Why shouldn’t we all be better off — critique of economists‘ notion of efficiency

Again following pointers by Greg Mankiw, I found an economist criticizing the ideal of efficiency in a NYTimes „Economix“ blog post, and a critical (i.e., pro-efficiency) reply by another economist. So, what do economists traditionally recommend as good public policies?

By the Kaldor-Hicks criterion, a public policy is judged to enhance economic efficiency and overall social welfare — and therefore is to be recommended by economists to decision-makers — if those who gain from the policy could potentially bribe those who lose from it into accepting it and still be better off (Kaldor), or those who lose from it were unable to bribe the gainers into forgoing the policy (Hicks). That the bribe was not paid merely underscores the point.

That is quite a mouthful. As the economist Steven E. Landsburg explains it bluntly to students in “Price Theory and Applications” :

In applications, the Kaldor-Hicks criterion and the efficiency criterion amount to the same thing. When Jack gains $10 and Jill loses $5, social gains increase by $5, so the policy is a good one. When Jack gains $10 and Jill loses $15, there is a deadweight loss of $5, so the policy is bad.

And what’s the problem about that?

Evidently, on the Kaldor-Hicks criterion one need not know who Jack and Jill are, nor anything about their economic circumstances. Furthermore, a truly stunning implication of the criterion is that if a public policy takes $X away from one citizen and gives it to another, and nothing else changes, then such a policy is welfare neutral. Would any non-economist buy that proposition?

So, efficiency is basically about achieving the maximum aggregate (i.e. sum over all people) welfare. And the criticism is that the individuals are neglected. Here’s an interesting part of the reply:

In fact, whenever a policy is inefficient, there’s always an alternative policy that, in principle, is better for everyone. That’s what inefficiency means.

So, an inefficient solution always leaves space for solutions that make everyone better off. As in:

Take a more realistic example: Should we spend, say, a billion dollars a year to subsidize end-of-life health care for poor people? It would be, I think, a terrible mistake to settle this question without at least asking whether the recipients might prefer that we spend our billion dollars some other way — say by subsidizing their groceries or just giving them cash. If so, the difference in value between what they’re getting and what they could be getting (as measured by the recipients) is a deadweight loss. The bigger that deadweight loss, the more we should reconsider our spending priorities.

I think this is a pretty good point to leave thinking these positions through to the inclined reader… Even though I should mention that the author defending the efficiency criterium mentions some limitations to it himself.

My opinion in as few sentences as possible is, as it has often been recently: I don’t think either way of thinking is right or wrong. But by asking you to always start your thought process with considering efficiency (as the second author does), your thinking is steered into a certain direction quite strongly. And that thinking has to be justified by the effects it will cause in your life (and others‘).

Datum: Mittwoch, 15. September 2010 0:43
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  1. 1

    As I, and some economists elsewhere, have tried to point out in Landsburg’s comments section, this discussion highlights the logical contradictions in efficiency theory and shows why efficiency analysis as it’s traditionally understood is self-contradictory:

    In fact, whenever a policy is inefficient, there’s always an alternative policy that, in principle, is better for everyone. That’s what inefficiency means.“

    The implied logical contradiction is that agents are rational, utility maximizing agents but are NOT taking advantage of mutually advantageous trades. The economist’s are trying to attach normative significance to what are really positive predictions about what agents WILL (not SHOULD) do, and not noticing that they contradict themselves.
    If the trades are not being made, then by definition the agents are not maximizing utility, and hence efficiency analysis has no basis.

    Economists ought to understand that inefficiency can never be observed. If you think you’ve found an inefficiency, you must be wrong because the mutually advantageous trade is not being made.

    Please see the paper I cite in my posts on that cite for the full argument.

  2. 2

    Thanks for that addition!

    I hope it’s ok if i quote from one of your comments over there a couple paragraphs that make that point even clearer to me:

    I do think, though, that the basic logic of the critique of efficiency analysis stands no matter how fancy you make the utility-maximizing models (e.g. adding uncertainty, time). I still think it’s a non sequitur to argue that:

    According to my economic model, which assumes rational utility-maximizing agents, people will choose policy Y, which is different from the observed status-quo policy X. Therefore, we should change to policy Y.

    The problem is that the fact that people are currently NOT choosing policy Y MUST mean that either:

    1) People are not rational utility-maximizers.
    2) The ancillary premises relating to the nature of the decision problems they face in your model are incorrect.

    If 1 is the case, then efficiency has no substantive application in the real world. If 2 is the case, you have to go back to the drawing board and get a different model. It doesn’t matter if the policy incorporates time and uncertainty, so that you are just recommending a different policy function based on ex-ante expectations: if people are doing the best they can, then they are doing the best they can, and hence their decisions can’t be improved.

    Ultimately, I think efficiency analysis is an attempt to derive “ought”’s from “is”’s. If economics is a science, then the purpose of utility functions is to predict and describe how people behave. The best utility functions are those which come closest to predicting observed behavior. When people behave differently from what’s predicted, the model is wrong, not the people.

    And I’d like to add a quote coming from a comment by Uwe Reinhardt, the original NYTimes author, adding a perspective my own constructivist take on the matter:

    As Ken Arrow warns us in his 1963 essay on health care, “A definition is just a definition, but when the definiendum is a word already in common use with favorable connotations, it is clear that we are really trying to be persuasive; we are implicitly recommending the achievement of optimal states.”