Kenneth Arrow was among the rarest of rare economists - exceptionally brilliant, learned, gentle and public-spirited. His departure from this world earlier this week, at the handsome age of 95, was a huge loss not only for the economics profession but for all of us.
Arrow shot to fame with his PhD thesis, published as a monograph (Social Choice and Individual Values) the same year, in 1951. The thesis includes a demonstration of what came to be known as "Arrow's impossibility theorem". The theorem states, roughly speaking, that social preferences cannot be derived from individual preferences (e.g. through voting) without violating at least one of five plausible conditions. It looked, at that time, like a big blow to the possibility of democratic decision-making. As Amartya Sen pointed out, however, what the theorem really showed was that social choice required a richer informational base than individual, ordinal rankings of the social states. Also, partial orderings of social states were still possible under the stated conditions, and sometimes these can take us a long way. Seen in that light, the impossibility theorem became a constructive foundation for social choice theory, a lively field of economic enquiry to this day.
Three years later, Arrow made another historic contribution to economics (with Gérard Debreu) by proving the existence of an equilibrium in a competitive economy under general conditions. This work belonged to a body of research that coalesced around the so-called "fundamental theorems of welfare economics" (Arrow himself presented proofs of these theorems in 1951). The first theorem states that a competitive equilibrium is Pareto efficient, in the sense that no other feasible allocation of resources would make some people better off and no-one worse off. The first fundamental theorem of welfare economics is often invoked as a proof of the efficiency of the market, but this interpretation can be turned on its head: the theorem can also be read as a proof that the conditions under which markets are efficient (even in the limited sense of Pareto efficiency) are very restrictive. Some of these conditions are relatively well understood, like the absence of "externalities" - the situation where one person's consumption or production decisions affects other persons. In the real world, externalities are so pervasive that they should be considered as the rule more than the exception.
The theorem, however, also involves implicit assumptions that are rarely discussed. For instance, it is based on a model that excludes non-market institutions - the only "agents" are consumers and producers. That makes it impossible to consider aspects of market economies that are, in practice, very important. Consider for instance the fact, increasingly well recognized, that extreme inequality tends to undermine democracy. This issue cannot even be discussed in the Arrow-Debreu model because there are no democratic institutions in it.
Arrow himself was well aware of the limitations of the theorem. Much of his later work, notably on the economics of information and uncertainty, can be seen as an exploration of various departures from the theorem's stringent assumptions. Arrow is one of the founders of information economics, largely concerned with the consequences of what is known as "asymmetric information" - what happens when economic transactions involve people who have unequal access to information. For instance, in the field of health care, asymmetry of information between doctor and patient is a major issue: the patient is a sitting duck, and an unscrupulous doctor can easily take advantage of his or her ignorance.
I suspect that the term "moral hazard" (Arrow preferred to call it "hidden action") originally referred to this sort of exploitation, though it later acquired a more restricted meaning in the context of insurance contracts. The situation just described, of a doctor exploiting a patient, was a central concern of another of Arrow's seminal papers, "Uncertainty and the Welfare Economics of Medical Care" (published in 1963). The paper still makes illuminating reading today. It argues, for instance, that health care is not a suitable object of profit-making. As Arrow pointed out, the relation between doctor and patient depends on trust, and the patient's trust would be undermined if he or she thought that the doctor is just trying to maximise profits. Medical ethics and other institutions are essential to restrain the power of profit-seeking.
Going beyond this specific issue, the paper discussed a range of ways in which market competition is no guarantee of efficiency (let alone equity) in the field of health care. As Arrow put it in his concluding remarks: "It is the general social consensus, clearly, that the laissez-faire solution for medicine is intolerable". Advocates of the privatization of health care in India (or rather further privatization, since India's health-care system is already one of the most commercialized in the world) would do well to read or re-read Arrow's profound analysis of market failures in this field.
These are just a few insights from Arrow's early work, which expanded across an immense canvas over the years. Aside from being a brilliant economist, Arrow was also a public-spirited citizen. He applied his formidable analytical powers to many important social issues, from world peace to climate change. He spoke and wrote on these issues with characteristic forthrightness until the very end of his life. In this and other ways, Arrow was a role model for generations of economists concerned with bringing their work to bear on real-world issues.
(The author is Visiting Professor at the Department of Economics, Ranchi University.)Disclaimer: The opinions expressed within this article are the personal opinions of the author. The facts and opinions appearing in the article do not reflect the views of NDTV and NDTV does not assume any responsibility or liability for the same.