Saturday, November 11, 2006

Economics and Morality

Today, I wish to discuss the difference between economic and moral value to show that economic efficiency (at least as people typically understand it) is not a moral good.

To do this, I am going to borrow a phrase that a commenter, mike h, made to an earlier posting.

Before I do this, I want to be fair to mike. Mike was speaking (or writing) in simple terms that are appropriate for a comment for an internet blog. He left out a lot of details. I am going to be responding to Mike’s quote by adding some of those details – I think they are important.

This does not, in any way, infer that Mike was not aware of those details. In other words, I am not criticizing Mike or saying that he was wrong. A physicist may try to simplify an explanation of a physical event by assuming massless strings and frictionless surfaces – in order to focus on a core subject (e.g., the effect of gravity). My comments here are akin to adding the mass of the string and friction back into the equations.

I want to use Mike’s statement because I think he provided an excellent description of the starting point.

The idea is that trade makes both parties better off, since individuals generally know what is best for themselves. Parties will continue to trade until supply equals demand, and up to that point they were making themselves better off without making anyone else worse off. If the market price is above or below the market clearing price, then the possibility to make some people better off without making anyone else worse off still exists. That situation is not optimal.

The first piece of economic friction that I want to add back into this equation has to do with false beliefs.

The phrase that people “generally know what is best for themselves” is false and, even when it is true, it is only generally true with a lot of exceptions. People are full of ignorance.

False Beliefs

In fact, it is almost never (and, probably, never) the case that a person knows what is best for himself. In every trade that a person participates in (and every trade that a person does not participate in), there is always some piece of information out there that the agent does not have that would have allowed the agent to make a better deal. People do the best they can and, though they can never do what is in their best interest, with some luck they can do well enough.

There is a particular ‘market clearing price’ for ion bracelets that depend substantially on the claim that it improves health and has other magical effects. Economics tells us a great deal about this price and how it fits into the market. There is another price that ion bracelets would have if people were not so irrational and gullible. That price is probably $0.00. Anything paid for an object above its honest and truthful price is a loss – an instance of people believing that particular desires (for health) are being fulfilled when, in fact, they are not.

One thing we can say is that, even though I do not know what is in my best interest, I know more than anybody else does. Furthermore, if another agent were to make my trades for me, the chances are good that he will sacrifice my interests (at least to some extent) for other interests that he may have. So, we still have reason to trust each agent to make their own trades – even if an agent does not, in fact, know what is best for himself.

One of the ways to correct for this problem is by putting a high value on truth (true beliefs) - of science and reason. Truth is expensive to acquire, and none of us can afford more than a very small sliver of it. However, the fact that it is expensive for me to learn the truth about a product does not imply its true ability to fulfill my desires is reflected in what I am willing to pay for it. The two can still be very much different.

Dishonest Trade

Not only are we forced to make trades in the face of our own substantial ignorance, we must also deal with the fact that others have an incentive to deceive us. By manipulating what we believe, others have the capacity to manipulate our actions – causing us to behave in ways (engage in trades) where they benefit – trades that we would otherwise refuse to participate in if we knew the truth.

One of the ways that we can reduce the inefficiencies caused by deception is to influence the values that other traders bring to the table. Assume that we had the power to alter the values of other traders, such that they desired honest trade. That is to say, they have an aversion to deception. Through this, the value of a good obtained through deception is worth less to the agent than the value of that same good obtained through honest trade. The degree to which we can make goods obtained dishonestly less valuable to others by giving them an aversion to acquiring these goods, to that degree we can increase the incidents of honest trade.

The stronger we make this aversion to dishonest trade, the less likely others will be to trade dishonestly – even when it would otherwise profit them to do so. The tools for promoting this aversion to deception are praise, condemnation, reward, and punishment.

The market clearing price is the price at which people will engage in trade given the beliefs and desires that they actually have. Actual trade is determined by actual beliefs and desires. However, there is another price – the price that people would trade at if they had perfect knowledge and ‘good’ desires – desires such as honesty. This, I would argue, is the moral price, and it is not always the same as the actual price.

The Income Effect on Trade

Now, I would like to turn to another example – an example that I used when discussing “price gouging” in the wake of hurricane Katrina. It concerns a case in which an agent has a bottle of water to sell and two customers to sell it to. One is a wealthy person who wants the water so she can shampoo her poodle. The other is a poor person with twenty dollars who wants the water to give to her sick child.

In order to get the bottle of water to shampoo her dog, the wealthy person offers $20.01, and she gets the water.

According to standard economic claims, the water went to its most highly valued use.

Only, this is not true. If the second person had as much money as the first, we may assume that she would have bid the price far above twenty dollars. In fact, it is not unreasonable to assume that she would have clearly outbid the woman who wants to shampoo her dog. The second woman values the welfare of her child. However, she is powerless to put express that value in the marketplace.

This is an extreme situation. However, it is a type of situation that works its way into the supply and demand curves of economics. One of the reasons that demand tends to go down as price goes up is because lower-income purchasers have to drop out. When they do, it is a mistake to say that the goods actually went to those who valued them the most. In many cases, those with money get to bid resources away from those who value them more, because the rich can afford to take them instead and use them for trivial purposes.

The rich do not have to bid the price above what the poor are capable of paying for this to be a problem. The fact is, a gallon of gas at $3.50 costs a poor person more (in terms of the value of alternatives for that $3.50) than a gallon of gas to a rich person at that same price. As the price of gasoline goes up, rich people can continue to buy their SUV’s and use them for trivial purposes. As they do so, they keep gasoline scarce, and they keep the price up. This forces the poor people to do without gasoline – even when the poor person would have valued the use of $3.50 in gasoline more than the rich person.

Another way of saying the same thing is this: It is true that the poor person who decides not to spend $3.50 on a gallon of gasoline values something else more than that $3.50 worth of gasoline. It is not necessarily the case that he values what he would have been able to do with the gasoline less than what the rich person is doing with that gasoline.

To determine whether this is the case, it is not enough to know that the rich person buys gasoline at a higher price than the poor person does. We have to look at whether the rich person would have bought that gasoline if he had the same access to income as the poor person. If the poor person would have paid more for the gasoline (bidding it away from the rich person) had their economic circumstances been equal, then their differences in income is causing gasoline to go to a lower-valued use.

The greater the income gap becomes – the larger the difference between the wealth of the top 10 percent and the bottom 10 percent – the more social loss occurs by rich people bidding resources away from poor people who would have valued their use of those resources more.

This is not an argument for socialism or any type of demand that society should give everybody exactly the same income. The information and incentive aspect of markets are extremely important, and it would be extremely costly to eliminate them and try to do without. I would (and have) argued against such a proposal. It is a case of the cure being worse than the disease.

However, the fact that we have other reasons to continue to use the market to allocate goods and services does not change the fact that the free market allows rich people to bid resources away from poor people who value them more in fact.

Correcting the Income Effect

It is unwise to force everybody to equal levels of income to ensure that goods and services are actually going to their most highly valued users. However, there is another way to influence trade to at least partially correct for this problem.

I mentioned above how we can get more honest trade by giving people (through praise, condemnation, reward, and punishment) an aversion to dishonestly acquired goods. If a good acquired dishonestly is worth less to a person than a good acquired honestly, then that person is less likely to try to obtain that good through lying.

In addition, if people are given a desire to help others, then we can reduce the problem of rich people bidding goods and services away from people who have more valued uses for that money but cannot afford it. Instead, rich people may be motivated to provide goods and services to the poor that the poor would not otherwise be able to afford.

The Bill and Melinda Gates Foundation, with Warren Buffett’s multi-billion dollar contribution, is an example of this. These people placed a high value in providing poor people with goods and services that they otherwise would not have been able to afford. This provides a small correction to the problem of rich people bidding goods and services away from poor people who value them more but could not afford them.

Other options to correct for the fact that rich people bid goods away from poor people who value them more are the income tax and the estate tax.


So, it is not always the case that, if the price is different from the market-clearing price that we can make at least one person better off without making anybody worse off.

That depends on whether people’s beliefs about the product are true – if they are buying what they think they are buying. Every dollar spent on ion bracelets for health reason is a dollar wasted – regardless of what the market clearing price for bracelets happens to be.

It also depends on whether people’s demand is fed by good desires. Is the value that people place on a good acquired dishonestly sufficiently below the value of that same good acquired honestly? If not, then the market clearing price includes the value of dishonestly acquired goods, which do not always benefit everybody.

Finally, is this a case of rich people bidding up the price of a good so that they can use it for trivial reasons (that they really do not care that much about), bidding those resources away from poor people who value the good or service more but are less capable of expressing their preferences in market terms?

Furthermore, in all three cases, we can use morality to at least partially correct for market failure. A love of true belief, an aversion to dishonest trade, and a desire to help those who are less fortunate, mitigate against, even if they do not solve, these problems.

There are other examples of market failure, such as externalities and free riders, that I have not discussed. For some reason, economists seem to spend a lot more time on those failures than they do on the failures I mentioned above. At least, that is my perception. The reason that I discussed these failures is precisely because they are so rarely mentioned. Yet, they are cases where market value and actual value are not necessarily the same, and markets fail to make everybody better off.

1 comment:

Jeremy Gregg said...

I really enjoyed this piece. Thanks for taking the time to write with such eloquence on a topic that is extremely contentious.