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The Inequality of Nations

Markets are mechanisms of social choice, in which dollars effectively equal votes; those with more purchasing power thus have more influence over market outcomes. Governments are also social choice mechanisms, but voting power is – or is supposed to be – distributed equally, regardless of wealth.

MILAN – The eighteenth-century British economist Adam Smith has long been revered as the founder of modern economics, a thinker who, in his great works The Wealth of Nationsand The Theory of Moral Sentiments, discerned critical aspects of how market economies function. But the insights that earned Smith his exalted reputation are not nearly as unassailable as they once seemed.

Perhaps the best known of Smith’s insights is that, in the context of well-functioning and well-regulated markets, individuals acting according to their own self-interest produce a good overall result. “Good,” in this context, means what economists today call “Pareto-optimal” – a state of resource allocation in which no one can be made better off without making someone else worse off.

Smith’s proposition is problematic, because it relies on the untenable assumption that there are no significant market failures; no externalities (effects like, say, pollution that are not reflected in market prices); no major informational gaps or asymmetries; and no actors with enough power to tilt outcomes in their favor. Moreover, it utterly disregards distributional outcomes (which Pareto efficiency does not cover).

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