Nobel Prize-Winner Makes Intermediate Error
By Bryan Caplan
In Globalization and Its Discontents, Nobel prize-winning economist Joseph Stiglitz tells us:
Behind the free-market ideology there is a model, often attributed to Adam Smith, which argues that market forces – the profit motive – drive the economy to efficient outcomes as if by an invisible hand. One of the great achievements of modern economics is to show the sense in which, and the conditions under which, Smith’s conclusion is correct. It turns out that these conditions are highly restrictive. Indeed, more recent advances in economic theory… have shown that whenever information is imperfect and markets incomplete, which is to say always… then the invisible hand works most imperfectly. (p.73)
If Stiglitz wrote “whenever information is imperfect and markets incomplete, which is to say always… then the invisible hand might work imperfectly” he would be dead-on. But he makes the far stronger claim that imperfect information implies inefficiency. This is provably wrong. Standard theorems demonstrate that perfect information (plus other assumptions) implies efficiency. They do not demonstrate that imperfect information implies inefficiency.
OK, so where’s my proof? To refute the claim that imperfect information always implies inefficiency, all I have to do is produce a homework problem with imperfect information and perfect efficiency. As Gerard Debreu might have said with his French accent, “That’s completely trivial.”
My counter-example: Suppose that the value of a used car to a current owner is uniformly distributed on the interval from $0 to $100. (That is a fancy way to say that every dollar value from 0 to 100 is equally likely). These cars would however be worth three times as much to someone else. The catch: Current owners know the true worth of their car; buyers only know the average value of cars on the market.
What happens? If the buyers bid $50, then every car worth $50 or less gets sold. The average value to the original owners: $25. The average value to the new owners: $75. Profit: $25. Competition forces the buyers to bid more. So they bid up to $75. Average value to original owners: $37.50. Average value to new owners: $112.5. Profit: $37.50. Competition ultimately pushes the price up to $150. Average value to original owners: $50. Average value to new owners: $150. Profit: $0.
Despite imperfect information, laissez-faire manages to squeeze every penny of value out of this misnamed “market for lemons.”
If I’ve lost you, this is a slight variant of a standard homework problem. In the usual problem, the numbers are rigged to make the market outcome disastrous; in my variant, the numbers are rigged to make the market outcome perfect. Which is closer to the truth? Contrary to Stiglitz, “the great achievement of modern economics” is to show that this is an empirical question beyond the purview of pure theorists.
Stiglitz is hardly the first economist to get this wrong. Lots of intermediate textbooks do the same. But that’s no excuse. When he translates high theory into plain English, even Joe Stiglitz needs to double-check his work.