On the Modern Economic Theory of Incentives, Markets, and Socialism

Acentral tenet of partisans of a free-market system is that it uniquely provides economic agents with the incentives that secure an optimal economic outcome. “I believe in markets,” “People respond to incentives” are among the mantras they repeat tirelessly. Sometimes they take a darker twist, as in the former EU budget commissioner Gunther Oettinger’s ominous “Markets will teach them.”

A recent, authoritative example of this view is the October 2018 report on the “Opportunity Cost of Socialism” published by the White House Council of Economic advisors. Just before recalling Margaret Thatcher’s definition of freedom, it states: “In assessing the effects of socialist policies, it is important to recognize that they provide little material incentive for production and innovation.”

But the die-hard advocates of free markets do not exclusively belong to politics or policy environments. They seem to have the solid guarantee of academic respectability. A prominent case is Gregory Mankiw’s Principles of Economics (1998), possibly now the most widely adopted and influential textbook in economics; a quick glance at the book’s introduction teaches one the ten “principles” of the economic discipline that define the relationship between incentive-driven individual decisions and the aggregate welfare generated by trade in competitive markets.

The present essay is an attempt at instilling some doubt about this view, while retaining the basic premises of its holders. We shall proceed in a mostly historiographical way, retracing some basic tenets of the otherwise complex theoretical elaborations of the notions of market efficiency and incentives. The picture that will eventually emerge turns out to be more nuanced, if not bleak.

First, the relationship between (perfect) competition and individual incentives remains unclear if one investigates it through the lens of the traditional Neo-Classical (Walrasian) theory, which is still today a fundamental reference for the free-markets discourse. In that perspective, individuals only interact via the impact of their independent behaviors on market prices. Their “incentives” are therefore limited to determining their preferred amounts of goods and services to be bought or sold at given prices. Trade takes place in a centralized market place, and they are mediated by a fictitious institution assumed to be perfectly able to monitor transactions and to enforce individual agreements. Such a representation of the market mechanism, we shall argue, shares several features with those of socialist economies, as acknowledged by several among the founders of Neo-Classical theory.

Posted on INET (Institute for New Economic Thinking)

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