Limitations of the Market

Arrow notably debated with philosophers and economists on the necessary distinction between economic and political decision-making (Arrow 1970, p. 18). He initially stated that the motivation within each of the two types of decision-making is different.

11.3.1 The Price System and Justice

In the 1960s, Arrow did not clearly criticize injustice of market outcomes; however, he clearly stated in the 1970s that the distribution of goods on the basis of a price system does not necessarily achieve distributive justice. On this point, there is a clear distinction between Arrow and other new welfare economists of the time, such as Little and Bergson.

Arrow refers to the condition of Pareto efficiency, wherein everyone is better off under a particular distribution than another, and so society as a whole is judged to be better off. Arrow interprets that some economists viewed such a value judgment as both efficient and just; however, if this were true, then laissez-faire policy and the consequences of the free market are both efficient and just, because they lead society to Pareto efficiency (according to the first fundamental theorem of welfare economics) (Arrow 1983, p. 176).

Arrow opposes this idea, stating that there are three drawbacks of the price system. The first of which is its imperfection, wherein something can contribute to social good but not have a price.

To understand Arrow's position in detail, it is worth noting that one of the assumptions of the fundamental theorem of welfare economics is the universality of the market. From this assumption, resources and goods traded on the market are based on ownership rights and any benefits or expenses arising from such transactions between individuals are settled with money. Thus, there exist no public goods, future goods, or externalities.

In order for such market universality to be achieved, one of the following conditions must be met. First, all the objects of production, consumption, and their influences are commercialized and made available on the market. In practice, this is impossible. Second, externalities that cannot be accom­modated by the market are removed through law, the practice of morality, and social customs. This is because negative externalities include illegal and immoral conduct, such as fraud, theft, threats, and failure to honor contracts, as well as harm to others due to unintentional errors. Externalities, then, must be prevented in order to achieve market efficiency, which requires that certain norms are followed with respect to law, moral­ity, and customs. The Pareto-optimal state cannot be produced only through free competition among individuals seeking their own self­interest; moral behavior is also necessary from the standpoint of positive externalities. In other words, law and morality are necessary conditions for the establishment of the first fundamental theorem (Shionoya 2005, pp.

The second drawback is that even if these three assumptions are satisfied and the competitive equilibrium obtained satisfies Pareto optimality, this is not necessarily desirable for the social good. According to Arrow, market theory assumes personal ownership; however, social welfare improves when individuals use the goods they own to contribute to society. He considers the view that “the distribution of goods in a market satisfies distributive justice” overlooks the public utility of private goods. To clarify this point, it is necessary to consider Arrow's criticism of Robert Nozick.

Nozick's entitlement theory states that an individual has the right to self­property; thus, it follows that an individual has the right over the property that he or she produces by using labor and talent. An individual can exchange this property by trade that meets the following three principles: (1) the principle of justice in transfer, meaning that an owner can exchange property with others; (2) the principle of justice in acquisition, stating that one can acquire any good if no one else owns it; and (3) the principle of rectification, where one can get back goods lost by illegal means. Individuals are entitled to goods acquired through one of these three principles (Nozick 1974, ch. 7).

Arrow points out that “Nozick's criteria are very much like the welfare economics theorem” (Arrow 1983, p. 177), because both consider that the equilibrium achieved under perfect competition in the market is desirable. Arrow admits that Nozick does not assume perfect competition by stating that “Pareto optimality is not implied in Nozick's voluntary, just transfers” (Arrow 1983, p. 177). According to Nozick's idea, however, only redistri­bution that improves one's satisfaction can be accepted, because rational agency would voluntarily accept only such a redistribution of goods. This idea is similar to competitive equilibrium being desirable (Arrow 1983, p.

In short, Nozick regards an individual's talent as his or her own prop­erty, and the goods that someone acquires by his or her talent as their own private property. Arrow rejects this idea and considers one's talents and goods to be more valuable if they are used socially. For him, the redistri­bution of goods is recommended. It must be noted that Arrow opposes Rawls' idea that one's property constitutes common goods, and instead insists that it belongs to the individual. Arrow does consider, however, that individuals have a social obligation to contribute to maximizing social welfare by using the property they obtain through their talents. Arrow does not clarify whether one has a moral or legal obligation to make a voluntary contribution (i.e., if it is a matter of moral duty or an obligation to, for example, pay taxes to rectify an imbalance). Nonetheless, it is clear that Arrow does not regard market consequences as desirable (Arrow 1983, pp. 185-187).^[132]

If Arrow criticizes Pareto optimality from only the above two view­points, he would be a welfarist in a broad sense, because those criticisms argue that Pareto optimality cannot always maximize social welfare. However, he does criticize welfarism by saying that Pareto optimality can be unjust from the non-welfarist point of view. The third drawback of the price system is that it does not provide for the fair distribution of income.

In short, Arrow notes that the consequences of economic decision­making do not necessarily fulfill the requirement of distributive justice. According to Arrow, something beyond the market is required to achieve efficiency, social welfare, and distributive justice (Arrow 1974, p. 17). In other words, the price system cannot be the final arbiter of social welfare (Arrow 1974, p. 14). From this, it follows that Arrow cannot be regarded as a welfarist on the basis of his work in the 1970s, even when he evaluates the consequences of the market. This is because he uses non-welfaristic meas­ures, such as fairness and equality, for the evaluation.

11.3.2 The Problem of Racial Discrimination

In the 1970s, there was a growing consensus that the theoretical develop­ment of microeconomic analysis advanced by Arrow and others could be used for purposes other than market analysis. This trend was called “economics imperialism” by researchers in other disciplines. Against this historical background, Arrow expanded the scope of economics to cover social issues and made contributions to racial discrimination issues in the 1970s by adopting formal theory to solve them (Arrow 1972b; Arrow 1972c; Arrow 1973b; Chassonnery-Zaigouche 2015).

Arrow himself, however, argued in a 1998 article that the market and economic analysis cannot adequately handle racial discrimination because it is a statistical fact that many black people are excluded from certain jobs, residential neighborhoods, and certain aspects of social community, such as restaurants. Economic methods analyzing racial discrimination in em­ployment include an approach that assumes that white employers prefer not to hire black employees. One of the problems with this assumption is that such a preference will neither benefit shareholders nor help companies survive competition. Next, one can also assume that white employees prefer not to have black people as colleagues; however, this assumption merely leads to the conclusion that there would be segregated factories that have either only white workers or only black workers, and it cannot explain why wage disparities occur. Yet another assumption could be that employ­ers, by virtue of personal experience, believe that white people usually have higher productivity than black people and that their decisions are based on this experience. However, it is unlikely that employers have enough ex­perience in this regard considering that racial segregation has existed from the outset (Arrow 1998, pp. 93-97).

The upshot of all of this is that economic analysis is unsuitable for elucidating the causes of racial discrimination. It would be better to approach the issue with an assumption that the preferences of individuals arise from social interactions that are not necessarily mediated by the market. According to Arrow, “I am going to suggest in this paper that market-based explanations will tend to predict that racial discrimination will be eliminated. Since they are not, we must seek elsewhere for non­market factors influencing economic behavior. The concepts of direct social interaction and networks seem to be good places to start” (Arrow 1998, p. 93). In other words, non-market social relationships change the allocation of resources; thus, from the methodological perspective, as well as from others, Arrow does not believe that economic analysis is univer­sally applicable.

11.4