Economic Welfare and the Allocation of Resources for Resilience

In 1959 Kenneth Arrow wrote "Economic Welfare and the Allocation of Resources for Invention"

Economic Welfare and the Allocation of Resources for Invention published as part of a 1962 NBER publication The Rate and Direction of Inventive Activity: Economic and Social Factors. Arrow's framework can be used to think about how we allocate resources to create a more resilient economy and society. Here I quote his main points in the context of critical resources and resilience rather than information and invention.

Arrow starts with the classic question of welfare economics: "to what extent does perfect competition lead to an optimal allocation of resources?" ... "competition insures the achievement of a Pareto optimum under certain hypotheses", but a core assumption is that "there is no uncertainty in the production relations and in the utility functions."

Uncertainty is one of the three classical reasons for the possible failure of perfect competition to achieve optimality in resource allocation. Indivisibilities and inappropriability are the other two. If firms can't relieve themselves of all risks (they can't), then any unwillingness or inability to bear risks will give rise to a nonoptimal allocation of resources since there will be discrimination against risky enterprises ... "The inability of individuals to buy protection against uncertainty similarly gives rise to a loss of welfare."

"Unfortunately, it is only too clear that the shifting of risks in the real world is incomplete ... There are a number of reasons why this should be so, but I will confine myself to one, of special significance with regard to invention resilience. In insurance practice, reference is made to the moral factor as a limit to the possibilities of insurance." .. "A fire insurance policy, even when limited in amount to the value of the goods covered, weakens the motivation for fire prevention. Thus, steps which may improve the efficiency of the economy with respect to risk bearing may decrease its technical efficiency."

"The main conclusions to be drawn are the following: (1) the economic system has devices for shifting risks, but they are limited and imperfect: hence, one would expect an underinvestment in risky activities; (2) it is undoubtedly worthwhile to enlarge the variety of such devices, but the moral factor creates a limit to their potential."

If any particular item of information critical resource has differing values for different economic agents, this procedure will lead both to a nonoptimal purchase of information resources at any given price and also to a nonoptimal allocation of the information resource purchased.

"It should be made clear that from the standpoint of efficiently distributing an existing stock of information resources, the difficulties of appropriation are an advantage, provided there are no costs of transmitting information resources, since then optimal allocation calls for free distribution. The chief point made here is the difficulty of creating a market for information resilience if one should be desired for any reason."

Information Resources should be transmitted at marginal cost, but then the demand difficulties raised above will exist. From the viewpoint of optimal allocation, the purchasing industry will be faced with the problems created by indivisibilities; and we still leave unsolved the problem of the purchaser's inability to judge in advance the value of the information resource he buys. There is a strong case for centralized decision making under these circumstances.

To sum up

Arrow writes "we expect a free enterprise economy to underinvest in invention and research resilience (as compared with an ideal) because it is risky, because the product can be appropriated only to a limited extent, and because of increasing returns in use. This underinvestment will be greater for more basic research more infrequent events. Further, to the extent that a firm succeeds in engrossing the economic value of its inventive resilience activity, there will be an underutilization of that information as compared with an ideal allocation."

To paraphrase in the context of pandemic preparedness: we expect the market to underinvest in necessary resources like masks and ventilators because (1) it is unknown when they'll be necessary (due to uncertainty), (2) if they become necessary companies won't be able to charge prices sufficient to make a century of mask-stockpiling worthwhile, and (3) masks, like vaccines, have increasing returns in use (the more people wearing them the better for everyone). Further, to the extent that a firm succeeds in price gouging, not as many masks and ventilators would be distributed as we would want.

Over 90 percent of the masks and 80 percent of the PPE used in American hospitals today are not manufactured in America. Arrow, who set out the general equilibrium equations showing that competitive markets are efficient, gives us a framework for thinking about a more thoughtful industrial policy that relies a little less on an "invisible hand" and more on common sense and strategy.