Léon Walras is considered by some to be the greatest economist ever, for his marginal theory of value and general equilibrium theory. He put the concepts of Supply and Demand, and Adam Smith’s Invisible Hand, on a solid mathematical footing, including explaining circumstances where they wouldn’t work, where governments and therefore the public must intervene. We have seen many such cases, most notably monopolies, hyperinflations, and asset bubbles, but also the Republican program of tax cuts and deregulation as the answer to every problem. Gérard Debreu much later gave a deeper mathematical treatment of these same concepts and issues.
Let us see how the idea of marginal value helps to explain the diamond–water paradox, which goes back to before Adam Smith.
- What is the marginal utility of water? The first few units, necessary for life, can be assigned infinite value. Further units for drinking and cooking, and then for washing or for growing crops have various finite values based on personal preferences or opportunities for profit. Then again we get into market distortions, as when allocations of river or lake or ground water add up to more water than there is. Apart from that, the world’s supply of water from rain is huge, and its marginal value is therefore quite low in most places, so that many of us can waste it on lawns.
- What is the marginal utility of a diamond? Nobody needs to own diamonds in order to live. There are industrial and scientific uses of diamond, and strong social preferences for diamond jewelry. Blood diamonds are a major distortion of the market, as is the deBeers monopoly on diamond marketing. The supply of diamond is limited by geology. Diamonds formed in the Earth’s mantle in vast quantity billions of years ago, but only rarely come to the surface in volcanoes.
Supply and demand are such familiar and foundational concepts that they are introduced right at the beginning of economics textbooks and courses, with little examination of the complications that occur in real markets. But it was not so in the times of Adam Smith and his successors. Walras took his time getting through these complexities in his book. One of his great contributions was to talk about the nature and value of frictionless or competitive markets. He compared this to the study of frictionless systems in physics before taking up the complexities of mechanical friction.
Perfect Competition
A frictionless market can also be called a perfectly competitive market.
In economics, specifically general equilibrium theory, a perfect market, also known as an atomistic market, is defined by several idealizing conditions, collectively called perfect competition, or atomistic competition. In theoretical models where conditions of perfect competition hold, it has been demonstrated that a market will reach an equilibrium in which the quantity supplied for every product or service, including labor, equals the quantity demanded at the current price. This equilibrium would be a Pareto optimum.[1]
The theory of perfect competition has its roots in late-19th century economic thought. Léon Walras[2] gave the first rigorous definition of perfect competition and derived some of its main results. In the 1950s, the theory was further formalized by Kenneth Arrow and Gérard Debreu.[3]
The basic features of perfectly competitive markets are as follows.
It is, or should be, obvious that none of these conditions exists in a perfect form. Some require regulation, such as taxes on externalities, effective antitrust laws, and regulation of some industries with strong network effects as public utilities.
However, both theory and practice confirm that approaching these conditions more closely improves the working of markets to allocate products efficiently and prevent excess profit-taking. Corporations, of course, hate this, especially the limitation of marginal revenue to marginal cost. So they lobby continuously against them, and they find many politicians willing to take their campaign contributions and other benefits and legislate in their favor. We will come back to this when discussing Market Fundamentalism, the doctrine that corporations can do no wrong and must not be regulated in any way.
Each of these factors has a vast literature of its own, including discussions of their economic value and the often dirty politics involved in trying to enforce or evade them. Subsidies for fossil fuels have been much in the news about reversing Global Warming. You can expect to hear much more, now that President Biden has proposed cutting all direct fossil fuel subsidies in the US, amounting to tens of billions of dollars. He is also supporting vast expansions of renewable energy, batteries, and semiconductors, but is still allowing oil and gas exploration, even though both of those products are uneconomical.
Equilibrium
I am not going to get into the math, either Walras’s or Debreu’s. What is important to us is, firstly, that we can define the conditions where markets will come to efficient equilibria, and therefore we can say what should be done about them politically, and secondly, what benefits follow from improved equilibria.
What we are looking for, and what we get from the theory, is efficient allocation of products to users. This includes ending systemic racism in housing and employment and much more, and unequal pay for men and women, and all improvements in productivity going to the bosses and the owners, with nothing for the workers. That would be amazing. We’re working on it, and getting better at that.
A Walras equilibrium is a Pareto optimum, in which improving economic outcomes for some (let’s say The Bosses and their pet politicians) requires economic injury to others (workers, suppliers, consumers…). Marxism proposes vast economic injury to The Bosses for the benefit of The Workers, but it has never turned out that way. Marxist-Leninist economics has nothing to do with competition or economic optima. There was always just a new bunch of unregulated bosses, and very limited benefits to anyone else. See, for example, The New Class, by Milovan Djilas, who was imprisoned for it.
Capitalism is the oppression of man by man. Communism is precisely the reverse.
Social Democracy is, so far, much better at balancing these factors than other economic systems. Which is not to say that it is really good at it, but if you want to argue about it, you have to come up with something demonstrably better, and not just finger-pointing.
Further Reading
Éléments d'économie politique pure/Elements of Pure Economics, by Léon Walras. Free PDF.
The Vision of Leon Walras: Markets Interacting in an Equilibrium System, by Donald Walker
Theory of Value: An Axiomatic Analysis of Economic Equilibrium, by Gerard Debreu
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