In this lecture, we analyze the claim that S&D equilibria are efficient, and come to the opposite conclusions.
The writeup for this lecture is divided into five parts, listed below. Clicking on the Chapter heading will open the document:
Chapter 5A · Efficient for Whom?
This chapter builds no new model. It uses the town of Chapter 4, six students and six owners, to examine the textbook's verdict on two outcomes. In the price-war outcome three students are housed and total surplus is $1,050. In the cross match all six are housed, but surplus is only $300. The textbook calls the first efficient and the second inferior. The chapter first states the textbook's argument at full strength: the three premises behind total surplus, arbitrage, and "get the prices right." It then tests each premise on named people. Willingness to pay is shown to merge three things: ability to pay, private value and social value. The owners' minimums turn out to be rent passed off as cost. The idea that a dollar counts the same in anyone's hands was a choice, not a finding of science. Counted socially, the verdict reverses. The chapter answers three standard replies: the compensation test, the second welfare theorem, and "market failures come later." It then shows how arbitrage undoes the cross match, and how the rule against bidding over a brother's bid would protect it. In a town with four rooms for six students, sharing houses everyone. The chapter ends by contrasting two conceptions of society, the jungle and the brotherhood, and by introducing the invisible hand as the jungle's theorem.
Chapter 5B · The Doctrine and Human Nature
This chapter quotes the textbook's own statement of the invisible hand and splits it into four claims:
people are moved by self-interest;
self-interest serves society better than kindness;
free markets make society's welfare as large as possible;
this is what Adam Smith meant.
It tests the first claim. It traces the claim to Edgeworth, who needed it for a mathematical science, and then sets out the evidence on social norms, trust (the trust game, trade between strangers online) and reciprocity. It ends with a puzzle. Breaking an agreement for a better offer pays, yet most agreements are kept. This is the ultimatum game's puzzle of money left on the table, met again, and the chapter proposes that the answer lies in a learned norm of keeping one's word.
Chapter 5C · Maximisers and Integrity
This is the lecture's agent-based model, built step by step by the Guide to Building Models. The same twelve people are either maximisers, who break agreements whenever it pays, or people of integrity, who keep their word and leave others' agreements alone. Starting from the cross match, the runs show four things:
if one whole side of the market holds to integrity, nothing moves;
every broken agreement needs a maximiser on each side;
a person of integrity cannot protect herself;
when the three richest students and the three owners with the cheapest rooms maximise, the town reaches exactly the price-war outcome.
When people learn from what pays, a single pair of maximisers tips the town into the jungle within seven years. A norm strong enough to outweigh the gain stops the spread, and a theory that calls breaking one's word rational wears the norm down. Gazumping in England compared with Scotland serves as a test the model was not built for. The chapter then takes the second claim to the world: social dilemmas and Ostrom's commons, trust and growth, giving and happiness, and Darwin's cooperating tribes against Spencer. Its verdict is that the claim is false.
Chapter 5D · Free Markets in History
This chapter tests the third claim against history, since no town of twelve can test it:
The doctrine as policy: the Washington Consensus and shock therapy.
Where it failed: Chile in 1982, Russia in the 1990s, and the crash of 2008, with Greenspan's "shocked disbelief".
Market or plan: the Mises–Lange–Hayek debate and Soviet pricing, presented as a false choice.
The visible hand: East Asia's guided development, Hong Kong's public housing, the big push, education, Keynes and the Depression, the Banking Act of 1933 and its dismantling, and Malaysia's recovery in 1998.
A section on Islam answers the argument that the hadith on price-fixing favours free markets: the market of Madinah was a market of rules, overseen through hisbah. The conclusion is that markets work when they are held inside rules and norms that a community upholds.
Chapter 5E · Whose Doctrine, and Whom It Serves
This chapter tests the fourth claim by reading Smith. He used "invisible hand" only three times, each in passing. The butcher passage is about buying dinner from strangers, not a theory of society. The Wealth of Nations is full of warnings against merchants and employers, and The Theory of Moral Sentiments makes justice, including kept promises, the pillar of society. The modern reading is a twentieth-century invention, summed up in Stigler's "granite of self-interest." The chapter then asks whom the doctrine serves, using:
the town's winners;
the empty freedom of a student with $100 to bid for a $250 room;
Foucault on knowledge and power, and Clark's theory of pay;
Kalecki's argument, shown with a hostel open to all that takes away the owners' power;
Qur'an 59:7.
It then traces how the doctrine survived despite failing its tests: the Mont Pelerin Society, Alkire and Ritchie's account of the free-market strategy, Friedman on crises, Figure 5E.1 on American wealth shares, and the way the textbook teaches it. A closing table records all four claims as false. The chapter ends on the brotherhood, and points ahead to Polanyi in Chapter 6.
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The first part explains and analyzes the textbook Efficiency claim for the S&D Equilibrium, and shows that this is built on three assumptions, and none of the three actually hold. This is discussed in Chapter 5: Countering the Claims of S&D Efficiency. Slides for this part are: L5 Part 1 Slides. The second part covers my paper, Failures of the Invisible Hand.