Friday 3 February 2012

Encouraging Arrow-Debreu worlds

Chris Dillow warns that economics only results in real-world changes when it serves the interests of the powerful.
This poses the question. How come economics is performative in some regards (option pricing, bosses’ pay) but not in others, such as contingent markets?
It’s certainly not because Arrow-Debreu theory is new or marginal. It is much older, and far more widely taught in universities than the work of Jensen and Murphy cited by Aditya.
Nor is it because state-contingent markets would be an obviously bad idea. Yes, we know from the theory of the second best that it is not necessarily efficient to remove a single market distortion, so it’s theoretically possible that the introduction of a few such markets would be sub-optimal. But whether this would be the case in practice takes some proving. And anyway, plenty worse ideas than these have been turned into economic reality.
There is, of course, a simple answer to this question. Economics is performative when it serves private interests, but not (necessarily) when it serves public ones. Traders immediately saw the usefulness of the Black-Scholes option pricing formula, and bosses quickly saw the use of Jensen and Murphy’s work. But the benefits of better state-contingent markets accrue to millions and cannot so easily be captured privately. They are an example of a Nordhausian innovation - one with high social benefits and low private benefits and which do not therefore exist. Paradoxically, markets are incomplete because of a market failure - that there’s a positive externality to creating complete markets.
I could, of course, put this more crudely. Economics is performative when it serves the interest of the powerful, and not performative when it doesn’t. In this sense, the problem is not with economics, but with a class structure that causes the “real world” to be a corrupted and perverted form of a market economy.
As powerful counterexample, here's Justin Wolfers working to push us closer to Arrow Debreu worlds in helping to get prediction markets legalized in the United States. Prediction markets are exactly the kind of Nordhausian innovation that shouldn't exist. The Case-Shiller markets also help move us to Arrow-Debreu.

It's fun to think about the market failure of there not being enough markets. One obvious solution is that governments support rather than oppress prediction markets. Three cheers for New Zealand's iPredict, and for the policy environment that allows it to exist.


  1. Do you have any clue what this sentence means: "But the benefits of better state-contingent markets accrue to millions and cannot so easily be captured privately." Is it implied that because the benefits accrue to millions, THEREFORE the benefits cannot be easily captured? Can you spell non sequitur?

    1. A lot of the informational benefits coming from the prices aren't easily captured. With most markets, the price signal is a wonderful side-effect. For the missing markets, the costs of engaging in trades that produce the price signal must be higher than the gains captured, as is obvious by the fact that they're missing. For those missing markets where the information is of some positive value to a wide and dispersed set of folks, it's possible to imagine a case for market failure.