Economic System: Efficiency And Equality

A good economic system has two features: efficiency and equality. How to achieve this?

From Hal Varian's 'Microeconomics' (2010):

The Second Theorem of Welfare Economics asserts that under certain conditions, every Pareto efficient allocation can be achieved as a competitive equilibrium.

What is the meaning of this result? The Second Welfare Theorem implies that the problems of distribution and efficiency can be separated. Whatever Pareto efficient allocation you want can be supported by the market mechanism. The market mechanism is distributionally neutral. Whatever your criteria for a good or a just distribution of welfare, you can use competitive markets to achieve it.

Prices play two roles in the market system: an allocative role and a distributive role. The allocative role of prices is to indicate relative scarcity; the distributive role is to determine how much of different goods different agents can purchase. The Second Welfare Theorem says that these two roles can be separated: we can redistribute endowments of goods to determine how much wealth agents have, and then use prices to indicate relative scarcity.

Policy discussions often become confused on this point. One often hears arguments for intervening in pricing decisions on grounds of distributional equity. However, such intervention is typically misguided. As we have seen above, a convenient way to achieve efficient allocations is for each agent to face the true social costs of his/her actions and to make choices that reflect those costs. Thus in a perfectly competitive market, the marginal decision of whether to consume more or less of some good will depend on the price – which measures how everyone else values this good on the margin. The considerations of efficiency are inherently marginal decisions – each person should face the correct marginal tradeoff in making his/her consumption decisions.

The decision about how much different agents should consume is a totally different issue. In a competitive market, this is determined by the value of the resources that a person has to sell. From the viewpoint of the pure theory, there is no reason why the state can't transfer purchasing power (endowments) among consumers in any way that is seen fit. But the message of the Second Welfare Theorem is important. Prices should be used to reflect scarcity. Lump-sum transfers of wealth should be used to adjust for distributional goals. To a large degree, these two policy decisions can be separated.

People's concern about the distribution of welfare can lead them to advocate various forms of manipulation of prices. It has been argued, for example, that senior citizens should have access to less expensive telephone service, or that small users of electricity should pay lower rates than large users. These are basically attempts to redistribute income through the price system by offering some people lower prices than others. When you think about it, this is a terribly inefficient way to redistribute income. If you want to redistribute income, why don't you simply redistribute income? If you give a person an extra dollar to spend, then he can choose to consume more of any of the goods that he wants to consume – not necessarily just the good being subsidised.

India's Politics And Academics: Chicken/Egg (People/System) Problem

Both Indian politics and Indian academics suffer from the same fundamental problem: the chicken-and-egg problem – or the people-and-system problem. Good people are not there in the field. Why? Because the system is not good. And why is the system not good? Because good people are not there. That is: Good people will enter the field only when the system becomes good – and the system will become good only when good people enter the field.

Of course, this is a fundamental principle of the universe. And as per this principle, there should be no progress in the world at all. But the history of the world is nothing but the story of progress. So how does progress happen – in spite of the chicken-and-egg / people-and-system principle? There are two reasons. The first reason is that the principle is not 100% rigid/watertight. Especially with regard to the egg-to-chicken part – ie, the relationship between the quality of a system and the entry of good people. Some good people (who are fools) enter a field even though the system is not good.

The second reason is that luckily for us, human/social systems are not 'digital' but 'analog'. That is – they are not binary/discrete (bad vs good; 0 vs 1) but continuous (a gradient/spectrum from bad to good; 0 to 10). So a few good people (fools) enter a bad system and make it better – which attracts more good people – who make the system even better – and so on. This is nothing but the upward spiral / virtuous cycle of progress. Of course, the critical factor here is the speed of the process – especially when we are in a dynamic environment / competitive world. We can only hope that both our academics and our politics get on to a self-sustaining path of improvement (good systems + good people) as soon as possible – and move on it as fast as possible. Aum . . .