This is the flavour of the season considering the recession in the west (post sub-prime). Is it possible that the free-market operations are actually sub-optimal? Well …yes it can!!!
lets begin with a few definitions. what is sub-optimal? if one player in a game can be made better off without making anybody else worse-off then the current equilibrium is sub-optimal. (that was easy 🙂 ). In other words (uh..oh) if we are in a situation where nobody can gain without somebody else losing it is Pareto-Optimal.
Now it can be very easily demonstrated that in a prisoner dilemma scenario the markets can get stuck in a Nash- equilibria that is NOT pareto-optimal. look at picture.
Now we need the government to enter and create regulations that will ensure that free-market players do not cheat (Dominant strategy) and opt for greater collective good.
can you relate any real life market failures?
I’d like to differ a bit when u said free-market can be sub-optimal.
Lets say 2 producers undercut each other thereby reaching Nash Eqm payoff of (1,1).
The pareto optimal of (3,3) is pareto optimal when only these 2 players are considered.
If u include the consumers, (3,3) is no more pareto optimal.
The only area (I know of) where free market is sub-optimal is environmental pollution.
point taken!
however, consider the current scenario…would you agree if I said that for short term pay-offs financial institutions have cheated (i dont mean illegally) which have made all the actors worse-off?
Scenario 2: 1930 the Stock-market bubble burst. was that not a failure of the free market? essentially a market is expected to value a stock corectly (at least in the same ballpark)…wat happened was a gross overstatement of various radio stocks.
My replies
1. I maintain my stand that the current sub prime crisis is the result of govt intervention rather than a free market failure. The Bush-Greenspan pair had skewed interest rates and taxes to create incentives to buy houses and consume. Banks were merely agents and were trying to maximise their revenues. They took the risk and paid for it. I don’t see any market failure here.
I define market failure as inefficient allocation of resources in the absense or any change in govt intervention.
2. Actually the bubble burst was the success of free market.
When markets were at their peak, that figure was arrived with the information available at that juncture. The fact that markets crashed show their efficiency. They do not take long to adjust to reality.
Natraj,
your first point is a classical case of inefficient allocation of resources. The point of a sound financial system is to aggregate savings and direct them towards the best value generating proposition. The markets were unable to identify this ..They were too carried away by a skewed incentive structure (short term).
Blaming greenspan is like saying … I fell over the bridge because the railing was too low.
In summary I am saying that Markets will ensure removal of hidden innefficiencies, but the government is required to build the right railing (framework).