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Imbalances Market Create: Incentives and Fall outs

By Sudip Patra

A great dream of neoclassical economists was the unification of two ends of society, namely the individual search for utility maximisation and the social welfare maximisation. What is the route from individual preference to social welfare? So asked  the great minds, for example Piguo, Marshall, Pareto and also the  modern thinkers like Samuelson, Arrow, Sen, and others. Incentive compatibility: meaning individual rational agents only choose those activities which are compatible with their utility maximizing choices/ are Pareto optimal, has become the main logic for market efficiency and even the willingness to participate in the market. The dream being that through Pareto optimal allocations/outcomes in a market, maximum social welfare will be attained (Certainly the mathematical proof of the theory is very technical and we can refer to the general equilibrium theory developed by Arrow and Debreu).

However, in the pursuit of such a route, there have been interesting and dangerous consequences. Here I am not mentioning about the typical market failures: externalities, public goods, information asymmetry which can be treated with some technical sophistry in standard economics, but I am hinting at the far reaching internal imbalances caused by this myopic pursuit of incentive compatibility. The concerns were first raised by cognitive scientists (Daniel Kahnman – thinking fast and slow), and then by the whole behavioural economics camp. The moot idea is that human beings can not be reduced to typical utility calculating machines.

There is a more enriching version, human brains have two operating systems embedded in them . The first system generates emotions, sense of fairness and justice, and the second system  generates deductive rationality which very roughly can be translated into utility calculus. Now the predominance of any of these systems can lead to choices which we may regret later, and that is typically against the game theory equilibrium condition of no regret. Now social scientists and economists have argued that the market mechanism over decades have tilted the balance towards system two activities, which has actually given rise to many dire consequences: more choices but less happiness, more regret, more focus on extrinsic motivation than intrinsic motivation which has caused shrinkage of altruistic activities and as well as shrinking of public goods provision, to name a few.

The task to recover from the distortions created by the standard incentive approach in the market is daunting, and contributions from many areas are warranted. Behavioural economics has always tried to expand the very  foundation of utility in economic theory, for example though in typical game theory context we see utilities of competing players  depends only on their absolute payoffs, in behavioural games we  can see more comprehensive utility formulations with differences of pay offs and other ‘system1’ factors, so that altruism, fairness, justice can be explained without dubbing these activities irrational.

Samuel Bowles has done extensive cross country and cross cultural research on the adverse impact of policies solely based on extrinsic incentives. The studies found that in cases where people are driven by intrinsic motives (altruistic behaviour being one such) if policies are imposed based on extrinsic reward, the same policy may backfire. Such examples show that human beings are far more complex than utility calculating machines.

The objective of this write up is not to discourage market solutions, but to create awareness about the intrinsic limitations of market based solutions. Once the famous hard nosed Chicago boys (Gary Becker) declared that complete markets are the only solutions for social problems, but after a few decades we see intrinsic limitations of market ringing the alarm bell, are Economists listening?

Professor Sudip Patra is an Assistant Professor of Management Practice at O.P. Jindal Global University . His research interest encompasses dividend signaling theory under information asymmetry, game theory for applied corporate finance, econometric modeling, and allied areas.

Featured Image Source : Government Executive

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