Contemporary welfare economics sees the economic problem in two different ways: from one angle the problem is seen as that of choosing an allocation of resources; from the other vantage p oint the problem is seen as organizational. We propose that m uch of the orga nizational argument is implicitly evoluti onary.
The allocation problem is formalized in optimization language. A given set of resources, technologies, and preferences is postulated. Resources and technologies together define a set of production possi bilities. Efficiency at the level of production requires that the economy be at the frontier of that set. When preferences for com modities are considered as well, the set of allocations that involve the efficient production and distribution of an efficient output mix gives rise to a utility possibility frontier. If one postulates, in addition, a social welfare function that relates social preferences to indivi dual preferences, the economic problem can be posed as that of maxi mizing that function -subject, ultimately, to the underlying condi tions of resource availability, technology, and preference.
From another perspective, welfare economics views the economic problem as choosing an organizational structure rather than as (directly) choosing an allocation and distribution. Onto the economic problem defined in allocational and distributional terms, let us graft such assumptions as convexity of preferences and production sets, that all goods are private, that perfect contracts can be costlessly written and enforced, and that private firms can be expected to cor rectly maximize profits and private households to maximize utility. Then the dual o rganization al theorems of contemporary welfare eco
nomics emerge. Any competitive equilibrium is Pareto optimal, and any Pareto optimal position (including that which maximizes social welfare) can be achieved as a competitive equilibrium with a suitable set of transfer payments (Arrow and Hahn, 1971).
Notice an important difference between the contemporary discus sion of the allocation problem and the organization problem. While in analysis of the allocation problem the full set of possible allocations is recognized and defined, no such explicit recognition of possible organiza tional alternatives is made in the argument about the optimality (given the ancillary assumptions) of a regime of consumer sover eignty and free-market enterprise. The task of explicit consideration of organizational alternatives is finessed by the proposition that a competitive regime, given the extra assumptions, will do as well as can be done. Note that the argument does not hold that competition can outperform central planning or any other organizational alterna tive; rather, it is that other alternatives can at best tie competitive equilibrium.
Once these facts are noted, it is apparent that contemporary argu ments in favor of real free enterprise cannot be rationalized by mod ern analytical welfare economics alone. Many sophisticated econo mists have recognized this explicitly, and some even have proposed that the most i mportant achievement of modem normative theory is to demonstrate dramatically the s triking implausibility of the propo-sition that a regime of free enterprise would ever achieve optimality. Yet Western economists tend to advocate free enterprise as a basic organizational solution to the economic problem, even though it is admitted that many of the conditions required for the optimality theorems do not obtain. It is acknowledged that in many tech nologies there are economies of scale that give rise to nonconvexities (and hence in these industries profit-maximizing firms will not likely act as price takers) . Many goods are “public” and externalities are pervasive. Complex contracts are hard to write and enforce. It is acknowledged that firms and households may lack perfect information. And it is certainly recognized that the political economy of real ity may not generate an ethically ideal (or even humane) system for redistribution of wealth. These problems with the competitive orga nizational solution are viewed as partially remediable with ancillary organizational machinery to spur competition as much as possible, make demand effective for public goods, control externalities, and aid the needy. It is this patched-up system, with admitted flaws, that Western economists tend to support and advocate. It should be apparent that such advocacy cannot rest much weight of argument on modern welfare economics.
It also is clear that in advocating the free enterprise solution with patchups, most economists have an alternative (of a stylized variety) in mind. At the economic system level, this alternative is Soviet- style central planning. At the sectoral level, the alternative is public own ership or detailed governmental regulation. Despite the recognized flaws in private enterprise, there is near consensus among Western economists that a regime of central planning will do (and, where it is established, does do) a worse job. There is, furthermore, widespread disenchantment with attempts on the part of government to regulate particular sectors in economies that rely primarily on markets for coordination. These negative reactions to planning and regulation do not find any basis in the theorems of welfare economics. Nothing in those theorems says that planning or regulation cannot be made to work (optimally).
Clearly, modern economists have some ideas about the role of organization in guiding economic activity and about the way in which different organizational structures perform that are disjoint from the analysis in Arrow and Debreu. In contemporary discussion it is possible to discern two roughly distinguishable analytic aspects of the problem. One of these involves information and computation. If we accept for the moment the way in which modem welfare eco nomics poses the allocation and distribution problem and the condi tions for its optimal solution, it is apparent that to achieve that solu tion an enormous amount of disparate data need to be somehow acquired, brought to appropriate places for computation, and com-bined in a computation task of staggering scope. The data involve personal preferences, characteristics of available technologies, and assessments of resource availability. The other analytic aspect in volves problems of command and control. Assume that the appropri ate information has been gathered, the computations made, and the appropriate allocations and distributions discovered or decided upon. Farms, factories, distribution centers, and consumers are widely scattered. Within any particular factory a large number of people may be involved in activities that must mesh together. A “so lution” to the economic problem cannot be effected unless these dis parate actors are informed as to what they should do. And once they are informed, they must somehow be motivated or coerced to do the right things.
It is clear that many economists believe that the market competi tion alternative has attractive characteristics regarding both the in formation and computation problem and the command and control problem. Decentralized free enterprise operating in a market envi ronment has been touted as superior to government ownership of firms and central planning on the grounds that the latter solution would involve vastly more information sending and would require the computation of much larger problems. It also seems to be be lieved strongly by most Western economists that free enterprise is much more sensitive to demands, more strongly motivated to cater to preferences of consumers, and more likely to produce efficiently than is government bureaucracy.
This, we argue, is one key to the puzzle of why contemporary economists tend to argue for free enterprise and against central plan ning much more strongly than could possibly be justified by the theorems of welfare economics that are often held up as the scientific basis of the argument. Behind the scenes is an implicit theory of the role of organization in solving big allocation problems, and some conjectures about the way in which different organizational struc tures perform. However, in contrast to the optimal allocation argu ments that at least have rigor, the organizational arguments are poorly articulated and often seem more to reflect casual empiricism or prejudice than careful theorizing and empirical study. Also, while there seems to be a belief that the organizational arguments can sim ply be tacked onto the optimal allocation arguments, there is reason to wonder about this. The problems addressed by the organizational arguments-problems involving information and computation, command and control- have no explicit place within the main stream of modern welfare economics.
In particular, although the welfare economics a rguments presume an equil ibrium context, most of the discussions of organizational problems explicitly or implicitly assume a dynamic context, in which preferences, resources, and technologies are changing over time in a way that is not fully predictable. Thus, allocation must track a mov ing optimum. Were the context static or predictable , the organiza tional aspects of the problem might not be overwhelmingly diffi cult or costly. The information-computation problem could be solved “once and for all” (and this is the way the problem is viewed in formal theory). The costs of making this once-and-for- all analysis might not loom large when they are amortized over the time horizon of the economic system; arguably, the differences between organiza tional structures regarding these costs would not be particularly im portant. Similarly, the command and control problem does not seem particularly difficult or costly if what everybody is supposed to do can be specified in advance once and for all. Then effective command and monitoring schemes would likely be relatively simple to devise, under a wide range of organizational alternatives .
In reality, the nature and magni tude of the organizational problem is intimately connected with the degree of economic flux.3 In a world of flux, organizational performance comparisons must be concerned with accuracy and speed of response to changed conditions. This perception is explicit in the writings of the classical economists. From Smith to Marshall, the a rguments in favor of free enterprise tended to stress the adaptive and energetic aspects of private enter prise. The problems of command and control and of information computation were both recognized, although the former tended to be better articulated than the latter. And it is clear that, from the begin ning, private enterprise was compa red with a regime of greater gov ern mental involvement. The classical org anizational analysis is both more explicitly dynamic and more explicit about comparison than contemporary formal thinking.
The Mises- Lange- Hayek interchange brings out the relevant issues strikingly. It proceeded without the advantage (or disadvan tage) of post- World War II formal welfare economics. Mises pro posed that prices arising out of free competitive markets were an es sential aspect of any decently working inform ation and computation system. Absent these, producers have no economically relevant in formation to enable them to judge what consumer goods to produce or what input mixes to employ in production. With these, the compu tation problem simplifies to calculations of profit or cost. Lange rec-ognized the role of prices and responded to Mises with his proposal that in socialism, as in capitalism, consumers should make their own spending decisions, given their incomes and prices, and that p ro ducers should choose input mixes to minimize the cost of production and output levels such that marginal cost equals price; excess de mands and supplies of final products and inputs should be fed back to a central agency which adj usts prices up or down accordingly-in effect, sim ula ting a market.
Hayek’ s objection to the Lange proposal involved an interesting blend of propositions about information computation and about command and controL He argued that Lange’s information-flow scheme could not handle the enormous amount of detailed data spe cific to particular times and places. A rise in the demand for apples in local region X ought to be reflected in a rise in the price of apples in local region X. To channel excess- demand information back to the center for processing and to wait for central determination that prices ought to rise would be time-consuming and cumbersome. Farmers and grocers in region X would act to increase prices much more rap idly if they themselves had the authority to do so. A consequence is that internal supply would be stimulated and apples would flow into the region from outside more quickly und er real free enterprise than under Langian socialism. Hayek also argued that private profit seeking farmers and grocers have greater incentive to take the appro priate output actions in response to changed prices than would bureaucrats occupying the same jobs .
This discussion of the comparative merits of market socialism and private enterprise was noteworthy both for the explicitness with which t he case for the latter was made in comparative terms and for the scope of the consid erations adduced. But from the earliest days of the discipline, the case for markets and competition was always im plicitly (and sometimes explicitly) a comparative case. It had in view alternative approaches, recently experienced or proposed, to impor tant issues of economic policy. And it was not a case for a perfect organizational answer to a static and stylized problem, but for a real organizational answer to a real, ambiguous, and ever-changing problem. More than Hayek, but perhaps less than Schumpeter, the classical economists saw the virtues of the system as including an ability to generate a variety of innovations, to screen and s elect from these, and to assure that in the long run most of the gains would ac crue to consumers .
Clearly it is a serious oversimplification to view the discipline’s long tradition of concern with the merits of competition as involving little more than a series of primitive attempts to articulate the theorems of modern welfare e conomics. Contemporary welfare eco-nomics sees the allocation problem in terms of picking a best element from a set. When the organizational problem is formalized, it is in terms of getting the signals and incentives right for the control of clerks . The older view of the allocation problem, like our view, sees the allocation problem as involving in an essential way the explora tion of new alternatives; the organizational problem is viewed in a similar light. An evolutionary perspective on welfare economics, then, is not a radical departure. Rather, like our evolutionary posi- tive theory, it represents a return to the traditi onal perspectives of classical economics and makes explicit the views that are implicit in contemporary appreciative reasoning.
While sympathetic with the older tradition and with contem porary informal normative discussion, we diverge from these in ‘at least three respects . First, we think that the advocates of free enter prise have been too facile in arguing the merits of the stylized system in a stylized dynamic environment. The issue here is theoretical. Second, there is inadequate recognition of the extent to which some of the most fundamental problems of economic organization are either dispatched by assumption in those stylized arguments or are subsumed in a ilminimal” list of governmental functions – the impli cation being that they could be easily handled if only the government would mind its own business. Here, the problem involves the dubi ous linkage between the institutional assumptions of theory and the range of institutions that could conceivably exist in a real system. Third, we note that these advocates often have had a tendency to apply general stylized argument to real policy issues and hence to neglect the fact that the actual economic system is much more com plicated than the stylized model. The issue here is that in real policy analysis the details of the situation and of the specific organizational alternatives under consideration often are of central importance.
Regarding the theoretical argument, it o ught to be noted that there is little in the way of theoretical justification for the apparently wide spread belief that free enterprise is capable of rapidly and accurately tracking changing optimal configurations of inputs and outputs. Not only is there no theoretical support for the proposition that a compet itive regime tracks a moving equilibrium closer than other (unde fined) organizational regimes, but there is very little understanding about how a competitive regime tracks a moving target at all. Mathe matical theorists have yet to work out theoretical proofs of the stabil i ty of competitive equilibrium that are based on plausible institu tional assumptions and adequately reflect the important elements of irreversibility in economic decisions. Neither have they made a case that the seemingly inevitable departures from intertemporal effi ciency in real market systems can be counted on to be ilsmall” in some interesting sense. Similarly, as we have stressed, it is apparent that there is no way that the performance of a competitive regime in generating innovations can be brought within the scope of the stan dard optimality theorems. It is, of course, an important virtue of mod ern form al theory that it is quite clear about which propositions are established theorems and which are not. The difficulties arise in appreciative discussions of intended practical relevance, when the implications of theorems are handled loosely or abandoned in favor of more primitive pro market intuitions.
Any number of examples could be chosen to illustrate the point that modern advocacy of private enterprise solutions tends to suffer from vagueness or utopianism in its treatment of institutional matters. Three particularly important (and closely interrelated) ones involve the treatment of property rights , contracts, and law enforce ment. In almost all formal economic theory, property rights and con tractual obligations are assumed to be costlessly delineated in unam biguous terms and enforcement of the civil and criminal law is perfect and costless. By virtue of the combined force of these as sumptions of clarity, perfection, and costlessness, the problem of providing the basic institutional underpinnings of a system of vol untary exchange is assumed away. It is then not too surprising that voluntary exchange can be shown to be a largely effective solution to such social problems as are left .
A real legal system that could approach the theoretical standards of clarity and perfection in the delineation and enforcement of enti tlements would be an elaborate and expensive system indeed. This is particularly obvious if the system of entitlements is supposed to be so sophisticated as to bring within its scope all of the externality problems that economists sometimes treat as “merely” problems in the definition and enforcement of property rights-for example, the question of whether a chemical plant is entitled to dispose of its haz ardous wastes in ways that contaminate the ground water, or whether neighboring property owners are entitled to uncontami nated ground water. Of course, informal advocacy of free-enterprise solutions is rarely encumbered by explicit reliance on the blatantly unrealistic institutional assumptions of formal theory. But it avoids the issue at the price of being vague about crucial parameters of the system advocated. Is it one in which an elaborate state apparatus exists to make sure that social interactions conform to a paradigm of voluntary exchange, assuring protection of an elaborate and sharply defined schedule of enti tlements for each member of society? If so, how is the impartiality of this apparatus to be guaranteed? Or is this ideal s ociety one that is much more anarchic, in which the coercive application of various forms of private power is routinely a deter-min ant of important social outcomes? If so, how can the analysis of a stylized system of voluntary exchange be considered indicative of the nature of those outcomes?
Regarding the importance of looking at the details when exam ining real policy issues, we note first that arguments in the Hayekian vein often seem to have in view an i mage of private-enterprise insti tutions that is both narrow and idealized . The image is exemplified by the apple-market example we gave above and seems to share some of the nostalgic rusticity of that example. It is essentially an image of a collection of geographically dispersed spot markets in which atomistic competition prevails. But we· know that the private-enterprise “solution” to the problem of economic organiza tion is not always a market solution; for better or for worse, it clearly involves large elements of centralized planning and direction within the boundaries of large private corporations. It is rarely an atomistically competitive solution . And often when competition is keen, it is because it is national or global in scope. Alongside the favorable image of the responsiveness of the local apple market should therefore be placed the darker pictures associated with the shutdown of the local applesauce plant-a decision made in a re mote corporate headquarters in response to actual or conjectured developments in even more remote sectors of the globe. And the real private- enterprise solution is often not all that private: it draws on a variety of forms of governmental support. Those apple growers prob ably belong to a producers’ cooperative organized under government auspices.
These considerations do not imply any particular judgment on the merits of the private-enterprise solution as against any specific real istic alternative, nor do they render Hayek’s insights irrelevant. They do, however, caution against the ascription of general systemic virtues and faults to particular real organizational arrangements. The “private enterprise” of ag.riculture is vastly different from the “pri vate enterprise” of aircraft manufacturing. And both of these sectors are substantially and differently shaped by public programs. The unique organizational characteristics of a particular sector ought to come to the fore in the analysis of policy toward that sector.
Institutional diversity and complexity clearly poses a challenge to any theoretical scheme that is intended to illuminate a broad range of specific questions. The response of evolutionary theory to this chal lenge is set forth in more detail in the following chapter. Here we simply note that evolutionary normative analysis adheres naturally to a principle espoused by many economists before us: the most useful form of normative analysis is the detailed comparison of rela tively specific organizational alternatives. It is not helpful to compare the performance of real markets with that of idealized central planners, or to compare the performance of real planners to that of idealized markets. It may be helpful, however, to consider at a rela tively abstract level the kinds of policy problems that seem almost inevitably to arise in a political economy that places heavy reliance on pro fit-seeking firms and markets.
Source: Nelson Richard R., Winter Sidney G. (1985), An Evolutionary Theory of Economic Change, Belknap Press: An Imprint of Harvard University Press.