The first fundamental theorem of welfare economics is often misunderstood, especially by technical economists.  Briefly, the theorem says that a market outcome is efficient (Pareto-optimal). The theorem, as proven with great mathematical beauty by Arrow and Debreu, requires a number of reasonably strong assumptions such as very large numbers of buyers and sellers who have perfect rationality and perfect information.

Since the conditions required for the theorem’s proof are unlikely to hold in the real world it’s common for people to reverse the theorem to suggest that markets cannot be efficient.  Thus Rodrik says:

The First Fundamental Theorem of Welfare Economics is proof, in view of its long list of prerequisites, that market outcome can be improved by well-designed interventions.

Now what is wrong with this is very simple.  The First Theorem gives sufficient conditions for a market to be efficient it does not give necessary conditions.

Thus, as a matter of logic, the fact that the theorem’s conditions are not satisfied does not prove that market outcomes can be improved, even by "well-designed" interventions.

As an empirical matter, the difference between the sufficient and necessary conditions turns out to be quite large.  We know from Vernon Smith’s work, for example, that markets can be competitive with only a handful of traders; nor do the traders have to be perfectly rational.  In fact, markets can be very efficient with zero-intelligence traders.

Perhaps even more importantly technical economists seem to think that the First Theorem is the ultimate expression of "the invisible hand" or what makes markets good but in fact the First Theorem is but a pinched and limited expression of the virtues of markets.  The First Theorem, for example, says nothing about innovation, experimentation, or the discovery process.  Nor does the First Theorem say anything about markets and political philosophy.  You will not learn from the First Theorem that markets are not simply a "mechanism," markets are peaceful exchange.

To be clear, I am correcting a misuse of the First Theorem.  I am not asserting that markets are always perfectly efficient.   But really what kind of standard is perfect efficiency anyway?  The internal combustion engine isn’t even close to being perfectly efficient but my car gets me to work every day, is fun to drive and gives me the freedom of the open road.

The central fact is that overwhelmingly suicide-terrorist attacks are not driven
by religion as much as they are by a clear strategic objective: to compel modern
democracies to withdraw military forces from the territory that the terrorists
view as their homeland. From Lebanon to Sri Lanka to Chechnya to Kashmir to the
West Bank, every major suicide-terrorist campaign–over 95 percent of all the
incidents–has had as its central objective to compel a democratic state to
withdraw.

That’s Robert Pape, author of Dying to Win: The Logic of Suicide Terrorism, an in interview from several years ago.  Steve Levitt points to the interview in one of his best posts.  Here’s one bit from Levitt.  Read the whole thing.

For most government officials, there is much more pressure to look like you
are trying to stop terrorism than there is to actually stop it. The head of the
TSA can’t be blamed if a plane gets shot down by a shoulder-launched missile, but he is in serious trouble if a tube of
explosive toothpaste takes down a plane. Consequently, we put much more effort
into the toothpaste even though it is probably a much less important threat.

Dani Rodrik responds here to my pointed remarks on his argument for industrial policy.  Rodrik’s response, however, is along the same lines of his earlier – "I’m sophisticated, you’re simplistic" – post on why economists disagree.  In this case, it’s ‘libertarians are ideologues who are immune to evidence.’

Rodrik, however, has painted himself into a corner because he cannot at the same time say that the "systematic empirical evidence" for market imperfections in education, health, social insurance and Keynesian stabilization policy is "sketchy, to say the least"  (also "difficult to pin down" and ‘unsystematic’) and also claim that libertarians are ideologues who are immune to evidence. 

Say rather that libertarian economists are immune to sketchy, unsystematic, difficult to pin down evidence.  Rodrik is thus right that he is "not as unconventional as I sometimes think I am. The real revolutionaries here are the libertarians."  The libertarian economists are revolutionaries, however, not because they are immune to evidence but because they respect evidence so much that they are unwilling to accept "conventional wisdom" simply because it is conventional.   

I will have more to say on this at a later date but that is enough for now.

Dani Rodrik points out that government interventions in areas such as "education, health, social insurance, and macroeconomic
stabilization" are

"targeted on a loosely-defined set of market imperfections that are rarely
observed directly, implemented by bureaucrats who have little capacity to
identify where the imperfections are or how large they may be, and overseen by
politicians who are prone to corruption and rent-seeking by powerful groups and
lobbies."

Absolutely correct.   The obvious conclusion?  Industrial policy is a good idea.  I kid you not.

The Wall Street Journal has a good piece by IP and Hilsenrath, How Credit Got So Easy
And Why It’s Tightening.  I’d focus a bit more on real factors rather than the Fed but they hit all the right points.

The Economist says it’s A Good Time for a Squeeze but wisely they do not neglect to mention that being a credit snob is still a bad thing (yes, yours truly gets a nod.)

In fact, the world now has more regional trade schemes than countries.

From Collier’s The Bottom Billion.

In a survey Robert Frank finds that people say they would rather live in a 3000 square foot home when their neighbors have 2,000-square-foot bungalows than live in a 4000 square foot home in a neighborhood of McMansions.  Greg Mankiw asks:

Do people really behave as reflected in this survey? I bet the 4,000 square foot
house surrounded by McMansions would sell for more than the 3,000 square foot house
surrounded by bungalows.

Let’s take it to the data.   I regressed the sales price of about 12,000 houses in Northern Virginia on a bunch of housing characteristics including number of bathrooms, bedrooms, levels, age of the house and so forth.  I also included the average sales price of homes in the same neighborhood.  The result?  Houses in neighborhoods with high average prices sell for more than similar houses in neighborhoods with lower average prices.  Thus the prima facie evidence is that the same house is worth more if it is surrounded by more expensive houses – the opposite of Frank’s hypothesis.

Now it could be that the high average price of other homes in the neighborhood is controlling for unobservables of "your" home so here is a more precise test.  I defined a variable (sqft-avgsqft) where sqft is the lot size of your house and avgsqft is the neighborhood average.  I then split this into a positive difference, when your house is bigger than your average neighbor’s house and a negative difference when it is smaller.  Bigger houses ought to sell for more everywhere but if Frank is right then square footage is more valuable when other people’s square footage is low (lording it over your neighbors).  Similarly, if Frank is right people should be especially averse to living in small houses in big neighborhoods thus a negative difference should result in much lower prices.

Below you can find the relevant part of the regression.  The bottom line is that houses with bigger lots sell for more (the positive coefficient on lotsqft) but the increase in price is less when your lot size is bigger than the average lot size.  In other words, people do not want to own the biggest house in the neighborhood.

What about when your house is smaller than average?  Here there is no penalty.  Contra Frank, people do not mind having a small house in a neighborhood of McMansions.

Although the data are inconsistent with Frank’s argument that the rich make the middle class worse off they are consistent with an alternative status effect in which people dislike lording it over their neighbors or in an alternative interpretation, the poor make the rich worse off. 

Paul Collier’s The Bottom Billion is the best economics book not written by a dear friend that I have read this year, it’s full of serious, important ideas and the writing sparkles.

You won’t find a better explanation of the time consistency problem, for example, than this brief bit on the Chad-Cameron pipeline.  As you may recall, the World Bank lent Chad money for the pipeline on condition that the money would be controlled not by the government but by an independent panel, the "College," with members drawn from civil society. 

The deal was that the government of Chad would pass a law establishing the College, and in return the oil companies would sink $4.2 billion of investment into oil extraction.  Now ask yourself which of these is easier to reverse, the law or the investment.  Once you have answered that, you have understood the time consistency problem…

Brilliant.  Collier then goes on to make the important point that the idea of giving control of resources to independent service organizations rather than to governments is in many cases a good one but the idea applies better to aid than to oil because…

With aid you do not have to sink $4.2 billion in order to get started.  It is just a flow of money that can be switched off, unlike the flow of oil.  Knowing this, the government has no incentive to tear up the deal.

Here is Tyler on the Bottom Billion.

Some states ban the use of credit scores to price auto insurance in part because African-Americans and Hispanics tend to have lower (worse) credit scores and thus pay higher auto insurance rates.  The brute facts, however, are that credit scores are good predictors of auto claims. Luke Froeb at Management R&D summarizes a recent FTC study on the issue.

1. Credit scores effectively predict … the total cost of [auto insurance] claims.
2. Credit scores permit insurers to evaluate risk with greater accuracy, which may make them more willing to offer insurance to higher-risk consumers … . [note: this is why you can call up GEICO, let them look at your credit report, and get an auto insurance quote over the phone].
3. ..as a group, African-Americans and Hispanics tend to have lower scores than non-Hispanic whites and Asians.
4. …scores effectively predict risk of claims within racial and ethnic groups.
5. The Commission could not develop an alternative scoring model that would continue to predict risk effectively, yet decrease the differences in scores among racial and ethnic groups.

Thus banning the use of credit scores would at best force good drivers (of all races) to subsidize bad drivers.  At worst, if insurance companies cannot price according to risk an adverse selection problem could be created in which good drivers purchase less insurance (to avoid having to pay the subsidy to bad drivers) thus pushing rates even higher and perhaps unraveling the market.