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Economics and Fairness

I have been engaged reading Gavin Kennedy's blog defending Adam Smith from a variety of 20th and 21st century misunderstandings, in particular the notion that Adam Smith was the intellectual father of the concept of the "invisible hand".

We both read the same post by the philosopher John Perry about John Rawls. Gavin responded to the post by querying the underlying assumptions about Adam Smith, but I had a different take, based on recent re-readings of Vernon Smith's work in experiment economics.

First, here is John Perry's post.

"In A Theory of Justice (1971, 1999), John Rawls proposed a striking and original marriage of liberty and equality, animated by a tolerant and democratic faith in human possibilities.

For much of the past century, the idea of a politcal philosophy devoted to both liberty and equality seemed to many people a contradiction in terms.

Outraged by vast differences between the lives of rich and poor, egalitarians condemned the classical liberalism of John Locke and Adam Smith for giving undue attention to legal
rights and liberties, while remaining in different to the fate of ordinary people.

Traditional liberalism, they complained, prized equality before the law, but showed complacency in the face of profound and grim inequalities of fortune on earth. Classical liberals, in contrast, embraced personal liberty, and condemned egalitarians for their paternalism and willingness to sacrifice human freedom in the name of some possible future utopia."

But, here is the challenge that anyone interested in combining market economics with fairness faces.

Consider the experiments in market economics, first done by Vernon Smith. Here is a nice example.

"The simple experimental design outlined above provides a building block for all subsequent experimental market designs.

After all, a market at its core is nothing other than a place where bilateral trades are facilitated between multiple buyers and sellers. Suppose we want to construct a market with 5 sellers and 5 buyers.

In this case we would hand a card to each seller indicating the cost of production. For example, one seller would be given a card indicating a cost of $10. The other four sellers would have costs of $12, $14, $16, and $18. People assigned to be buyers would receive a card indicating their resale value.

Continuing the example, suppose these values were $22, $20, $18, $16, and $14. Each seller and each buyer in this design have the opportunity to make one transaction.

Given the range of values for buyers and the range of costs for sellers, what will occur when they are allowed to trade? Will sellers have the upper hand?

Will the buyers? Will all trades that might benefit both buyers and sellers occur or will some beneficial trades fail to take place because of incomplete information or so-called market failure?

When trades do take place will they be across a wide range of prices or a narrow band?

Economic theory in its simplest incarnation of supply and demand makes a strong set of predictions.

What are the supply and demand schedules here? Consider an axis set that has price on the vertical axis and quantity on the horizontal axis.

The supply schedule answers the question "How many units would voluntarily be brought to the market at different prices?" Thus supply in this experimental structure is an ascending stair-step pattern that starts at $10 and rises $2 per step for each unit in the market. Above $18 the supply curve is vertical for no other than the fifth unit can ever be purchased in this setting. Likewise, the demand schedule answers the question "How many units will be voluntarily purchased in the market at different prices?" Using the same analysis as that for the sellers, we find that the demand schedule is a descending stair-step pattern that starts at $22 and falls $2 per step for each unit demanded in the market. Below a price of $14 the demand schedule also is vertical for no more than the five units are desired in this setting.

For this scenario, textbook economics predicts that equilibrium will be reached where supply equals demand. In this case that means that four units would be traded at the identical price of $16."

Smith and others showed the simple double auction, buyers yelling out their prices, and sellers yelling out theirs, would produce the equilibrium of 4 trades at $16. (It is still a mystery theoretically as to why so few traders are needed.)

A moment's reflection shows that this equilibrium with four trades produces great inequalities, or potentially great inequalities. And the cost producer with $18 is shut out.

It also doesn't take much reflection to see that each buyer/seller could be splitting $4 if an omniscient being could mediate and match the high cost producer with the high cost resellers.

But the design question is how would you rearrange the auction rules to bring about this fair result?

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Full post as published by Misleading Advertising Law on December 16, 2008 (boomark / email).