay them not to do it. Then, the harm to you will be prevented and they will incur an additional benefit.

In the above example, we could all agree to pay $30 (which let’s say is worth 1 milliQALY) to each person who doesn’t burn a gallon of gasoline that would pollute our air. Then, if I were thinking about burning some gasoline, I wouldn’t want to do it, because I’d lose the $300 in payments, which costs me 10 milliQALY, while the benefits of burning the gasoline are only 5 milliQALY. We all reason the same way, and the result is that nobody burns gasoline and actually the money exchanged all balances out so we end up where we were before. The result is that we are all better off.

The first thought you probably have is: How do I pay everyone who doesn’t hurt me? How do I even find all those people? How do I ensure that they follow through and actually don’t hurt me? These are the problems of transaction costs and contract enforcement that are usually presented as the problem with the Coase theorem, and they certainly are very serious problems. You end up needing some sort of government simply to enforce all those contracts, and even then there’s the question of how we can possibly locate everyone who has ever polluted our air or our water.

But in fact there’s an even more fundamental problem: This is extortion. We are almost always in the condition of being able to harm other people, and a system in which the reason people don’t hurt each other is because they’re constantly paying each other not to is a system in which the most intimidating psychopath is the wealthiest person in the world. That system is in fact Pareto-efficient (the psychopath does quite well for himself indeed); but it’s exactly the sort of Pareto-efficient system that isn’t worth pursuing.

Another response to externalities is simply to accept them, which isn’t as awful as it sounds. There are many kinds of externalities that really aren’t that bad, and anything we might do to prevent them is likely to make the cure worse than the disease. Think about the externality of people standing in front of you in line, or the externality of people buying the last cereal box off the shelf before you can get there. The externality of taking the job you applied for may hurt at the time, but in the long run that’s how we maintain a thriving and competitive labor market. In fact, even the externality of ‘gentrifying’ your neighborhood so you can no longer afford it is not nearly as bad as most people seem to think—indeed, the much larger problem seems to be the poor neighborhoods that don’t have rising incomes, remaining poor for generations. (It also makes no sense to call this “gentrifying”; the only landed gentry we have in America is the landowners who claim a ludicrous proportion of our wealth, not the middle-class people who buy cheap homes and move in. If you really want to talk about a gentry, you should be thinking Waltons and Kochs—or Bushs and Clintons.) These sorts of minor externalities that are better left alone are sometimes characterized as pecuniary externalities because they usually are linked to prices, but I think that really misses the point; it’s quite possible for an externality to be entirely price-related and do enormous damage (read: the entire financial system) and to have little or nothing to do with prices and still be not that bad (like standing in line as I mentioned above).

But obviously we can’t leave all externalities alone in this way. We can’t just let people rob and murder one another arbitrarily, or ignore the destruction of the world’s climate that threatens hundreds of millions of lives. We can’t stand back and let forests burn and rivers run dry when we could easily have saved them.

The much more reasonable and realistic response to externalities is what we call government—there are rules you have to follow in society and punishments you face if you don’t. We can avoid most of the transaction problems involved in figuring out who polluted our water by simply making strict rules about polluting water in general. We can prevent people from stealing each other’s things or murdering each other by police who will investigate and punish such crimes.

This is why regulation—and a government strong enough to enforce that regulation—is necessary for the functioning of a society. This dichotomy we have been sold about “regulations versus the market” is totally nonsensical; the market depends upon regulations. This doesn’t justify any particular regulation—and indeed, an awful lot of regulations are astonshingly bad. But some sort of regulatory system is necessary for a market to function at all, and the question has never been whether we will have regulations but which regulations we will have. People who argue that all regulations must go and the market would somehow work on its own are either deeply ignorant of economics or operating from an ulterior motive; some truly horrendous policies have been made by arguing that “less government is always better” when the truth is nothing of the sort.

In fact, there is one real-world method I can think of that actually comes reasonably close to eliminating all externalities—and it is called social democracy. By involving everyone—democracy—in a system that regulates the economy—socialism—we can, in a sense, involve everyone in every transaction, and thus make it impossible to have externalities. In practice it’s never that simple, of course; but the basic concept of involving our whole society in making the rules that our society will follow is sound—and in fact I can think of no reasonable alternative.

We have to institute some sort of regulatory system, but then we need to decide what the regulations will be and who will control them. If we want to instead vest power in a technocratic elite, how do you decide whom to include in that elite? How do we ensure that the technocrats are actually better for the general population if there is no way for that general population to have a say in their election? By involving as many people as we can in the decision-making process, we make it much less likely that one person’s selfish action will harm many others. Indeed, this is probably why democracy prevents famine and genocide—which are, after all, rather extreme examples of negative externalities.

The irrationality of racism

pnrj core principles, heuristics and biases , , , , , , , , , , , , , , , , , , , , , ,

JDN 2457039 EST 12:07.

I thought about making today’s post about the crazy currency crisis in Switzerland, but currency exchange rates aren’t really my area of expertise; this is much more in Krugman’s bailiwick, so you should probably read what Krugman says about the situation. There is one thing I’d like to say, however: I think there is a really easy way to create credible inflation and boost aggregate demand, but for some reason nobody is ever willing to do it: Give people money. Emphasis here on the people—not banks. Don’t adjust interest rates or currency pegs, don’t engage in quantitative easing. Give people money. Actually write a bunch of checks, presumably in the form of refundable tax rebates.

The only reason I can think of that economists don’t do this is they are afraid of helping poor people. They wouldn’t put it that way; maybe they’d say they want to avoid “moral hazard” or “perverse incentives”. But those fears didn’t stop them from loaning $2 trillion to banks or adding $4 trillion to the monetary base; they didn’t stop them from fighting for continued financial deregulation when what the world economy most desperately needs is stronger financial regulation. Our whole derivatives market practically oozes moral hazard and perverse incentives, but they aren’t willing to shut down that quadrillion-dollar con game. So that can’t be the actual fear. No, it has to be a fear of helping poor people instead of rich people, as though “capitalism” meant a system in which we squeeze the poor as tight as we can and heap all possible advantages upon those who are already wealthy. No, that’s called feudalism. Capitalism is supposed to be a system where markets are structured to provide free and fair competition, with everyone on a level playing field.

A basic income is a fundamentally capitalist policy, which maintains equal opportunity with a minimum of government intervention and allows the market to flourish. I suppose if you want to say that all taxation and government spending is “socialist”, fine; then every nation that has ever maintained stability for more than a decade has been in this sense “socialist”. Every soldier, firefighter and police officer paid by a government payroll is now part of a “socialist” system. Okay, as long as we’re consistent about that; but now you really can’t say that socialism is harmful; on the contrary, on this definition socialism is necessary for capitalism. In order to maintain security of property, enforcement of contracts, and equality of opportunity, you need government. Maybe we should just give up on the words entirely, and speak more clearly about what specific policies we want. If I don’t get to say that a basic income is “capitalist”, you don’t get to say financial deregulation is “capitalist”. Better yet, how about you can’t even call it “deregulation”? You have to actually argue in front of a crowd of people that it should be legal for banks to lie to them, and there should be no serious repercussions for any bank that cheats, steals, colludes, or even launders money for terrorists. That is, after all, what financial deregulation actually does in the real world.

Okay, that’s enough about that.

My birthday is coming up this Monday; thus completes my 27th revolution around the Sun. With birthdays come thoughts of ancestry: Though I appear White, I am legally one-quarter Native American, and my total ethnic mix includes English, German, Irish, Mohawk, and Chippewa.

Biologically, what exactly does that mean? Next to nothing.

Human genetic diversity is a real thing, and there are genetic links to not only dozens of genetic diseases and propensity toward certain types of cancer, but also personality and intelligence. There are also of course genes for skin pigmentation.

The human population does exhibit some genetic clustering, but the categories are not what you’re probably used to: Good examples of relatively well-defined genetic clusters include Ashkenazi, Papuan, and Mbuti. There are also many different haplogroups, such as mitochondrial haplogroups L3 and CZ.

Maybe you could even make a case for the “races” East Asian, South Asian, Pacific Islander, and Native American, since the indigenous populations of these geographic areas largely do come from the same genetic clusters. Or you could make a bigger category and call them all “Asian”—but if you include Papuan and Aborigine in “Asian” you’d pretty much have to include Chippewa and Najavo as well.

But I think it tells you a lot about what “race” really means when you realize that the two “race” categories which are most salient to Americans are in fact the categories that are genetically most meaningless. “White” and “Black” are totally nonsensical genetic categorizations.

Let’s start with “Black”; defining a “Black” race is like defining a category of animals by the fact that they are all tinted red—foxes yes, dogs no; robins yes, swallows no; ladybirds yes, cockroaches no. There is more genetic diversity within Africa than there is outside of it. There are African populations that are more closely related to European populations than they are to other African populations. The only thing “Black” people have in common is that their skin is dark, which is due to convergent evolution: It’s not due to common ancestry, but a common environment. Dark skin has a direct survival benefit in climates with intense sunlight.  The similarity is literally skin deep.

What about “White”? Well, there are some fairly well-defined European genetic populations, so if we clustered those together we might be able to get something worth calling “White”. The problem is, that’s not how it happened. “White” is a club. The definition of who gets to be “White” has expanded over time, and even occasionally contracted. Originally Hebrew, Celtic, Hispanic, and Italian were not included (and Hebrew, for once, is actually a fairly sensible genetic category, as long as you restrict it to Ashkenazi), but then later they were. But now that we’ve got a lot of poor people coming in from Mexico, we don’t quite think of Hispanics as “White” anymore. We actually watched Arabs lose their “White” card in real-time in 2001; before 9/11, they were “White”; now, “Arab” is a separate thing. And “Muslim” is even treated like a race now, which is like making a racial category of “Keynesians”—never forget that Islam is above all a belief system.

Actually, “White privilege” is almost a tautology—the privilege isn’t given to people who were already defined as “White”, the privilege is to be called “White”. The privilege is to have your ancestors counted in the “White” category so that they can be given rights, while people who are not in the category are denied those rights. There does seem to be a certain degree of restriction by appearance—to my knowledge, no population with skin as dark as Kenyans has ever been considered “White”, and Anglo-Saxons and Nordics have always been included—but the category is flexible to political and social changes.

But really I hate that word “privilege”, because it gets the whole situation backwards. When you talk about “White privilege”, you make it sound as though the problem with racism is that it gives unfair advantages to White people (or to people arbitrarily defined as “White”). No, the problem is that people who are not White are denied rights. It isn’t what White people have that’s wrong; it’s what Black people don’t have. Equating those two things creates a vision of the world as zero-sum, in which each gain for me is a loss for you.

Here’s the thing about zero-sum games: All outcomes are Pareto-efficient. Remember when I talked about Pareto-efficiency? As a quick refresher, an outcome is Pareto-efficient if there is no way for one person to be made better off without making someone else worse off. In general, it’s pretty hard to disagree that, other things equal, Pareto-efficiency is a good thing, and Pareto-inefficiency is a bad thing. But if racism were about “White privilege” and the game were zero-sum, racism would have to be Pareto-efficient.

In fact, racism is Pareto-inefficient, and that is part of why it is so obviously bad. It harms literally billions of people, and benefits basically no one. Maybe there are a few individuals who are actually, all things considered, better off than they would have been if racism had not existed. But there are certainly not very many such people, and in fact I’m not sure there are any at all. If there are any, it would mean that technically racism is not Pareto-inefficient—but it is definitely very close. At the very least, the damage caused by racism is several orders of magnitude larger than any benefits incurred.

That’s why the “privilege” language, while well-intentioned, is so insidious; it tells White people that racism means taking things away from them. Many of these people are already in dire straits—broke, unemployed, or even homeless—so taking away what they have sounds particularly awful. Of course they’d be hostile to or at least dubious of attempts to reduce racism. You just told them that racism is the only thing keeping them afloat! In fact, quite the opposite is the case: Poor White people are, second only to poor Black people, those who stand the most to gain from a more just society. David Koch and Donald Trump should be worried; we will probably have to take most of their money away in order to achieve social justice. (Bill Gates knows we’ll have to take most of his money away, but he’s okay with that; in fact he may end up giving it away before we get around to taking it.) But the average White person will almost certainly be better off than they were.

Why does it seem like there are benefits to racism? Again, because people are accustomed to thinking of the world as zero-sum. One person is denied a benefit, so that benefit must go somewhere else right? Nope—it can just disappear entirely, and in this case typically does.

When a Black person is denied a job in favor of a White person who is less qualified, doesn’t that White person benefit? Uh, no, actually, not really. They have been hired for a job that isn’t an optimal fit for them; they aren’t working to their comparative advantage, and that Black person isn’t either and may not be working at all. The total output of the economy will be thereby reduced slightly. When this happens millions of times, the total reduction in output can be quite substantial, and as a result that White person was hired at $30,000 for an unsuitable job when in a racism-free world they’d have been hired at $40,000 for a suitable one. A similar argument holds for sexism; men don’t benefit from getting jobs women are denied if one of those women would have invented a cure for prostate cancer.

Indeed, the empowerment of women and minorities is kind of the secret cheat code for creating a First World economy. The great successes of economic development—Korea, Japan, China, the US in WW2—had their successes precisely at a time when they suddenly started including women in manufacturing, effectively doubling their total labor capacity. Moreover, it’s pretty clear that the causation ran in this direction. Periods of economic growth are associated with increases in solidarity with other groups—and downturns with decreased solidarity—but the increase in women in the workforce was sudden and early while the increase in growth and total output was prolonged.

Racism is irrational. Indeed it is so obviously irrational that for decades now neoclassical economists have been insisting that there is no need for civil rights policy, affirmative action, etc. because the market will automatically eliminate racism by the rational profit motive. A more recent literature has attempted to show that, contrary to all appearances, racism actually is rational in some cases. Inevitably it relies upon either the background of a racist society (maybe Black people are, on average, genuinely less qualified, but it would only be because they’ve been given poorer opportunities), or an assumption of “discriminatory tastes”, which is basically giving up and redefining the utility function so that people simply get direct pleasure from being racists. Of course, on that sort of definition, you can basically justify any behavior as “rational”: Maybe he just enjoys banging his head against the wall! (A similar slipperiness is used by egoists to argue that caring for your children is actually “selfish”; well, it makes you happy, doesn’t it? Yes, but that’s not why we do it.)

There’s a much simpler way to understand this situation: Racism is irrational, and so is human behavior.

That isn’t a complete explanation, of course; and I think one major misunderstanding neoclassical economists have of cognitive economists is that they think this is what we do—we point out that something is irrational, and then high-five and go home. No, that’s not what we do. Finding the irrationality is just the start; next comes explaining the irrationality, understanding the irrationality, and finally—we haven’t reached this point in most cases—fixing the irrationality.

So what explains racism? In short, the tribal paradigm. Human beings evolved in an environment in which the most important factor in our survival and that of our offspring was not food supply or temperature or predators, it was tribal cohesion. With a cohesive tribe, we could find food, make clothes, fight off lions. Without one, we were helpless. Millions of years in this condition shaped our brains, programming them to treat threats to tribal cohesion as the greatest possible concern. We even reached the point where solidarity for the tribe actually began to dominate basic survival instincts: For a suicide bomber the unity of the tribe—be it Marxism for the Tamil Tigers or Islam for Al-Qaeda—is more important than his own life. We will do literally anything if we believe it is necessary to defend the identities we believe in.

And no, we rationalists are no exception here. We are indeed different from other groups; the beliefs that define us, unlike the beliefs of literally every other group that has ever existed, are actually rationally founded. The scientific method really isn’t just another religion, for unlike religion it actually works. But still, if push came to shove and we were forced to kill and die in order to defend rationality, we would; and maybe we’d even be right to do so. Maybe the French Revolution was, all things considered, a good thing—but it sure as hell wasn’t nonviolent.

This is the background we need to understand racism. It actually isn’t enough to show people that racism is harmful and irrational, because they are programmed not to care. As long as racial identification is the salient identity, the tribe by which we define ourselves, we will do anything to defend the cohesion of that tribe. It is not enough to show that racism is bad; we must in fact show that race doesn’t matter. Fortunately, this is easy, for as I explained above, race does not actually exist.

That makes racism in some sense easier to deal with than sexism, because the very categories of races upon which it is based are fundamentally faulty. Sexes, on the other hand, are definitely a real thing. Males and females actually are genetically different in important ways. Exactly how different in what ways is an open question, and what we do know is that for most of the really important traits like intelligence and personality the overlap outstrips the difference. (The really big, categorical differences all appear to be physical: Anatomy, size, testosterone.) But conquering sexism may always be a difficult balance, for there are certain differences we won’t be able to eliminate without altering DNA. That no more justifies sexism than the fact that height is partly genetic would justify denying rights to short people (which, actually, is something we do); but it does make matters complicated, because it’s difficult to know whether an observed difference (for instance, most pediatricians are female, while most neurosurgeons are male) is due to discrimination or innate differences.

Racism, on the other hand, is actually quite simple: Almost any statistically significant difference in behavior or outcome between races must be due to some form of discrimination somewhere down the line. Maybe it’s not discrimination right here, right now; maybe it’s discrimination years ago that denied opportunities, or discrimination against their ancestors that led them to inherit less generations later; but it almost has to be discrimination against someone somewhere, because it is only by social construction that races exist in the first place. I do say “almost” because I can think of a few exceptions: Black people are genuinely less likely to use tanning salons and genuinely more likely to need vitamin D supplements, but both of those things are directly due to skin pigmentation. They are also more likely to suffer from sickle-cell anemia, which is another convergent trait that evolved in tropical climates as a response to malaria. But unless you can think of a reason why employment outcomes would depend upon vitamin D, the huge difference in employment between Whites and Blacks really can’t be due to anything but discrimination.

I imagine most of my readers are more sophisticated than this, but just in case you’re wondering about the difference in IQ scores between Whites and Blacks, that is indeed a real observation, but IQ isn’t entirely genetic. The reason IQ scores are rising worldwide (the Flynn Effect) is due to improvements in environmental conditions: Fewer environmental pollutants—particularly lead and mercury, the removal of which is responsible for most of the reduction in crime in America over the last 20 years—better nutrition, better education, less stress. Being stupid does not make you poor (or how would we explain Donald Trump?), but being poor absolutely does make you stupid. Combine that with the challenges and inconsistencies in cross-national IQ comparisons, and it’s pretty clear that the higher IQ scores in rich nations are an effect, not a cause, of their affluence. Likewise, the lower IQ scores of Black people in the US are entirely explained by their poorer living conditions, with no need for any genetic hypothesis—which would also be very difficult in the first place precisely because “Black” is such a weird genetic category.

Unfortunately, I don’t yet know exactly what it takes to change people’s concept of group identification. Obviously it can be done, for group identities change all the time, sometimes quite rapidly; but we simply don’t have good research on what causes those changes or how they might be affected by policy. That’s actually a major part of the experiment I’ve been trying to get funding to run since 2009, which I hope can now become my PhD thesis. All I can say is this: I’m working on it.

The Asymmetry that Rules the World

pnrj market failure, Top 10 things to know about economics , , , , , , , , , , , , , , , , , , , , , ,

JDN 2456921 PDT 13:30.

One single asymmetry underlies millions of problems and challenges the world has always faced. No, it’s not Christianity versus Islam (or atheism). No, it’s not the enormous disparities in wealth between the rich and the poor, though you’re getting warmer.

It is the asymmetry of information—the fundamental fact that what you know and what I know are not the same. If this seems so obvious as to be unworthy of comment, maybe you should tell that to the generations of economists who have assumed perfect information in all of their models.

It’s not clear that information asymmetry could ever go away—even in the utopian post-scarcity economy of the Culture, one of the few sacred rules is the sanctity of individual thought. The closest to an information-symmetric world I can think of is the Borg, and with that in mind we may ask whether we want such a thing after all. It could even be argued that total information symmetry is logically impossible, because once you make two individuals know and believe exactly the same things, you don’t have two individuals anymore, you just have one. (And then where do we draw the line? It’s that damn Ship of Theseus again—except of course the problem was never the ship, but defining the boundaries of Theseus himself.)

Right now you may be thinking: So what? Why is asymmetric information so important? Well, as I mentioned in an earlier post, the Myerson-Satterthwaithe Theorem proves—mathematically proves, as certain as 2+2=4—that in the presence of asymmetric information, there is no market mechanism that guarantees Pareto-efficiency.

You can’t square that circle; because information is asymmetric, there’s just no way to make a free market that insures Pareto efficiency. This result is so strong that it actually makes you begin to wonder if we should just give up on economics entirely! If there’s no way we can possibly make a market that works, why bother at all?

But this is not the appropriate response. First of all, Pareto-efficiency is overrated; there are plenty of bad systems that are Pareto-efficient, and even some good systems that aren’t quite Pareto-efficient.

More importantly, even if there is no perfect market system, there clearly are better and worse market systems. Life is better here in the US than it is in Venezuela. Life in Sweden is arguably a bit better still (though not in every dimension). Life in Zambia and North Korea is absolutely horrific. Clearly there are better and worse ways to run a society, and the market system is a big part of that. The quality—and sometimes quantity—of life of billions of people can be made better or worse by the decisions we make in managing our economic system. Asymmetric information cannot be conquered, but it can be tamed.

This is actually a major subject for cognitive economics: How can we devise systems of regulation that minimize the damage done by asymmetric information? Akerlof’s Nobel was for his work on this subject, especially his famous paper “The Market for Lemons” in which he showed how product quality regulations could increase efficiency using the example of lemon cars. What he showed was, in short, that libertarian deregulation is stupid; removing regulations on product safety and quality doesn’t increase efficiency, it reduces it. (This is of course only true if the regulations are good ones; but despite protests from the supplement industry I really don’t see how “this bottle of pills must contain what it claims to contain” is an illegitimate regulation.)

Unfortunately, the way we currently write regulations leaves much to be desired: Basically, lobbyists pay hundreds of staffers to make hundreds of pages that no human being can be expected to read, and then hands them to Congress with a wink and a reminder of last year’s campaign contributions, who passes them without question. (Can you believe the US is one of the least corrupt governments in the world? Yup, that’s how bad it is out there.) As a result, we have a huge morass of regulations that nobody really understands, and there is a whole “industry” of people whose job it is to decode those regulations and use them to the advantage of whoever is paying them—lawyers. The amount of deadweight loss introduced into our economy is almost incalculable; if I had to guess, I’d have to put it somewhere in the trillions of dollars per year. At the very least, I can tell you that the $200 billion per year spent by corporations on litigation is all deadweight loss due to bad regulation. That is an industry that should not exist—I cannot stress this enough. We’ve become so accustomed to the idea that regulations are this complicated that people have to be paid six-figure salaries to understand them that we never stopped to think whether this made any sense. The US Constitution was originally printed on 6 pages.

The tax code should contain one formula for setting tax brackets with one or two parameters to adjust to circumstances, and then a list of maybe two dozen goods with special excise taxes for their externalities (like gasoline and tobacco). In reality it is over 70,000 pages.

Laws should be written with a clear and general intent, and then any weird cases can be resolved in court—because there will always be cases you couldn’t anticipate. Shakespeare was onto something when he wrote, “First, kill all the lawyers.” (I wouldn’t kill them; I’d fire them and make them find a job doing something genuinely useful, like engineering or management.)

All told, I think you could run an entire country with less than 100 pages of regulations. Furthermore, these should be 100 pages that are taught to every high school student, because after all, we’re supposed to be following them. How are we supposed to follow them if we don’t even know them? There’s a principle called ignorantia non excusat—ignorance does not excuse—which is frankly Kafkaesque. If you can be arrested for breaking a law you didn’t even know existed, in what sense can we call this a free society? (People make up strawman counterexamples: “Gee, officer, I didn’t know it was illegal to murder people!” But all you need is a standard of reasonable knowledge and due diligence, which courts already use to make decisions.)

So, in that sense, I absolutely favor deregulation. But my reasons are totally different from libertarians: I don’t want regulations to stop constraining businesses, I want regulations to be so simple and clear that no one can get around them. In the system I envision, you wouldn’t be able to sell fraudulent derivatives, because on page 3 it would clearly say that fraud is illegal and punishable in proportion to the amount of money involved.

But until that happens—and let’s face it, it’s gonna be awhile—we’re stuck with these ridiculous regulations, and that introduces a whole new type of asymmetric information. This is the way that regulations can make our economy less efficient; they distort what we can do not just by making it illegal, but by making it so we don’t know what is illegal.

The wealthy and powerful can hire people to explain—or evade—the regulations, while the rest of us are forced to live with them. You’ve felt this in a small way if you’ve ever gotten a parking ticket and didn’t know why. Asymmetric information strikes again.