Week 1 Reading - Stiglitz Flashcards
What is Stiglitz’s main critique of Adam Smith’s ‘invisible hand’?
Stiglitz argues that the invisible hand may be invisible because it doesn’t exist or is too weak to be relied upon. Markets often fail to achieve Pareto efficiency due to imperfect information, incomplete markets, and other real-world frictions.
How does Stiglitz view the First Fundamental Theorem of Welfare Economics (FFTWE)?
The FFTWE states that any competitive equilibrium is Pareto efficient under ideal conditions. Stiglitz acknowledges its logical validity but criticizes its empirical relevance, arguing that real markets rarely satisfy the necessary assumptions.
What are the key assumptions of the FFTWE?
- Perfect competition
- Complete markets (all risks are insurable)
- Perfect information
- Rational agents
- Convex preferences and technologies
Why does Stiglitz challenge these assumptions?
He argues that imperfect information and incomplete markets are pervasive. These deviations from the ideal model mean that markets fail to achieve Pareto efficiency.
What is the Greenwald-Stiglitz Theorem?
It states that market economies with imperfect information and incomplete markets are not (constrained) Pareto efficient. This shows that Adam Smith’s invisible hand doesn’t guarantee optimal outcomes.
Why are imperfect information and incomplete markets important?
They cause externalities (hidden costs or benefits not reflected in prices) and prevent markets from efficiently allocating resources. Stiglitz emphasizes that these conditions are not exceptions but the norm in real economies.
What are some examples of market failures highlighted by Stiglitz?
- Unemployment (persistent and involuntary)
- Credit rationing (some people are denied loans even if they are willing to pay higher interest rates)
- Moral hazard (when individuals take more risks because they don’t bear the full consequences)
- Adverse selection (e.g., in insurance markets where higher-risk individuals are more likely to buy coverage)
What is the Neoclassical Synthesis, and why does Stiglitz reject it?
The Neoclassical Synthesis combines Keynesian macroeconomics (for short-term unemployment issues) with neoclassical microeconomics (assuming long-term market efficiency). Stiglitz calls this a dogma — not a rigorously proven theory — and argues that even after fixing unemployment, markets may still be inefficient.
Why does Stiglitz believe market inefficiencies are pervasive?
He argues that slight imperfections in information or small deviations from perfect competition can cause large inefficiencies — meaning real markets are almost never Pareto efficient.
What does the Second Fundamental Theorem of Welfare Economics (SFTWE) state?
It claims that any Pareto-efficient outcome can be achieved through market mechanisms if the government redistributes initial endowments via lump-sum taxes and transfers.
Why does Stiglitz critique the SFTWE?
He argues that lump-sum taxes are unrealistic because governments lack the information to tax people without affecting their behavior. Therefore, equity and efficiency cannot be separated — redistribution always distorts incentives.
How does Stiglitz believe governments should respond to market failures?
Since markets often fail due to imperfect information and incomplete markets, Stiglitz supports active government intervention — through corrective taxes, regulation, and public goods provision — to improve efficiency and equity.
What is Stiglitz’s view on ‘social justice’ and efficiency?
He rejects the idea that efficiency and fairness can be neatly separated. Policies aimed at redistributing wealth or correcting externalities are not just about equity — they often enhance efficiency too.
What does Stiglitz say about ideological support for the invisible hand?
He argues that faith in the invisible hand is often ideologically driven rather than empirically justified. The quest to ‘prove’ market efficiency — like Real Business Cycle theory — ignores real-world market failures.
How does Stiglitz contrast with Hayek?
While Hayek views markets as a discovery process that reveals information, Stiglitz counters that markets systematically fail to gather or use information efficiently — leading to persistent inefficiencies.
How can you use Stiglitz’s ideas to critique the FFTWE in an essay?
- Explain the FFTWE: It relies on strong assumptions — perfect information, competition, and complete markets — to prove Pareto efficiency.
- Introduce Stiglitz’s critique: Real markets deviate from these assumptions due to imperfect information and incomplete markets.
- Use the Greenwald-Stiglitz Theorem: Show how market inefficiencies are not rare anomalies but systemic.
- Challenge the invisible hand: Argue that Smith’s invisible hand doesn’t work when externalities, moral hazard, and asymmetric information are present.
- Conclude with policy implications: Stiglitz supports active government intervention — not to replace markets but to correct their failures.
