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Wednesday, March 22, 2017

Kenneth J Arrow : Brilliant Economist of the 20th Century

The youngest ever to win Nobel Prize in Economics, Kenneth Arrow, who was said to have shaped the 20th century economics along with John Maynard Keynes and Paul Samuelson, died aged 95 on February 21.

Kenneth J Arrow, hailed by many as the polymath, is “the most important theorist of the 20th century in economics”, said Professor Paul Samuelson, the first American Nobel Laurate in economics. One of the biggest breakthroughs in economics was Prof Arrow’s ‘impossibility theorem’ that emerged out of his PhD dissertation. Relying on mathematical logic, he has shown that there is no possible voting system that can consistently and sensibly aggregate the diverse preferences of the population and present a coherent picture, which can be used to make policy choices. Though mathematical and abstruse, his study simply philosophized that group decisions do not inherit the ‘rationality’ that we usually witness when an individual exercises his choice. To make this point precise, he had chosen technical conditions, viz., non-dictatorship, individual sovereignty, unanimity, freedom from irrelevant alternatives, and uniqueness of group rank and proved that it is impossible to formulate a social preference ordering that satisfies all of these conditions. This study explained why committees often find it difficult to arrive at consistent conclusions as also why with polarized electorate, democracy can become dysfunctional. The theorem gave rise to a new discipline: social choice theory that has implications for welfare economics. Learning from his theorem that no system works entirely well, the best of the economists engaged themselves since then in finding out if any voting system was better than others.
Prof Arrow’s next major contribution, for which he shared Nobel Prize with John Hicks in 1972, was in ‘general equilibrium’. Since 1776, economists have been talking about Adam Smith’s idea of “invisible hand” but no one could establish precise conditions under which there would be prices that would clear all markets, till Prof Arrow along with Gerard Debreu, using mathematical techniques of topology to develop a model that “presented an integrated system of production and consumption which takes account of the circular flow of income”—an improvement over Walras’s model—identified the specific conditions under which market outcomes had broadly desirable social virtues. For this to work, it however calls for utopian conditions: undistorted markets are required for all goods and services, for all future times and for all contingencies with full information available to all agents in the economy. In other words, his theory of ‘general equilibrium’ established: one, that there is a general equilibrium at which prices equalized supply and demand in every market at once; two, this equilibrium is efficient; three, any efficient allocation of resources could be attained by directly redistributing wealth and letting the competitive markets decide prices; and four, markets could still fail, for a single change in one variable will impact the whole economy.
Following this seminal work, Prof Arrow broke down each of the founding assumptions of the model to establish that markets could deliver suboptimal outcomes if uncertainty or asymmetry of information is in force. This led to the development of ‘information economics’ where information is used as an economic variable that still rules the financial markets. He had also established in a paper published in the early 1960s that asymmetric information between the provider and consumer of health services is making the health insurance market fragile. Pointing out the incentives for patients and their doctors to adopt medical procedures of questionable value when insurer pays the bills, Prof Arrow spawned the modern treatment of ‘moral hazard’. All this resulted in a new discipline: ‘health economics’. Indeed, it was his research on the topic that primarily shaped the Affordable Care Act that President Barack Obama launched in 2010 that incidentally mandates everyone to buy coverage irrespective of its need or otherwise.
In the early 60s, when ‘capital controversy was going on between the two Cambridges of the UK and the US, staying above it, Prof Arrow wrote a seminal paper describing the concept of ‘learning-by-doing’ in which it is stated that the more a company produces, the smarter it gets. As a company becomes more efficient by its experience, average cost of production comes down. And, this decline in prices with a rise in scale with increasing returns is likely to lead to uncompetitive markets dominated by a few large firms. This concept of ‘learning-curve’ developed by Prof Arrow led to the development of the ‘theory of endogenous growth’ by Paul Romer decades later.
He created the very basic mathematical concepts by which the market uncertainty could be measured and risk analysed. Indeed, it is his ideas that led to the designing of complex financial securities such as derivatives. His contribution to formulate the basis for modern theories of financial investment and corporate finance is well acknowledged by William F Sharpe who won Nobel Prize for his analysing the relationship between financial risk and return. When we juxtapose risk management in financial markets along with his concept of ‘asymmetric information’, we end up with a plethora of questions that demand right answers: Has securitization made the world more risky? Is it necessary to have macro-prudential regulation in financial markets? Answers to such questions invariably take us back to examine whether the set of broad conditions that Prof Arrow identified for markets to be in equilibrium are met in practice or not. His work is so fundamental that any researcher in these areas has to invariably invoke his arguments. For instance, Joseph Stiglitz who won Nobel Prize in 2001 for formalizing the study of markets with incomplete information, traces his work to Prof Arrow’s argument about existence of perfect markets as a matter of mathematical logic.

Besides being a great researcher, he is a man of high intellectual integrity. Prof Arrow, in one of his lectures—“A Cautious Case for Socialism”—delivered at the third Lionel Trilling Seminar of the academic year 1977-78, at Columbia University, said about his values thus: “Anyone who knows me will not be surprised; I have always preferred the contemplative to the active life. I prefer the freedom to see matters from several viewpoints, to appreciate ironies, and indeed to change my opinion as I learn something new. To be politically active means to surrender this freedom. I say nothing against activism—for others. It is only through the committed that necessary changes come. But each to his own path.” What a profound statement and which upcoming researcher can ignore these invaluable words!
Prof Arrow served on the Intergovernmental Panel on Climate Change and he was awarded the National Medal of Science, America’s highest scientific honor, in 2004 and the same was presented in 2006 by President George W Bush.
As seen above, much of his work deals with fundamental issues that indeed ushered in Meta changes. And such being his contribution to the discipline of economics that students often wonder, if modern economics is but a series of footnotes to Prof Arrow’s research. Yet, this gentle genius never flaunted his intelligence, says Lawrence H Summers, his nephew and the former US Treasury Secretary, quoting the incident: When he, drawing Prof Arrow’s attention to a paper that corrected a famous analysis published by one of Prof Arrow’s famous teachers, asked him, “what he thought”, he said quietly that he had known the error for decades, but such was his respect for his teacher that he did not publish his insight. That is Prof Arrow, the great intellectual and a great soul. May his soul rest in peace, amen!


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