Wednesday, September 17, 2014

Profit maximization in societal design

A recent study in the Journal of the Institute for Operations Research and the Management Sciences (INFORMS) (1) concludes what is obvious to some. They prove something that could be counterintuitive to most who do not care for economics and those who mix social preferences with economics and assume without proof, such a mixture leads to good policy and better societies.

The study looks at the automotive repair market and analyzes if the repair persons behave ethically and have social preferences, as opposed to purely profit maximizing businesses (e.g. free markets), whether society would be better off. The answer to a large swath of the population should be a resounding No – as a profit maximizing service provider seems like a bad person. In an environment where service providers are driven by ethical and social preference considerations, the study shows that the prices will rise – as they will tend to charge higher but uniform prices to everybody. If so, customers, who do not face price differentiation, will be forced to a higher uniform price, on average. In this case, analytical models show that society, as a whole will be worse off. In a society that contains both ethical and profit maximizing providers, the latter will quickly reflect the higher uniform price when it is convenient to them and reject service to those with higher costs. In a system with only profit maximizing providers and unconstrained transactions, market clearing prices will reflect the provider’s marginal cost, maximizing societal welfare.

Apparent common sense and social preferences are not necessarily good guiding principles for policy. Free markets and profit maximizing decision-makers, generally, push complex societies to higher welfare. The study correctly warns regulators and policy-makers to study social welfare issues before enacting uniform price policies.

(1) INFORMS study shows social welfare may fall in a more ethical market Published: Monday, August 25, 2014 - 15:41 in Mathematics & Economics, (e) Science News