Recently, I was made aware of an article by the famous Harvard economist Gregory N. Mankiw ("Defending the One Percent’’, The Journal of Economic Perspectives, 2013). In that article, he puts forward an interesting thought experiment. Assume we were in a state in which the market outcome would lead to absolute equality among economic agents. There was no need for redistribution, as anybody would get the same share of the pie anyway, and a lump-sum tax would finance government expenditures (which were still needed, as there is a demand for public goods). In Mankiw’s words, such a society would “enjoy not only perfect equality but also perfect efficiency”.

Now he considers entrepreneurs with original ideas entering the stage. The mentioned examples are Steve Jobs and J. K. Rowling, introducing the iPod and Harry Potter, respectively. This would lead to inequality, as people are willing to pay money to Jobs and Rowling for their ingenious products, and Jobs and Rowling would sooner or later be much richer than everyone else.

Is this inequality a problem? No, says Mankiw. Because everybody who paid Jobs and Rowling money did so voluntarily. The trades were to the benefit of both the seller and the buyer, and hence everybody must be better off in a situation with inequality. Mankiw claims that this story roughly fits what happened in the United States since the 1970s.

Voluntariness is at the center of Mankiw’s argument. Let me illustrate this with an example. Assume I go to Rustavi and buy a used car for 2000 Laris. If nobody forces me to buy the car, I must have benefited from this transaction. The car is worth more to me than 2000 Laris, as otherwise, I would not have agreed to the trade. Likewise, the seller of the car must be better off, as nobody coerced him to sell the car. 2000 Laris are worth more to him than his old car. If he was forced to sell, however, or I was forced to buy, this argument would not work anymore.

If economic transactions are voluntary, then each trade generates a surplus in welfare. We just have to let markets run, and by trading with one another we all get happier all the time. Capitalism is but a happiness machine!

Even if this line of argument may sound odd to non-economists, it lies at the heart of the libertarian support for free markets. It permeates books like Atlas Shrugged by Ayn Rand or The Machinery of Freedom by David Friedman.

HUMANS MAKE MISTAKES

About a year ago, I was visiting the annual meeting of the Armenian Economic Association in Yerevan. Bruce Boghosian, who happens to be the president of the American University of Armenia, presented an article he had written, challenging the view that voluntariness fixes all problems (“The Kinetics of Wealth and the Origin of the Pareto Law”, Working Paper, 2013).

Boghosian makes the assumption that the objects exchanged in trade have equal wealth. So if the car I want to buy in Rustavi is worth 2000 Laris, then it will not change owners for 1800 Laris, as then the seller would not agree to the trade. If the car was offered for 2200 Laris, however, then I would not agree to buy it – why should I pay more for the car than its value? In Boghosian’s model, trades are neutral in the sense that they do not change the wealth distribution. Before I bought the car in Rustavi, I had a 2000 Laris. Now I have 2000 Laris less but a car worth 2000 Laris. My wealth did not change.

This does not exclude, by the way, that both the buyer and the seller are better off through trading. Even though wealth is not affected by trading, it may be the case that the subjective utility goes up. As wealth can be made up of different commodities (e.g. houses, cars, jewelry), changing the composition of wealth can indeed make people happier even if the economic value is unaffected. Voluntary trades allow for realizing this potential.

Now Boghosian modifies the model in an apparently minor aspect. He includes the possibility that occasionally (it can be very rarely) a mistake happens to one of the traders. Instead of concluding a neutral trade, there is indeed a wealth transfer occurring.

Before I buy a used car in Rustavi, I will check its wheels, its interior, its motor, and maybe I will even have a test drive on the Rustavi parking space. Yet perhaps I overlooked something. Deep inside the car’s engine, something is damaged, and already on my way back to Tbilisi, the car stops its service. Then the car was not worth the 2000 Laris I paid for it. A wealth transfer took place from me to the seller.

Intuition says that if such mistakes happen randomly, they will cancel out. One day I am aggrieved by making a bad deal, losing some of my wealth, another day I am the one who takes advantage of the mistakes of my trading partner. On average, mistakes do not matter. Well, this intuition is wrong.

If the wealth transfer that takes place whenever such a mistake occurs is not an absolute amount of money but a given fraction of the wealth owned by the agent who makes a loss, then the trading dynamics lead to skewed wealth distribution. At its limit point, all wealth is accumulated in the hands of just one individual. The assumption that the wealth transfer is proportional to the wealth available to the damaged party is instrumental for this result, but it seems reasonable. When a millionaire and a pauper make trading mistakes, it is much more likely that the losses incurred by the former will be higher than those of the latter.

Boghosian’s result is mathematically stunning, but it also has important economic implications. He proves that the voluntariness of economic transactions is not enough for justifying inequality in a society. Inequality will aggravate merely through people making mistakes in their economic activities, which is, as we all know, very common for humans. And this follows endogenously from the market process, it is not even necessary to refer to exogenous blows that affect individuals unequally (like illnesses, strikes of fate, etc).

The combination of markets and voluntariness may be the best way to organize an economy. Yet this is no justification for letting the top 1% become so much richer than the rest of society.