Inequality is inseparable from markets

Cross posted to The Good blog

I think prices are often really good at allocating resources efficiently. I also think that utility is roughly the log of income and we have a duty to make sure that no one lives in poverty. It would be great if there was no tradeoff between these goals—efficient allocation of resources, inequality and poverty. But I think there is and it comes down to how the price mechanism works. I spend the first section of this post explaining the price mechanism, so feel free to skip it if you’re already familiar.

The price mechanism

The price mechanism has some really attractive qualities. When prices go up there’s an incentive to try to produce more of that good. Prices rise, in a competitive market, either because more people want a good and because that good has got more valuable—i.e demand has increased. Alternatively, prices could go up because it’s become more expensive to produce that good. In an uncompetitive market agents have a lot more leeway on how they set prices. But, eventually they’ll want to set them above their marginal cost. They can only do that because they have market power. If they didn’t, then other agents would come in and sell the goods at a lower price. As long as the price is above the cost of producing one additional unit of the good, agents are willing to undercut their competitors and sell the good at a lower price1.

In all three of these cases the price mechanism is doing something really useful. When demand goes up, the price mechanism does the really hard job collecting information from everyone in the economy—weighted by how much money they spend—and turning that into a single number that says, according to this weighted average, how much people value a good or service compared to everything else that can be bought and sold. When prices go up in an uncompetitive market it sends a different, but also extremely socially valuable signal. It says that there’s money to be made in this market, so more agents try to enter it, increasing competitiveness and lowering prices. Finally, if prices rise because marginal cost is going up it creates an incentive to find a way to produce the same goods more cheaply.

The tradeoff

So why does this bake in inequality, even in a perfectly functioning market? The way you know if you’ve followed the price signals correctly is that you’ve made money. The evaluation system is built in, in the same way that you know you’re good at judging probabilities in poker if you win over the long run. But this means that inequality is inseparable from markets. If you don’t get any reward for following the price signals correctly then they’ll won’t be an incentive to react to them and they’ll lose their power to allocate resources efficiently.

I think viewing prices in this way sharpens the tradeoff between redistribution and markets. When we do something like make healthcare free at the point of use, paid for by progressive taxation we’re removing healthcare from the incentive mechanism that keeps the price system working. Similarly, the more we redistribute income, the weaker the incentive to follow price signals becomes across the board. I think this maybe gives us some reason to prefer providing some goods free at the point of use rather than redistributing via taxation and welfare. There are some types of goods where having none or only a small amount is crippling. Healthcare, housing, food, heat in winter probably all fall under that category. Now there are some disadvantages to providing goods free at the point of use—you lose the ability to allocate them to those who want them most, again weighted by spending. In some areas the new rationing technique is very plausibly better than what you’d get under a market system, for instance in complex parts of medicine.

It’s very sad that this tradeoff exists, at least for my fellow social democrats. The ideal would be a society that’s able to combine the Haykeian power of markets to allocate goods efficiently by collecting information, while ensuring equality and at the very least a good standard of living for everyone. There are ways that this tradeoff can be made more or less sharp. If the economy is mostly bullshit or harmful then less efficient allocation according to the price mechanism may even improve welfare. If society is sufficiently unequal then again reducing efficiency of the price mechanism may be not that harmful because resources are being allocated very inefficiently anyway because they’re all going to rich people.

It would be very attractive if all inequality was caused by rent seeking and other market imperfections. But if some of the inequality comes intrinsically with a perfectly functioning market you’ll always face some tradeoff between inequality and using the price mechanism.

It’s actually somewhat more complicated than this. If agents fix the amount of a good that they’re selling and compete on price then you only need two firms to take the price down to marginal cost. If the firms are competing by deciding how much of a good to produce and a demand curve determines the price, as is more common, then only as the number of firms tends to infinity does price go to marginal cost.