Friday, December 30, 2011

Transparency and the invisible hand: Economics 101 does include it after all [update]

In two earlier posts (see here and here), I discussed how transparency is the necessary and sufficient condition for the invisible hand of the market to operate properly.  One might say that transparency is the foundation on which markets are built.

I asserted that it is only when buyers have access to all the useful, relevant information in an appropriate, timely manner that the invisibile hand of the market can properly set market clearing prices.

The clear corollary to this statement is that any form of opacity interferes with the ability of the invisible hand to properly set market clearing prices.  Opacity is the ultimate market imperfection.

I then asked my readers for help on whether this was covered in Economics 101 lectures, discussion sections and textbooks.

One of my readers sent me an e-mail describing where and how transparency is discussed with regards to the invisible hand.

The requirement for transparency in order for the invisible hand result to hold is usually mentioned in textbooks...The text below is from Macroeconomics:  Understanding the Wealth of Nations by David Miles and Andrew Scott)… 
the key phrase is  But market outcomes would only be efficient under certain circumstances: when agents understand the nature of the goods that are being offered for sale;”
You will find something like this in any textbook…economics texts always make clear that efficient market outcomes require that people know about the good being traded, in other words there has to be transparency  (which holds for all goods, including financial products).
From the textbook,
The political economist Adam Smith had a truly profound insight.  The free operation of forces in decentralized markets would lead not to chaos but to order:  resources would tend to be allocated to produce goods that society valued most.  He likened the operation of these forces to the workings of an invisible hand.
Smith argued that market mechanisms coordinate the actions of companies and households - all serving their own self-interest - to produce things that people want in the right quantities.  It was as if some giant benevolent, but invisible hand were guiding and coordinating the millions  of economic decisions made each day.
 But market outcomes would only be efficient under certain circumstances:  when agents understand the nature of the goods that are being offered for sale; when those agents behave rationally; when goods are produced under competitive conditions (i.e. no monopolies); and when all commodities that have value are offered for sale (i.e. when markets are 'complete').
 Efficiency here has a special, and unusual, meaning.  The allocation of resources is efficient if a reallocation of resources (perhaps as a result of government intervention) is unable to make anyone better off without making someone worse off.  We call such a situation Pareto efficient, named after the Italian economist Vilfredo Pareto (1848-1923).
The idea that market forces encourage the efficient use of resources is immensely powerful.  There is also a simple intuition behind it:  free markets tend to be efficient in this sense, because if they were not, then profitable opportunities would not be exploited.  But the conditions required to operate this invisible hand efficiently are demanding.
Please re-read both sections of highlighted text from the textbook again.

The first condition for the invisible hand to operate properly is transparency.

Of equal importance is that fact that opacity is not on the list of conditions for the invisible hand to operate properly nor is it used to qualify the transparency condition.

This naturally leads back to the Queen's Question:  why did the economics profession not see the financial crisis coming when everyone was talking about opaque structured finance securities?


My sons observed that while transparency is the first condition for the invisible hand to operate properly, unlike no monopolies, it is not specifically mentioned.  Rather it is implied. I confess that I missed this as I  relied on the interpretation provided by my reader.

They further observed that by not specifically mentioning transparency in the textbooks, is sets up the idea that information asymmetry and accounting control fraud are separate market imperfections as oppose to examples of ways that opacity is expressed in the marketplace.

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