Prices as democratic?

Recently, a good friend of mine (who is a sneaky economist) was complaining about the policies of political parties on twitter.  In general, we were just doing our usual thing of being sad about Arrow’s Impossibility Theorem.

But it also reminded me of a little view economists hold, that many non-economists may not nowadays, the idea of prices being a type of voting – or a representation of preferences.  Now economists are right (surprised I think this?), but there are elements and issues to it that can sometimes be underplayed.

We vote on issues to illustrate our preference regarding the issue.  Given we use the idea of “one vote one person” we are only showing our preference in an “ordinal” (ranking) sense rather than the “cardinal” sense.  But that is where we are going with voting – showing our preferences.

When we pay for a good, we show a willingness to pay for it (as we are buying it, the person, group, or institution on the other end has a willingness to sell).  But just like with tax, in order interpret a price as value we need a much larger “general equilibrium” view of things, that includes the idea of “endowment” (there is a reason Arrow is also a big thinker here after all 😉 ).  If someone is fundamentally endowed with more income, the fact they are willing to pay more for something doesn’t show they “value” it more.

This is why economists don’t just get big on prices, they get big on the idea of “equalising opportunity”.  Not equalising income or other outcomes, but equalising opportunity.  Why opportunity, well think of it this way, if someone genuinely works (relatively) harder in order to get more income to buy more goods and services they are showing that they fundamentally value these goods and services (relatively) more … or that work is inherently less costly for them as an individual.  The wage is part of that big web of prices, and when whatever we term “opportunity” is equalised in this way the wage provides one of the mechanisms through which people can inherently show the relative value they place on things, and then “vote” on the distribution, production, and allocation of goods by purchasing.

One of the key roles of government is “distributional”.  And the idea that they should work on distribution mainly through income transfers rather than randomly trying to fiddle with prices stems from this.  Making the price a type of “vote” in this sense makes economists view that it is endowment rather than price that should be looked at potentially clear (?).

Now you will no doubt say “what, we don’t think of it that way, what”.  That is cool.  But if this is our concern, I’d say take a step back, and lets list factors that determine prices.  We have the willingness to sell of those involved, but there are often “games” people play, or “monopolies”, or “information issues”.  This general principle helps to justify issues where we don’t think “prices are representing relative value fairly” GIVEN our view that equality of opportunity (in whatever normative way we mean this – the term is meant to be vague as its something we need to define subjectively to move forward.  Note:  After writing this I spotted Economist’s View talking on the issue) holds.  With a said market failure, we may intervene in pricing to help make the price represent the more democratic outcome – but once again, through this lens the ability to “vote” on your claim on resources depends on endowment – and we need a clear view about how we view endowments before we can conceptualise what we think is fair.

The fact we don’t walk up to something when we buy it and THINK it is like voting, doesn’t change the descriptive similarity!

Side track of GE

You may even say the view of GE is completely flawed as its unrealistic, and we shouldn’t talk this way at all.  To this I would have to say I don’t agree with your view – although you are in an interesting and fun area with your thoughts.  I could say some rubbish about “it is core assumption (required for the result) that need to be realistic, not our peripheral simplifying ones” – but we don’t have the ability to directly measure or even often model our core assumptions, and see if the result holds.  There are core assumptions that are inherently unrealistic.  One solution is to try and generalise, and then ask if a realistic assumption holds in a “hypothetical world” that exists within the space captured by our assumptions (this is a new Sugden paper from 2009, here is the original).  Another is to rely on certain non-testable assumptions due to their persuasive nature – which could be due to the belief of the community involved, or the fact they are captured in some inherent “common sense”. Both views assume there is some “objective reality”, and that our observation, intuition, and data only give us an unclear and partial window on that.

Both views are also broadly “scientific” if we are going all post-modern, and it is a bit hard to test the “hard core” if we are going down the Lakatos road – when we don’t have the required data (hence why Maki pushes us towards “scientific realism” in that second post) … which, given the push for logical consistency stemming from a hard core of assumptions makes economics consistent with the letter of the law on Lakatos … and since economics does predict “novel facts” (although not financial crises) it is progressive (scientific) rather than degenerate (pseudo-scientific).  I readily admit that my interpretation of the philosophy of science could be off here, no doubt I have biases 😉

Anyway the two views mentioned seem to be consistent as descriptions of GE, and much of economics more generally, IMO.   You would expect such generalisation to mean that, for each set of data there is more than one explanation.  Essentially, some of our core assumptions may be peripheral in this case, we just don’t know which ones – and don’t have the data available to help us narrow it down!  This is quite different to how I was taught at macro at university (although it is quite consistent with micro) – which was “we want a model that explains all the stylized facts, and don’t have it”.  However, what they weren’t telling me was that the models were all filled with ceteris paribus which could be loosened to explain the result … so in some sense we were flirting with the idea of hitting our ceteris paribus assumptions, but never doing it as students.

My preference is to say that economics is the study of tendencies, and that when it comes to description we are trying to isolate tendencies as a starting point and construct knowledge from there – I’d say this view is consistent with both of those explanations.  GE models help us to think about our tendencies in a way that challenges partial equilibrium logic.  It adds a layer of understanding, and in that way we can use it to check and challenge our intuition – as literary theorists, the very purpose of theory is to challenge our common sense intuitions!!!

However, I have a clearer point.  If you find my discussion of assumptions not useful and you are not persuaded by logic from GE models due to assumptions, that is cool.  But you don’t have  an additional model of prices (if you do, feel free to provide me a copy 🙂 ).  Without any understanding of prices, there is no way to justify a role for intervening in them.  IMO, this is the main reason economics students eventually learn some level of respect for the idea of GE models – after looking at them with disdain at first.

Ok ok, what’s the point

The point here is, economists often view a price as a way that social desires, needs, wants, and preferences are aggregated – and as a mechanism for illustrating where scarcity is most apparent, and how relative production and investment should shift as a result.  In this sense, loosening price controls and pushing for competition was seen as more democratic – and this is true as long as we have our little conversation as a society about the “endowment/equality of opportunity” issue.

None of this is particularly enlightening I don’t think, but as a framework it is nice – it gives us a way to pool all the different fairness arguments we hear, and determine whether they are claims about specific market failures (coming in the price) or about endowment/equality of opportunity issues (coming in our philosophical framework and view on the drivers of wealth/income inequality).

The distinction is important, the tools and appropriate policies differ when the problem is different, and given the utter uncertainty involved in any case we want to be careful before we start trying to “improve things”.  Viewing prices and endowment in this way, with an appeal to democratic principles, gives us somewhere we can all start talking from.

We can go a step further and discuss Futarchy, but I’ll leave that up to Eric 😉

  • Paul Walker

    What is interesting about GE is the way that post 1970 is not used anywhere as much as before then. Partial equilibrium has made a big comeback. In the conclusion to some stuff I’m working on I get to rant about:

    A final point about the models of the firm discussed in this essay is that they highlight a general issue to do with post-1970 microeconomics, that is, the retreat from the use of general equilibrium (GE) models.Footnote[When discussing the influence of Gerard Debreu on economics Duppe (2010: 2-3) nicely sums up the fate of GE as well. “From the point of view of today Debreu’s influence on the body of economics could be called zero, in that general equilibrium theory (GET) is the economics of yesterday. While GET had mirrored most analytic advances in economic theory before Debreu, after Debreu most theoretical innovations came as alternatives to GET (from game theory to complexity theory)”. Historian of economic thought Roger Backhouse writes that “[i]n the 1940s and 1950s general-equilibrium theory [ dots ] became seen as the central theoretical framework around which economics was based” (Backhouse 2002: 254) and that by the “[ dots ] early 1960s, confidence in general-equilibrium theory, and with it economics as a whole, as at its height, with Debreu’s {em Theory of Value} being widely seen as providing a rigorous, axiomatic framework at the centre of the discipline” (Backhouse 2002: 261), but “[…] there were problems that could not be tackled within the Arrow-Debreu framework. These include money (attempts were made to develop a general-equilibrium theory of money, but they failed), information, and imperfect competition. In order to tackle such problems, economists were forced to use less general models, often dealing only with a specific part of the economy or with a particular problem. The search for ever more general models of general competitive equilibrium, that culminated in {em Theory of Value}, was over”. (Backhouse 2002: 262). One set of particularly problematic results for general equilibrium are the Sonnenschein-Mantel-Debreu (SMD) theorems. “In part because of a conviction that progress could not be made in general equilibrium theory, there was a substantial redirection in economic theory. As the results in SMD theory became well known, for example through Wayne Shafer and Hugo Sonnenschein’s survey (1982), economists began to question the centrality of general equilibrium theory and put forward alternatives to it. Thus in the ten years following the Shafer-Sonnenschein survey, we find a number of new directions in economic theory”. (Rizvi 2006: 230).]

    As early as 1955 Milton Friedman was suggesting that to deal with “substantive hypotheses about economic phenomena” a move away from Walrasian towards Marshallian analysis was required. When reviewing Walras’s contribution to GE, as developed in his “Elements of Pure Economics”, Friedman argued,

    “[e]conomics not only requires a framework for organizing our ideas [which Walras provided], it requires also ideas to be organized. We need the right kind of language; we also need something to say. Substantive hypotheses about economic phenomena of the kind that were the goal of Cournot are an essential ingredient of a fruitful and meaningful economic theory. Walras has little to contribute in this direction; for this we must turn to other economists, notably, of course, to Alfred Marshall”. (Friedman 1955: 908).

    By the mid-1970s microeconomic theorists had largely turned away from Walras and back to Marshall, at least insofar as they returned to using partial equilibrium analysis to investigate economic phenomena such as strategic interaction, asymmetric information and economic institutions.

    All the models considered above are partial equilibrium models, but in this regard the theory of the firm is no different from most of the microeconomic theory developed since the 1970s. Microeconomics such as incentive theory, incomplete contract theory, game theory, industrial organisation, organisational economics etc, has largely turned its back, presumably temporarily, on GE theory and has worked almost exclusively within a partial equilibrium framework. This illustrates the point made at the beginning of the paper that there is a close relationship between the economic mainstream and the theory of the firm; when the mainstream forgoes general equilibrium, so does the theory of the firm.

    One major path of influence from the mainstream of modern economics to the development of the theory of the firm has been via contract theory. But contract theory is an example of the mainstream’s increasing reliance on partial equilibrium modelling. Contract theory grew out of the failures of GE. As Salanie (2005: 2) has argued,

    “[t]he theory of contracts has evolved from the failures of general equilibrium theory. In the 1970s several economists settled on a new way to study economic relationships. The idea was to turn away temporarily from general equilibrium models, whose description of the economy is consistent but not realistic enough, and to focus on necessarily partial models that take into account the full complexity of strategic interactions between privately informed agents in well-defined institutional settings”.

    As was noted in the previous section the Foss, Lando and Thomsen classification scheme divides the current literature on the theory of the firm into two general groups based on which of two of the standard assumptions of GE theory, namely symmetric information and complete contracts, is violated when modelling the firm. In contract theoretic terms the former gives rise to principal-agent type models and the latter to incomplete contract type theories.

    The necessity of having to violate basic assumptions of GE theory so that we can model the firm, suggests that as it stands GE can not deal easily with firms, or other important economic institutions. Bernard Salanie has noted that,

    “[ … ] the organization of the many institutions that govern economic relationships is entirely absent from these [GE] models. This is particularly striking in the case of firms, which are modeled as a production set. This makes the very existence of firms difficult to justify in the context of general equilibrium models, since all interactions are expected to take place through the price system in these models”. (Salanie 2005: 1).

    This would suggest that to make GE models a ubiquitous tool of microeconomic analysis – including the analysis of issues to do with the firm – developing models which can account for information asymmetries, contractual incompleteness, strategic interaction, the existence of institutions and the like is not so much desirable as a necessity.

    Basically I would argue that GE, as it is, is seen as being too limited to be able to be used to do the things that economists want to do.

    • Interesting stuff!

      “Basically I would argue that GE, as it is, is seen as being too limited
      to be able to be used to do the things that economists want to do.”

      From reading your post I think this conclusion is a bit too broad – GE, as it is, is seen as being too limited for SOME questions of economic analysis. Such as the description of the firm. And the “cost” in terms of the loss of GE effects is sufficiently small in those areas. It doesn’t make too much sense for me to apply this to all of economics – for example with macroeconomics moving towards GE models from large empirical models over the same timeframe!

      However, if we wanted to look at issues of general macroeconomics or associated public economics – where viewing the set of prices as a form of voting would fit in – the loss from ignoring GE effects is huge.

      This is why I believe that macro is usually “a few decades behind” micro – macroeconomists have to find a way to fit the tools and knowledge embedded in partial equilibrium models to fit questions where there are important GE effects.

      I’d also note here why I think AD management by a central bank is so popular. By having this, we ensure that other policies can generally be looked at in a partial equilibirum sense! Of course, this has led to a situation with more active governments using broader policies where we do need a broader GE understanding to properly analyse them (eg the introduction of working for families … and how this may end up in a situation where the real exchange rate is higher).

      • Paul.Walker

        I’m not saying that all econ is PE but by far most is, A footnote that is missing from the above reads:

        “This is not to say there has been no work at all on GE within these areas. For an example of work on a GE approach to firms see Zame (2007). For a discussion of the Arrow-Debreu model when faced with moral hazard and adverse section see Guesnerie (1992). For a look at effects to provide strategic foundations for GE see Gale (2000). On the GE approach to tax and to international trade see, for example, Shoven and Whalley (1984), Creedy (1997), Jones (2011) and Woodland (2011). There has also been much work on computable general equilibrium analysis, see Boehringer, Rutherford and Wiegard (2003) and Sue Wing (2004) for overviews.”

        But this is a small part of micro these days. And certainly the use of the Arrow-Debreu framework is limited to very small areas of micro. The problem is that GE as we know it can’t handle things like information asymmetries, contractual incompleteness, strategic interaction, the existence of institutions etc which lie at the base of almost all micro issues. Hence the reduced use of GE.

        How far these issues are important for macro is another question. But insofar as they are important then GE in macro will be of limited use until a “better” GE is developed.

        • Indeed. Although, the use of DSGE models in macro is something that can’t be forgotten here – they don’t allow for the same number of firms, but they capture something important to the question … namely expectations and monopolistic competition.

          Having GE models with strategic elements would be nice, very nice, and that is definitely a way forward in time!

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  • Owen

    In other words, prices are the visible hand of economics.

    • I’d say that government, by redistributing endowments, is the visible hand. While prices offer a mechanism for democracy, we need a view on opportunity and the such as well – allocative inefficiency is preferable to segregation of opportunity 😉