Make Economics Policy Relevant: Depose the Omniscient Benevolent Dictator
Holcombe, Randall G., Independent Review
Economic policy analysts typically specify a model that describes an optimal outcome--for example, an efficient allocation of resources, an optimal distribution of income, an optimal growth path, or an optimal macroeconomic outcome of stability with full employment and low inflation. Because economic models can become complex when they account for many things, all models employ simplifying assumptions to focus on one particular issue. Models that analyze policies to promote economic growth, for example, differ from models that describe the optimal distribution of income or the optimal policy for internalizing an externality (see Holcombe 1989). Nevertheless, the methodology is the same: develop a model that incorporates the particular issue, then show in the model the optimal result and identify what keeps the economy from producing the optimum. The recommended policy is one that should move the economy from a nonoptimal position to the optimal one by removing impediments to the attainment of an optimal outcome, by changing the incentive structure so that market participants trade to a Pareto optimum, or, where markets pose more difficult problems, by imposing regulations, government mandates, or government production to allocate resources optimally.
When the invisible hand of the market fails, economic policy recommendations typically do not go beyond advising that the visible hand of government move the economy to the optimal outcome, without any detailed discussion of whether government action can achieve this outcome or whether public-sector actors have an incentive to implement the optimal outcome. Government is modeled as if it is an omniscient benevolent dictator. To make economics policy relevant, however, this omniscient benevolent dictator must be deposed. Government in contemporary Western countries is neither omniscient nor benevolent nor dictatorial.
The Planner's Problem
The omniscient benevolent dictator is often represented in economic analysis as the planner's problem. The analyst derives the conditions required for an optimal allocation of resources, and the planner's problem is to create those conditions. The policy problem is couched entirely in comparative-static terms, identifying the optimal outcome and the status quo, with policy recommendations intended to change the situation from the latter to the former. The comparative-statics methodology for evaluating economic policy measures goes back at least to A. C. Pigou (1920, chap. 1), who lays out a methodology for evaluating policy measures by comparing economic welfare with and without the implementation of the policy measure. Frank Ramsey (1928) explicitly lays out a planner's problem for finding the rate of saving that maximizes consumption over successive generations. In response to Ludwig von Mises's ( 1951) claim that central planners cannot allocate resources rationally, Oskar Lange and Fred Taylor (1938) argue that central planners can allocate resources at least as efficiently as the market. (1) Abba Lerner (1944) delivers a policy analysis based on the planner's problem that identifies conditions for the optimal allocation of resources and then advises that the government implement these conditions.
We see, then, that the omniscient benevolent dictator who solves the planner's problem has been a part of economic analysis for at least three-quarters of a century, but it gained increased stature with the Arrow and Debreu (1954) proof of the uniqueness and stability of competitive equilibrium. Using competitive general equilibrium as a benchmark, one can develop a formal framework to depict cases in which the market fails to reach that optimum. In a frequently cited article, Takashi Negishi shows that the "existence of an equilibrium is equivalent to the existence of a maximum point of this special welfbxe function" (1960, 92). Francis Bator (1957) shows the conditions for welfare maximization and demonstrates (Bator 1958) conditions under which markets fail to reach this maximum. …