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Efficient for Whom?

LECTURE 5 · PART 1

Why economists call the price-war outcome efficient, and why the verdict fails

A

B

C

D

E

F

P

Q

R

S

T

U

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The economist’s argument at full strength

STAGE 1 · SLIDES 1–9

The textbook’s case, stated more clearly than the textbook states it, before anything is said against it.

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The question lecture 4 left

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3

3 housed

D, E and F, in the rooms of P, Q and R, at 340, 330 and 310

D

E

F

3 sent home

A, B and C. B and C lost rooms they had already secured

A

B

C

3 rooms empty

The rooms of S, T and U stand empty

S

T

U

The textbook’s word for this outcome: efficient

Why do economists call this outcome efficient, and are they right?

Lecture 5 · Efficient for Whom? · Part 1

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The economist’s world

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Three premises:

Benefit. What a buyer will pay measures all the good the purchase does.

Cost. What a seller requires measures all that society gives up to supply it.

Money. A lira counts the same in anyone’s hands, so payments between people are neither gains nor losses.

Consequence: the social gain from any trade is willingness to pay minus cost. The price only divides that gain between buyer and seller.

Lecture 5 · Efficient for Whom? · Part 1

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Two outcomes: which is better?

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	Price wars	Cross-matching
Who is housed	D, E and F	All six: A–P, B–Q, C–R, D–S, E–T, F–U
Rooms left empty	S, T and U	None
Is every deal voluntary?	Yes	Yes. Every student pays within his budget; every owner gets more than his minimum
The textbook’s verdict	Efficient	Inferior

Cross-matching is lecture 4’s cooperative outcome, with rents of 75, 175, 275, 375, 475 and 575.

The textbook’s reasoning

An owner’s minimum is what letting his room costs society; a student’s budget is what housing him is worth to society. Compared with the price wars, cross-matching houses A, B and C, valued at 600 by their budgets, by letting the rooms of S, T and U, which cost 1,350 by their minimums. On this accounting, it leaves society 750 worse off.

Which outcome would you choose for this town? Why does the textbook choose the other?

Lecture 5 · Efficient for Whom? · Part 1

Slide 3��VOICEOVER��Put the two outcomes side by side. In the price wars, three students are housed and three rooms stand empty. In cross-matching, each student is paired with the owner in the same position, A with P, B with Q, and so on, and everyone is housed. Every deal is voluntary: no student pays more than he can, and every owner gets more than he asked. Most people, seeing the two, would choose cross-matching without hesitation.��The textbook chooses the price wars. Its reasoning is this. Treat each owner's minimum as what society gives up when his room is let, and each student's budget as what society gains when he is housed. Then cross-matching gains 600 by housing A, B and C, and gives up 1,350 by letting the rooms of S, T and U. On that accounting, it leaves society 750 worse off.��Why does this feel wrong? Partly because the textbook's diagram tells the story one unit at a time. Beyond the equilibrium, it says, the next student values a room less than the next owner asks. In our town that would mean C renting S's room, a deal no one would make. In cross-matching nothing of the kind happens: C lives in R's room, at a rent both accept. The textbook's numbers are totals, not a description of any deal a real person would strike. Whether those totals measure anything real depends on the premises, and that is what Stage 2 tests.

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In that world, arbitrage is the engine of welfare

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Under posted prices

F pays T 500, while B pays P 150: an arbitrage opportunity. F and P can deal at any rent between 150 and 500, and both gain. B loses her room and T his tenant, but total gains rise from 750 to 1,000.

The theorem (in the economist’s world)

Welfare can be increased only where an arbitrage opportunity remains. So once every arbitrage opportunity is used up, welfare is at its maximum, and every room lets at the same rent: one price maximises welfare.

The converse fails

The price wars ended at 310, 330 and 340, so D and P could still gain by dealing at 320. But welfare is already at its maximum: this arbitrage would only move gains between people.

Edgeworth (1881); Shapley and Shubik (1971).

Board: find all the arbitrage opportunities left in the posted-price outcome.

Lecture 5 · Efficient for Whom? · Part 1

Slide 4��VOICEOVER��In lecture 4 we saw arbitrage opportunities everywhere in the posted-price market. F was paying T 500 while B was paying P only 150. F and P could both do better by dealing with each other. If they do, B loses her room and T loses his tenant, but on the economist's accounting, total gains rise from 750 to 1,000.��This is a general result. In the economist's world, welfare can be increased only where some arbitrage opportunity remains. Turn that around: once every arbitrage opportunity has been used up, welfare is at its maximum. And when no arbitrage remains, no one can be paying more for a room than someone else is receiving, so every room lets at the same rent. That is why economists treat one price as the mark of an efficient market.��One caution. The result does not say that every arbitrage increases welfare. Our price wars stopped at 310, 330 and 340, and D and P could still gain by dealing at 320. But welfare is already at its maximum, so that last arbitrage would only shift gains from one person to another.��Instructor note: answer for the board exercise. The posted-price outcome had rents of B–P 150, C–Q 200, D–R 400, E–S 450 and F–T 500. An arbitrage opportunity exists whenever one student pays more than another owner receives. There are ten: C, D, E and F with P; D, E and F with Q; E and F with R; and F with S.

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“Getting the prices right”

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In the economist’s world there is one right price: the competitive equilibrium. In our town, a rent of about 310–340.

At the right price, every trade worth making is made, and none that destroys value.

The right price does the planner’s job: each person decides privately, and the result maximises social welfare. No one needs to know anything but the price.

So Mankiw’s benevolent planner can leave well enough alone (p. 147).

Hence the policy rule: get the prices right. Remove “distortions” (controls, subsidies, tariffs, rules about who may bid) and let prices find their level.

In our town, every alternative to the price-war rent is a distortion: posted rents, cooperative rents, the hostel’s doubling up, the rule against bidding over a brother’s bid.

“Getting the prices right” is the core of economic policy advice. Right for whom? Hold the question until Stage 2.

Lecture 5 · Efficient for Whom? · Part 1

Slide 5��VOICEOVER��Economists have a phrase for what policy should do: get the prices right. Behind it lies a powerful idea. In the economist's world there is a right price, the one at which supply equals demand. At that price, every trade worth making is made, and no trade that destroys value is made.��More than that, the right price solves society's problem without anyone having to solve it. No one needs to know the whole town's budgets and minimums. Each student only asks whether he will pay the rent, and each owner whether he will accept it. Their private decisions add up to the best outcome for everyone. That is why Mankiw's planner can leave the market alone, and why so much policy advice consists of removing whatever stops prices from finding their level.��In our town, that means the price-war rent is right, and everything else is a distortion: the posted rents, the cooperative rents, the hostel's doubling up, even the rule against bidding over a brother's bid. Notice what the claim depends on: that prices measure what society gains and loses. Hold that thought until Stage 2.��Instructor note. Amsden, Asia's Next Giant (1989), argues that South Korea industrialised by deliberately "getting relative prices wrong"; Wade, Governing the Market (1990), makes a similar case for Taiwan. Both are held for Part 2, where they answer the "free markets" claim.

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How is the right price found? False trades

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The right rent depends on every student’s budget and every owner’s minimum. That knowledge is scattered; no one holds all of it.
People reveal their numbers only by dealing, or refusing to deal, at some rent. So some trades happen at wrong prices: false trades.
Once false trades are final, they change who holds what, and that moves the right price itself. The market may never reach it.

Walras and Edgeworth both saw this, and proposed two ways out:

Forbid real trade

until the price is found: Walras’s written pledges (1900).

Allow every agreement to be undone

Edgeworth’s recontracting (1881). Lecture 4’s price wars took this way.

A plausibility argument, not a proof. How markets reach equilibrium has never been satisfactorily explained (Hicks, 1939; Arrow, 1959; Fisher, 1983).

Lecture 5 · Efficient for Whom? · Part 1

Slide 6��VOICEOVER��Where does the right price come from? It depends on everything about everyone: every student's budget, every owner's minimum. No one knows all that. People reveal their numbers only when they deal, or refuse to deal, at some price. So prices have to be tried before the right one is known, and some trades happen at the wrong prices. Economists call these false trades.��Here is the trouble. A false trade, once made, changes who holds what. B now has P's room; F has T's. The right price for the market that remains is no longer the one we started looking for. Trade at the wrong prices, and you may never reach the right one.��The founders of the theory saw this. Walras's answer was to forbid real trade until the right price was found. Edgeworth's answer was to let every agreement be undone. Our price wars in lecture 4 took Edgeworth's way.

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The same problem divided economists over socialism

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Lange (1936)

A planning board could find the right prices by trial and error, playing Walras’s auctioneer. Concedes: the market needs an auctioneer who forbids trade before equilibrium. No real market has one.

Hayek (1945)

Only real trading, by people using what they alone know, can discover prices. Concedes: real trades happen at wrong prices, so the market is never at the equilibrium where the efficiency theorem applies.

Historical background

Soviet planners set prices centrally, mostly from costs, and changed them rarely. Goods were allocated by plan.
Prices that ignored scarcity brought chronic shortages and queues (Kornai, 1980).
Lange’s ideas shaped reform elsewhere (Hungary, 1968). In 1967 he suggested computers could do the auctioneer’s work.

The textbook defends markets with an equilibrium theorem. The markets’ greatest defender held that real markets are never in equilibrium.

So the right price needs something no real market has: an auctioneer before any trade, or agreements that never bind.

Lecture 5 · Efficient for Whom? · Part 1

Slide 7��VOICEOVER��The same problem divided economists in the great debate over socialism. Lange argued that a planning board could find the right prices by trial and error, doing the auctioneer's job. Hayek replied that only real trading, by people using knowledge no board could gather, can discover prices.��Notice what each side concedes. Lange's market needs an auctioneer who forbids trade before equilibrium, something no real market has. Hayek's market discovers prices through real trades at wrong prices, so it is never at the equilibrium where the efficiency theorem applies. The textbook defends markets with that theorem, but the markets' greatest defender cannot lean on it. The only other way is the one lecture 4 showed: agreements that never bind.��A word of history, because this was not only a seminar debate. In the Soviet Union, prices were set by planners, not discovered by markets. But Soviet planners did not do what Lange proposed. They set prices mostly from costs, changed them rarely, and allocated goods by plan. Prices that did not move with scarcity produced chronic shortages and queues, which Kornai documented across the socialist economies. That experience gave Hayek's argument enormous weight. Lange's ideas found more of a home in reform programmes elsewhere in Eastern Europe. Near the end of his life, he suggested that computers might do the auctioneer's work, an idea that returns whenever computing power grows.

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Mankiw makes this argument, half aloud

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Part of the argument	In Mankiw, chapter 7
The price cancels	Explicit: the middle terms cancel (p. 145)
Benefit premise	Willingness to pay measures the good’s value to the buyer (p. 136). That no one else is affected appears only in a closing caveat (p. 150).
Cost premise	Opportunity cost, including the value sellers place on their own time (p. 141). The same closing caveat applies.
Money premise	Never stated. Total surplus is called the “natural” measure (p. 145), and equality is set aside.

The arithmetic is said aloud; the moral premises are not.

Lecture 5 · Efficient for Whom? · Part 1

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Why it isn’t said aloud

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Economists were trained to believe that only factual claims can be studied scientifically; evaluative claims lie beyond science (Hausman and McPherson, ch. 1).

So moral premises arrive disguised as definitions, “natural” choices or caveats, and never get examined.

One word then carries the verdict: efficient. In ordinary speech it means without waste, and it is praise.

Robert Nelson, Economics as Religion (2001): efficiency is the sacred value of economics; “transitional” unemployment is accepted on the path to it. B and C were our transitional casualties.

The remedy: economists must learn to reason about norms (Hausman and McPherson). Mathematics was once outside their skill set too, and the profession retooled (Weston, 1994).

If the three premises were stated plainly on the first page of chapter 7, would you accept them?

Lecture 5 · Efficient for Whom? · Part 1

Slide 9��VOICEOVER��Why is the argument not stated plainly? The answer lies in the history of the discipline. For decades, economists described their subject as a positive science. Friedman's essay "The Methodology of Positive Economics" set the tone in 1953, and one of the most widely used textbooks of the next generations was titled An Introduction to Positive Economics. Values, on this view, were matters of feeling, outside science.��Then positivism collapsed among philosophers, and critics such as Sen, and Hausman and McPherson, showed value judgments at work inside economic theory. Economists conceded the point, reluctantly. Today's textbooks rarely claim that economics is purely positive; Mankiw even announces, on the first page of chapter 7, that the chapter turns from positive to normative questions.��But the concession has stayed on the surface. Most economists think of values as a layer added on top, when the economist moves from analysis to advice, leaving the theory itself untouched. That is why Mankiw can announce a normative chapter and then introduce its moral premises as definitions and "natural" choices. The values are not on top of the theory. They are inside it: in what counts as a benefit, what counts as a cost, and whose lira counts for how much.��Then a single word does the moral work. Calling an outcome efficient is praising it. Robert Nelson describes efficiency as the sacred value of economics, worth tolerating "transitional" unemployment for. In our market, B and C were the transitional casualties: they lost their rooms on the way to the efficient outcome.��Hausman and McPherson argue that economists must learn to reason openly about values. That is a new skill for them, but so was mathematics once, and they learned it.��INSTRUCTOR NOTE�- The textbook title. Lipsey's An Introduction to Positive Economics first appeared in 1963 and ran through many editions; later editions dropped "Positive" from the title. Check the year of the change before citing it.�- If a student points to Mankiw's p. 135. Mankiw does admit that chapter 7 is normative. He admits it at the surface, then lets the values work unseen in the definitions underneath. The third paragraph of the voiceover makes this point.

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Most trades or most surplus? Testing the premises

STAGE 2 · SLIDES 10–23

The social accounting behind the verdict, the three premises it rests on, and why each one fails.

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Most trades or most surplus?

2 · TESTING THE PREMISES

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	Price wars	Cross-matching
Deals made	3	6: every possible voluntary deal
Students housed	D, E and F	All six
Rooms let	P, Q and R	All six
Social welfare, by the textbook’s measure (total surplus)	1,050	300
What it maximises	Surplus	The number of deals

With one price for everyone, no rent can house more than three. So the most deals and the most surplus coincide, and the textbook never has to choose.
Drop the single price, and the two come apart: cross-matching makes six deals at six different rents.

The textbook chooses the most surplus. Which would you choose, and what would you need to count to decide?

Lecture 5 · Efficient for Whom? · Part 1

Slide 10��VOICEOVER��Look again at the two outcomes from slide 3. The price wars make three deals. Cross-matching makes six, which is every deal that can be made voluntarily in this town. Each student is paired with an owner whose minimum he can meet, and each pays a rent the owner accepts. So we have two different things being maximised. Cross-matching gives the most deals; the price wars give the most surplus, as the textbook counts it.��Why does the textbook never notice that these are different? Because it assumes one price. With a single rent for everyone, no rent you choose can house more than three students. So under one price, the most deals and the most surplus are the same outcome, and the question never arises. It arises only when we drop the single price, as cross-matching does, with six different rents.��The textbook chooses the most surplus. Before we accept that choice, we need to see exactly what its accounting counts, and what it leaves out.��Instructor note: single rents. With one rent for everyone, the number housed at each rent is: 100 → 1, 150 → 2, 200 → 2, 250 → 3, 300 → 3, 350 → 3, 400 → 3, 450 → 2, 500 → 2, 550 → 1. Students can check this on the board if they doubt that three is the ceiling.

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The textbook’s social accounting

2 · TESTING THE PREMISES

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The textbook claims to measure social welfare. Its accounting of cross-matching, compared with the price wars:

Social benefits

600

A, B and C are housed. Valued by their budgets: 100 + 200 + 300.

Social costs

1,350

S, T and U let their rooms. Valued by their minimums: 350 + 450 + 550.

Net

−750

Social costs are much larger than social benefits: by this measure, cross-matching leaves society 750 worse off.

This accounting rests on three premises.

Lecture 5 · Efficient for Whom? · Part 1

Slide 11��VOICEOVER��Remember what the textbook claims to measure: not just the gains of buyers and sellers, but the welfare of society as a whole. Here is its accounting, laid out plainly. Moving from the price wars to cross-matching houses three more students, A, B and C. The textbook counts that as a social benefit, valued by what they can pay: 600 in all. It also lets three more rooms, those of S, T and U. The textbook counts that as a social cost, valued by what those owners ask: 1,350 in all. Social costs of 1,350 against social benefits of 600: by the textbook's measure, cross-matching leaves society 750 worse off.��Every number in that sum comes from a budget or an asking price. So the sum can be no better than the premises that turn budgets and asking prices into social benefits and social costs.

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Three premises, three questions

2 · TESTING THE PREMISES

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Premise (from slide 2)	The question for our town
Benefit: a budget measures the whole social benefit	Are budgets of 100, 200 and 300 the whole social benefit of housing A, B and C?
Cost: an asking price measures the whole social cost	Are minimums of 350, 450 and 550 the social cost of letting the rooms of S, T and U?
Money: a lira counts the same in anyone’s hands	Does a lira count the same to A as to F?

If any premise fails, the accounting fails with it.

Lecture 5 · Efficient for Whom? · Part 1

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Test 1: Three numbers the textbook treats as one

2 · TESTING THE PREMISES · TEST 1: BENEFITS

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	What it measures	For A, B and C
Ability to pay	What the student has	100, 200 and 300: 600 in all
Private value	What the room, and the education it makes possible, means to the student: a degree, a profession, a lifetime’s earnings	Far more than 600
Social value	What the town gains as well: teachers and doctors, and families whose prospects change	More still

Ability to pay → private value

The gap is a credit constraint: no one lends to a student against his future salary.

Private value → social value

The gap is an external benefit: it falls on people who never enter the rental market.

The textbook uses one number for all three: it calls a budget “willingness to pay,” says this measures how much the buyer values the good (Mankiw, p. 136), and adds it up as social benefit.

Board: for C, put a number on each of the three: what he can pay, what the room means to him, and what it means to the town.

C is willing to pay far more than 300. He is able to pay only 300.

Lecture 5 · Efficient for Whom? · Part 1

Slide 13��VOICEOVER��The textbook's accounting uses one number for each student, his budget, and calls it his willingness to pay. But three different things are hiding in that one number, and our whole argument depends on keeping them apart.��The first is ability to pay: what the student has. For C, that is 300. The second is private value: what the room, and the education it makes possible, means to C himself. That is a degree, a profession, a lifetime's earnings, far more than 300. If a bank would lend to him against his future salary, he would offer far more. He is willing to pay much more than 300; he is able to pay only 300. Economists call this gap a credit constraint.��The third is social value: what the town gains as well. If C finishes his degree, the town gains a teacher or a doctor, and his family's prospects change. None of these people pays any rent, so none of this appears in the market. Economists call this gap an external benefit.��The textbook collapses all three into one. It calls a budget "willingness to pay," says it measures how much the buyer values the good, and then adds it up as the benefit to society. For A, B and C, that number is 600. Their private value is far more, and the social value more still.

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Welfare, desire, choice

2 · TESTING THE PREMISES · TEST 1: BENEFITS

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	What it is	Observable?
Welfare	What is good for a person: health, knowledge, family, faith	Partly: health, nutrition, shelter and education can be observed
Utility, or desire	What a person wants. Bentham thought pleasure could be measured; Edgeworth imagined a “hedonimeter” (1881)	No
Choice	What a person actually picks	Yes

Positivism admitted only what can be observed. So economics redefined desire as whatever is chosen (Samuelson’s revealed preference, 1938), and welfare as getting what one desires.

Lecture 5 · Efficient for Whom? · Part 1

Slide 14��VOICEOVER��What we have just seen is not an accident of one chapter. The same collapse runs through the economic theory of the consumer.��Start with three different things. Welfare is what is actually good for a person: health, knowledge, family, faith. It is broad, but not invisible; Test 3 will show that economists once measured it. Desire, or utility, is what a person wants. Bentham thought pleasure could be measured, and Edgeworth even imagined an instrument, a hedonimeter, to measure it. But no one ever built one. Choice is what a person actually picks, and that can be observed directly.��In the twentieth century, economists came under the influence of positivism, which said that science may deal only with what can be observed. So they redefined the unobservable in terms of the observable. Samuelson's revealed preference says that what you prefer is simply what you choose. And welfare became getting what you prefer.

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Revealed preference: two assumptions that fail

2 · TESTING THE PREMISES · TEST 1: BENEFITS

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Revealed preference needs two assumptions

People always choose what they most desire.
What they desire is always good for them.

Both fail

Spinach is good for me, I want ice cream, and I eat the spinach to please my mother (Zaman, 2012).
Mankiw himself exempts the heroin addict (p. 140).

The parallel with slide 13

Social value, private value and ability to pay collapse into “willingness to pay.” Welfare, desire and choice collapse into “revealed preference.” In each case the one observable number takes the place of the others.

Hausman and McPherson (2006), chapter 8; Zaman, “The Normative Foundations of Scarcity” (2012).

Lecture 5 · Efficient for Whom? · Part 1

Slide 15��VOICEOVER��Revealed preference needs two assumptions: that people always choose what they most desire, and that what they desire is always good for them. Both fail every day. Spinach is good for me, I want ice cream, and I eat the spinach to please my mother. Even Mankiw has to set aside the heroin addict, whose choices plainly do not serve his welfare.��Now notice the parallel with slide 13. There, social value, private value and ability to pay were collapsed into one number, willingness to pay. Here, welfare, desire and choice are collapsed into one observation, revealed preference. In both cases, the one thing that can be measured takes the place of the things that matter. And in both cases the replacement arrives as a definition, never stated as a premise that might be false.��Instructor note. In the scarcity paper, Ayer, who had denied that mental states exist because they cannot be observed, later called this "feigning anaesthesia." It is a good aside if a student defends revealed preference as merely cautious.

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Test 2: Three numbers for the owners

2 · TESTING THE PREMISES · TEST 2: COSTS

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	What it measures	For S, T and U
Asking price	What the owner insists on receiving: in our model, his minimum	350, 450 and 550: 1,350 in all
Private cost	What letting the room costs the owner himself: the rent he could have had from someone else	With rooms standing empty, nothing. Where students are plentiful, the going rent
Social cost	What the town uses up when the room is occupied	Close to zero: some cleaning and wear

Asking price → private cost

The gap is holding out for more than one could get.

Private cost → social cost

The gap is the rent.

The textbook uses one number for all three, and calls the minimum a “cost.” Mankiw’s painter has a real cost: her time is used up (p. 141). S uses up nothing: the room is already built.

Board: for S, put a number on each of the three.

Lecture 5 · Efficient for Whom? · Part 1

Slide 16��VOICEOVER��Now the owners. Here too the textbook uses one number for three different things.��The first is the asking price: what the owner insists on receiving. In our model, that is his minimum. For S it is 350.��The second is private cost: what letting the room actually costs S himself. That is the rent he could have had from someone else. In our town, with rooms standing empty, that is nothing. Where students are plentiful, it is the going rent.��The third is social cost: what the town uses up when someone lives in the room. The room is already built. Occupying it needs some cleaning and causes some wear, and that is all.��The textbook calls the minimum a cost, as if all three were the same. For Mankiw's painter, cost is real: her time is used up. For S, nothing is used up. The gap between his asking price and his private cost is holding out. The gap between his private cost and the social cost has a name the classical economists knew well: rent.

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Rent: the gap between private and social cost

2 · TESTING THE PREMISES · TEST 2: COSTS

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“Corn is not high because a rent is paid, but a rent is paid because corn is high.” Ricardo (1817)

Rent is income received for no service rendered: the room already exists, and the owner provides nothing new by letting it. Rent follows demand; it is not a cost of supply.
Near a university, rooms are dear because the university brings students, not because rooms cost more to provide.

Smith

Landlords “love to reap where they never sowed.”

Mill

Rising land values are an “unearned increment.”

Henry George (1879)

Tax rent away: the community created it.

Where rent is large, prices diverge from social costs and can no longer guide efficient choices. That is why the rentier worried the classical economists.

Lecture 5 · Efficient for Whom? · Part 1

Slide 17��VOICEOVER��The classical economists had a name for income of this kind: rent, payment for no service rendered. Ricardo put it in one sentence. Corn is not high because a rent is paid; a rent is paid because corn is high. Rent follows demand. It is not a cost of supplying anything.��Our university town is Ricardo's case exactly. Rooms near the university are dear because the university brings students, not because the rooms cost more to provide. The owner collects value that the university and its students created.��Smith said landlords love to reap where they never sowed. Mill called the rise in land values an unearned increment. Henry George proposed taxing rent away, because the community had created it. Put their worry in modern terms: where rent is large, the price of a room is far above its social cost, and prices can no longer guide efficient choices. The classical economists, unlike the modern textbook, saw the rentier as a problem.

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What the gap does to students

2 · TESTING THE PREMISES · TEST 2: COSTS

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To a student

The rent is a real private cost: it is what he must pay.

To the town

Housing him costs almost nothing: the room is there, and empty.

So a student who cannot pay the rent goes home, though housing him would cost the town almost nothing.

The textbook’s 1,350 is a sum of asking prices. It measures neither the owners’ private costs, which are nothing while rooms stand empty, nor the social cost, which is close to zero.

What do S, T and U actually give up when their empty rooms are let?

Lecture 5 · Efficient for Whom? · Part 1

Slide 18��VOICEOVER��Now see what this gap does. To a student, the rent is entirely real: it is what he must pay, and if he cannot pay it, he goes home. But to the town, housing him costs almost nothing. The room is there; it is empty; occupying it needs some cleaning.��So the rent turns away students whom the town could house for almost nothing. That is the divergence between private and social cost, working against the very people the town most needs to keep.��And the textbook's sum of 1,350 is just the owners' asking prices added up. It does not measure what letting the rooms costs the owners, which is nothing while the rooms stand empty. Nor does it measure what it costs the town, which is close to zero. On the cost side, the textbook's accounting measures nothing real.��Instructor note. If students raise short-term lets to tourists as the owners' real alternative, the private cost becomes a tourist's rent, and the comparison becomes a tourist's stay against a student's education, each valued by willingness to pay. That takes the discussion straight back to slide 13.

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Test 3: Whose lira?

2 · TESTING THE PREMISES · TEST 3: WHOSE LIRA?

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A

A’s scholarship barely covers food. 100 lira buys her a week’s food.

F

F lives comfortably. 100 lira buys him a dinner out.

The textbook adds F’s gains and A’s gains as if each lira did the same good.

The textbook’s 1,050 (price wars)

F alone keeps 290.
The owners take 530.
A, B and C get nothing.

Cross-matching

Spreads its gains: every student and every owner gains something, including the three poorest.

If you had 100 lira to give away, would it matter as much to A as to F?

Lecture 5 · Efficient for Whom? · Part 1

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What economists once knew

2 · TESTING THE PREMISES · TEST 3: WHOSE LIRA?

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Before the 1930s, economics was organised around material welfare: food, health, shelter, the capacity to work (Marshall, Pigou).

Diminishing marginal utility: the first units of consumption bring far more benefit than the last. Bread matters more than luxuries.

So a lira does more good in a poor man’s hands than in a rich man’s.

Pigou, The Economics of Welfare (1920): other things equal, a transfer of income from rich to poor increases total welfare.

Taxing a rich man’s luxuries to buy bread for the poor was a welfare improvement, and economists said so.

Lecture 5 · Efficient for Whom? · Part 1

Slide 20��VOICEOVER��There was a time when economists said plainly what everyone in this room just said. Before the 1930s, economics was organised around material welfare: whether people had food, health, shelter and the strength to work. Its central principle was diminishing marginal utility. The first loaf of bread matters enormously; the hundredth luxury hardly at all.��From this, Pigou drew the obvious conclusion. Other things equal, moving income from a rich man to a poor man increases total welfare, because it meets more urgent needs at the expense of less urgent ones. Taxing a rich man's luxuries to buy bread for the poor was, in the economics of the day, a welfare improvement. The money premise, that a lira counts the same to everyone, would have looked strange to these economists.

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How it was removed, and why the reason fails

2 · TESTING THE PREMISES · TEST 3: WHOSE LIRA?

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How it was removed

Robbins (1932): comparing welfare between persons is unscientific, because one person’s satisfaction cannot be observed and set against another’s.
Economics was redefined as the science of scarcity, and the case for redistribution dropped out of the textbook.

Why the reason fails

Cooter and Rappoport (1984): the earlier economists used observable markers: health, nutrition, shelter, capacity to work.
Measured today: life expectancy, child mortality, literacy, Mahbub ul Haq’s Human Development Index, Sen’s capabilities.
In our town, whether A eats and whether C finishes his degree can both be observed.

So the money premise was a choice, not a requirement of science.

Lecture 5 · Efficient for Whom? · Part 1

Slide 21��VOICEOVER��What removed this idea? In 1932 Lionel Robbins argued that comparing one person's welfare with another's is not science, because no one can observe another person's satisfaction and weigh it against his own. Economics was redefined as the science of scarcity. With interpersonal comparisons ruled out, the argument for taxing luxuries to buy bread had nowhere to stand, and it quietly left the textbooks.��But Cooter and Rappoport showed that the earlier economists had never measured welfare by inner feelings. They looked at things anyone can see: whether people were healthy, fed, housed and able to work. We measure such things today: life expectancy, child mortality, literacy, the Human Development Index that Mahbub ul Haq devised, Sen's capabilities. In our town, whether A eats and whether C finishes his degree are facts, not feelings. So the claim that welfare cannot be compared was never forced on economics by science. Treating every lira alike was a choice.

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The verdict reversed

2 · TESTING THE PREMISES

25

Cross-matching against the price wars	The textbook’s accounting	Counting what it leaves out
Benefit of housing A, B and C	600: what they can pay	Private value far more; social value more still: three degrees, and the town’s teachers and doctors
Cost of letting the rooms of S, T and U	1,350: what the owners ask	Close to zero: the rooms are already built; the gap is rent
Whose lira	All count the same	Gains to the poorest students count for more
Net	Social costs exceed social benefits by 750	Social benefits far exceed social costs

Counted socially, the most deals beats the most surplus.

Lecture 5 · Efficient for Whom? · Part 1

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What the verdict teaches

2 · TESTING THE PREMISES

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Counted socially, the most deals beats the most surplus. The town should house all six.

The textbook’s accounting measures what students can pay and what owners ask, and nothing else.

“Getting the prices right” gets private values right, not social ones. This answers the question held over from slide 5.

The efficiency result holds only where private and social values coincide. For education, housing and health, they diverge systematically.

Next: how the market moves a town from cross-matching to the price wars, and what can stop it.

Lecture 5 · Efficient for Whom? · Part 1

Slide 23��VOICEOVER��This answers the question lecture 4 left us with. The gains-from-trade calculation counts what students can pay and what owners ask, and nothing else. It leaves out everything the town gains when a student stays, and everything it does not lose when an empty room is let.��It also answers the question we held over from slide 5: prices right for whom? Prices measure ability to pay and asking prices, which are private values. Getting the prices right gets private values right. Where private and social values diverge, as they do for housing and education, the right price can be the wrong one for society.��The efficiency result is correct only in a world where private and social values coincide. Our town is not that world, and neither is any town with students in it. In the next stage we see how the market actually moves a town from cross-matching to the price wars, and what can stop it.

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How the equilibrium does harm, and why the theory cannot see it

STAGE 3 · SLIDES 24–32

Arbitrage, the brother’s-bid rule, sharing, the bonds lost and built, and two conceptions of society.

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In our town, arbitrage does harm

3 · HOW THE EQUILIBRIUM DOES HARM

28

Under cross-matching

A

pays 75 to

P

F

pays 575 to

U

F and P strike a deal:

A goes home, and U’s room stands empty.

F and P can deal at any rent between 75 and 575, and both gain. On the textbook’s accounting, social welfare rises by 450.
A goes home without her education. U’s room, which costs the town almost nothing to let, stands empty.
The economist’s engine of welfare becomes an engine of harm once private and social values diverge.

The different rents were not waste. They were the price structure that housed everyone.

Lecture 5 · Efficient for Whom? · Part 1

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The rule that forbids this arbitrage

3 · HOW THE EQUILIBRIUM DOES HARM

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Do not bid over your brother’s bid. Agreements are to be fulfilled (Qur’an 5:1).

Lecture 4’s Islamic norms, read now as economics.

Read as economics, the rule forbids exactly the move that makes the market “efficient”: luring a party away from an agreement already made.
It holds in place the different rents that house everyone.
The price war is what you get when that move is allowed; cross-matching is what you get when it is forbidden.

The two societies of lecture 4 differ because they treat this one move differently.

Lecture 5 · Efficient for Whom? · Part 1

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The realistic case: scarce rooms and pure rent

3 · HOW THE EQUILIBRIUM DOES HARM

30

Four rooms

Housed

C

D

E

F

Go home

A

B

Four rooms for six students. Letting a room costs the town almost nothing, and no owner will leave a room empty.
The rent settles where exactly four students can pay: above 200 and at most 300.
At a rent of 250, the owners collect 1,000: pure rent, for rooms that cost the town almost nothing to let.
The rooms go to the four who can pay most, not to those with the highest private value, nor to those the town most needs educated.

Is there no way to house more than four students in four rooms?

Lecture 5 · Efficient for Whom? · Part 1

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The dilemma inside our market: compete or share

3 · HOW THE EQUILIBRIUM DOES HARM

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A rents a room at 100. F arrives, and has two choices:

	A	F	Landlord
F outbids, offering 150 for the room alone	Homeless	Housed, pays 150	150
F proposes sharing, each paying 75	Housed, pays 75	Housed, pays 75	150

The landlord receives 150 either way. Sharing houses both students, and both pay less.
Against this stands the cost of sharing: lost space and privacy.
The textbook cannot see this option: it defines the good as one room per person. Chapter 3’s hostel doubled up; in lecture 4, G joined A.

A Prisoner’s Dilemma

Both share: both housed, cheaply.
Both compete: rent climbs; one goes home.
Each is tempted to compete. The landlord gains from their rivalry.

This answers slide 26’s question: four rooms can house more than four students.

Lecture 5 · Efficient for Whom? · Part 1

Slide 27��VOICEOVER��Here is the answer to the question we left on slide 26. A is renting a room for 100, and F arrives with more money. F can do what the price war taught: offer the landlord 150 for the room, and A goes home. Or F can offer to share. Each pays 75; the landlord still gets 150. Both students are housed, and both pay less than they would have. Sharing has a cost, of course, in space and privacy, and that cost depends on many things. But often it is far smaller than the cost of one student going home.��Now think of two students, each able either to compete or to share. If both share, both are housed cheaply. If both compete, the rent climbs until one of them can no longer pay, and he goes home. Each is tempted to compete, hoping to win the room alone. This is the Prisoner's Dilemma, and we did not need to import it: it sits inside our own market. Notice who gains when the students compete: the landlord, who provides nothing more either way. And notice what the textbook cannot see. It treats a room as something one person buys at a price. Sharing is simply not on its list of options.

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What the price war costs that no ledger records

3 · HOW THE EQUILIBRIUM DOES HARM

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Muslim; Nawawi’s Forty, no. 35

“Do not envy one another, do not inflate prices against one another, do not hate one another, do not turn away from one another, and do not undercut one another’s sales, but be, O servants of Allah, brothers.”

In our market: B’s resentment toward F, a fellow student; P’s broken word to B; the lesson that the person beside you is a rival.
In Britain, Fractured Families (Centre for Social Justice, 2013) documents the cost of family breakdown.
Benjamin Nelson (1949): from tribal brotherhood to universal otherhood. Graeber (2011): market exchange leaves the parties “quits,” so that the relationship can end.

The theory has no place for these losses: its society has no bonds to lose. Yet friends share a room more easily than strangers.

Lecture 5 · Efficient for Whom? · Part 1

Slide 28��VOICEOVER��There is one more cost, and it never appears in any calculation. When F outbid B, the measure recorded a gain. It did not record B's resentment toward a fellow student, P's broken word, or the lesson the whole market taught: that the person beside you is your rival. The hadith puts the rule against undercutting another's sale in the same breath as envy and hatred, and it ends with a command: be brothers. The rule exists to protect the bond between people.��Walter Lippmann wrote of the "acids of modernity" dissolving the bonds that once held people together. In Britain, the Centre for Social Justice has documented what this has meant for families, and what family breakdown costs. Benjamin Nelson traced how the West moved from tribal brotherhood to universal otherhood, where everyone is a stranger. Graeber notes that market exchange is designed to leave the parties quits, so that the relationship can end.��The theory cannot see these losses because its society has no bonds to lose: only individuals and contracts. Yet we saw on slide 27 that the bond has real economic value. Friends can share a room; strangers find it hard.

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Building bonds

3 · HOW THE EQUILIBRIUM DOES HARM

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Muslim

“You will not believe until you love one another. Shall I tell you something which, if you do it, you will love one another? Spread salām among you.”

Tirmidhī

“Your smile in the face of your brother is charity.”

al-Bukhārī, al-Adab al-Mufrad

“Give gifts to one another, and you will love one another.”

al-Bukhārī, al-Adab al-Mufrad

“He is not a believer who eats his fill while his neighbour goes hungry.” Spending on kin, orphans, the needy and travellers is righteousness (2:177).

The institutions of a society reflect its spirit. The market’s exchange leaves people quits; Islam’s everyday practices leave people bound to one another.

Lecture 5 · Efficient for Whom? · Part 1

Slide 29��VOICEOVER��Islam does the opposite of the market: it sets out to build bonds, through acts so small they are easy to overlook. Spread the greeting of peace, and you will love one another. A smile at your brother is charity. Give gifts, and you will love one another. No one is a believer who eats his fill while his neighbour goes hungry. Among the rights of a Muslim upon a Muslim are to return his greeting, accept his invitation, visit him when he is sick, and follow his funeral.��None of these is a market transaction, and none could appear in a measure of surplus. But together they make a community in which a student who cannot pay is not a stranger, and in which two students can share a room. The institutions of a society reflect its spirit. The market's exchange is designed to leave people quits; these practices are designed to leave people bound to one another. Why are the two so different? Because they rest on two different ideas of what a society is, and that is where we turn next.

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Organising society without God

3 · HOW THE EQUILIBRIUM DOES HARM

34

After Europe’s wars of religion, religion was set aside as the basis for organising society. Political theory and economics arose to organise society without God, judgment day or the hereafter.

The old conception

Society as one body: shared goals, different parts serving different functions.

The new conception

A collection of individuals with no common goals, who agree to live under common rules: the social contract.

Hobbes (1651): a state of nature that is a “war of every man against every man”: the jungle.
Thatcher (1987): “there is no such thing as society.” Methodological individualism, stated as politics.

Lecture 5 · Efficient for Whom? · Part 1

Slide 30��VOICEOVER��We have seen that the theory cannot see the costs of competition: the broken bond, the rival where there was a brother. To understand why, we have to go back to where the theory came from. As we discussed in earlier lectures, modern political theory and economics arose in Europe after religion was set aside as the basis for organising society. Their task was to organise society without God, without judgment day, without the hereafter.��That changed what a society was taken to be. The older picture, which Christian Europe shared with Islam, was of society as one body: one set of goals, with different members doing different work. The new picture was of separate individuals, each with his own goals, who agree to live together under common rules. Hobbes began from a state of nature that was a war of every man against every man; society was the truce. Three centuries later, a British prime minister could say that there is no such thing as society. That is methodological individualism, the starting point of economic theory, stated as politics.��The society this picture produces is a jungle: individuals competing, each for himself, with competition as the normal way of life. Our price wars are a picture of it. It is often said that economists borrowed this picture from Darwin. The truth runs the other way: Darwin took the struggle for existence from Malthus, an economist, and said so in The Origin of Species. The jungle was a picture of society before it was a picture of nature.��Instructor note. Thatcher continued: "There are individual men and women and there are families." If a student raises this, it strengthens the point. Her picture has individuals, families and the state, and nothing between them: the community, the level the inherited map leaves out.

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The brotherhood

3 · HOW THE EQUILIBRIUM DOES HARM

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Qur’an 49:10

“The believers are but brothers.”

Qur’an 5:2

“Cooperate in righteousness and piety; do not cooperate in sin and aggression.”

Bukhārī, Muslim

The believers, in their love, mercy and compassion, are like one body: when one part aches, the whole body responds with sleeplessness and fever.

Society is one body with shared goals. Cooperation is the operating norm.

Lecture 5 · Efficient for Whom? · Part 1

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Two conceptions of society: the root of the difference

3 · HOW THE EQUILIBRIUM DOES HARM

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	The jungle	The brotherhood
Society is	Individuals with private goals, under common rules	One body, with shared goals and different functions
The operating norm	Competition	Cooperation
Everyday institutions	Exchange that leaves people quits	Salām, gifts, visiting the sick, feeding the neighbour
Another person’s agreement	An arbitrage opportunity	A brother’s bid, not to be bid over
A student who cannot pay	Goes home; his loss counts as zero	A seeker of knowledge, and the community’s obligation
Our town	Price wars: three housed	Cross-matching and sharing: all housed

The efficiency verdict is not a finding about markets. It follows from the conception of society built into the theory.

Lecture 5 · Efficient for Whom? · Part 1

Slide 32��VOICEOVER��Here, side by side, is the root of everything we have seen today. In the jungle, society is a set of individuals with private goals, and competition is normal. Its everyday institution is the exchange that leaves people quits. Another person's agreement is an arbitrage opportunity, and a student who cannot pay goes home with his loss counted as zero.��In the brotherhood, society is one body, and cooperation is normal. Its everyday institutions build bonds: the greeting of peace, the gift, the visit to the sick, the meal shared with a neighbour. Another person's agreement is a brother's bid that you do not bid over, and a student who cannot pay is a seeker of knowledge whom the community is obliged to support.��Same people, same rooms. The jungle produces the price wars, with three students housed. The brotherhood produces cross-matching and sharing, with all six housed. The textbook calls the first efficient because the jungle is built into its idea of society. Change the idea of society, and the verdict changes with it.

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Wrap-up

STAGE 4 · SLIDES 33–35

Why social costs disappear in a society of individuals, and the doctrine that says nothing is lost.

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Why social costs disappear in the jungle

4 · WRAP-UP

38

Social benefits and costs are those that fall on no single trader: on the town, on those left out, on the relationship itself.

In the jungle, society is nothing but individuals. Every benefit and cost must belong to some trader.

So whatever belongs to no trader has nowhere to be recorded. It disappears from the accounts, and then from view.

In the brotherhood, society is one body, so these things have a place: the community’s ledger.

Lecture 5 · Efficient for Whom? · Part 1

Slide 33��VOICEOVER��Let us gather up what we have found, and ask what ties it together. Look at what the textbook's accounting kept missing: the town's gain when a student stays, the loss to the student left out, the agreement broken, the bond between two students. None of these belongs to any one of the traders. They fall on the town, on outsiders, on the relationship itself. These are what we mean by social benefits and costs.��Now recall the jungle. In the jungle, society is nothing but individuals. There is no town, no community, no body that could own a benefit or bear a cost. So every benefit and every cost must belong to some trader. Whatever belongs to no trader has nowhere to be written down. It drops out of the accounts, and soon it drops out of view.��In the brotherhood, society is one body. When one part aches, the whole body feels it. So these benefits and costs have a place to be recorded: the community's ledger.

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What disappears from view

4 · WRAP-UP

39

In our town	What the jungle counts	What disappears
C goes home	His budget, unspent: no loss	His education, and the town’s teacher or doctor
F lures P away from A	Gains to F and P	A’s loss, the broken agreement, and trust
S lets his empty room	His asking price, as a cost	The fact that the town gives up nothing
F outbids B	A higher rent	B’s resentment, the bond between students, and the option to share
A pays rent from her scholarship	A lira like any other	A’s need

Each of these falls on no single trader: on the town, on outsiders, or on the relationship. So each disappears.

Lecture 5 · Efficient for Whom? · Part 1

Slide 34��VOICEOVER��Take each case in turn. When C goes home, the jungle sees a budget unspent and records no loss; what disappears is his education, and the teacher or doctor the town would have gained. When F lures P away from A, the jungle sees two traders who both gained; what disappears is A's loss, the broken agreement, and the trust that agreements will be kept.��When S lets his empty room, the jungle records his asking price as a cost. What disappears is the plain fact that the town gives up nothing: the room was there, and empty. When F outbids B, the jungle sees a higher rent. What disappears is B's resentment, the bond between two students, and the possibility that they could have shared. And when A pays rent from a scholarship that barely feeds her, the jungle sees a lira like any other; what disappears is her need.��Every one of these falls on no single trader. In a society of individuals, that is enough to make it vanish.

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The invisible hand: the jungle’s theorem

4 · WRAP-UP

40

The invisible hand: when each person strives for his own benefit, the result is the greatest benefit to society. Private and social are the same.

If that were true, the last column of slide 34 would be empty: there would be nothing left over to count.

That is why economists do not see the issues we have raised: their central doctrine says there is nothing there to see.

Mankiw states the assumption as a caveat: his analysis “assumed that the outcome in a market matters only to the buyers and sellers who participate” (p. 150).

Part 2: the invisible hand, examined claim by claim.

Lecture 5 · Efficient for Whom? · Part 1

Slide 35��VOICEOVER��Why do economists not see any of this? Because the jungle has a theorem, and it is called the invisible hand. It says that when each person strives for his own benefit, the result is the greatest benefit to society. In other words, private and social are the same, and nothing falls outside the traders' own accounts.��If that were true, the last column of the previous slide would be empty: no lost education, no broken trust, no bond, no need left unmet. The problems we have spent this lecture on would not exist. Mankiw even states the assumption, as a word of warning at the end of his chapter: the analysis assumed that a market's outcome matters only to the people trading in it.��So the invisible hand is not a minor detail of the theory. It is what allows a society of individuals to treat private striving as the public good. In Part 2 we examine it, claim by claim.