Thoughts on economics and liberty

Mathematical proof that Hayek was right

Came across a truly complex mathematical paper entitled, "Competitive Markets without Commitment" by Nick Netzer and Florian Scheuer, published in JPE Dec 2010. A PDF copy of an April 2010 version is available here.

A few extracts:

The question whether – and why – markets may perform better than centralized institutions, such as governments, has fascinated economists for a long time, at least since the work of Hayek (1945). However, despite the importance of this question for economics and beyond, it is still hard to find formal arguments for why markets may be able to outperform a benevolent government. Instead, the benchmark result is still provided by standard welfare theorems according to which a benevolent planner can always replicate the market outcome, or even improve upon it if the market is affected by failures such as adverse selection or externalities. In this paper, we compare markets and governments and show that a government, even though benevolent and facing the same constraints as competitive firms, may not be able to replicate the market equilibrium, but instead implements an allocation that is Pareto dominated by the market outcome. 

In particular, the market dominates a central planner even though it is affected by an adverse selection problem, overturning the classic justification for efficiency enhancing government interventions in competitive markets.  

Importantly, this result does not depend on the specifics of Rothschild-Stiglitz contracts, but turns out to be a robust implication of competition. We show that, whenever the outcome of an ex-post market satisfies a weak notion of competitiveness, called minimal contestability (Rothschild 2006), and it sufficiently separates agents who have taken different effort choices, it Pareto-dominates the government outcome. 

On the normative side, our results have implications for market regulation. We emphasize that, for markets to be able to deal with the commitment problem successfully, firms must be allowed to offer separating contracts, some of which involve under insurance and possibly strictly positive profits. These properties of the market equilibrium must not be regarded as a sign of market failure, and they do not provide support on their own for government interventions such as the provision of mandatory social insurance against unemployment or health risk, for instance. 

The paper most closely related to ours is the seminal contribution by Fudenberg and Tirole (1990)

My comment

Nice to know that the simple common sense argument of Hayek (easily verifiable through commonplace experience) can be mathematically proven, as well. For those not familiar with Hayek's argument, please read the simple version provided in chapter 2 of Breaking Free of Nehru.

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