Prof. Bryan Caplan

Econ 849

Fall, 2001


Week 1: Efficiency

I.                     The Many Meanings of Efficiency

A.                 The Merriam-Webster College Dictionary defines "efficiency" as "effective operation as measured by a comparison of production with cost (as in energy, time, and money)."

B.                 Economists occasionally do use "efficiency" in the dictionary sense - ratio of the value of output to input or something similar.

C.                But normally they use it in quite different ways, and unfortunately often equivocate between the various usages.

D.                The two most common uses in economics are:

1.                  Pareto efficiency

2.                  Kaldor-Hicks (or cost-benefit) efficiency

E.                 Since much of public finance analyzes efficiency, it is important to understand these terms' precise meanings.

II.                   Pareto Efficiency, I

A.                 Most of the famous theorems in welfare economics discuss Pareto efficiency.

B.                 A situation is Pareto efficient iff the only way to make one person better off is to make another person worse off.

C.                Similarly, a Pareto improvement is any change that makes someone better off without making anyone else worse off.

D.                Slight variant - a situation is Pareto efficient if there is no way to make everyone better off.  Note that in a perfectly continuous world, this is equivalent to the other definition.  Why?

E.                 In theory, it is quite possible that people will voice objections to Pareto improvements for strategic reasons.  So it is not equivalent to a demonstrated preference standard.

F.                 In a highly stylized theoretical setting, Pareto improvements are conceivable.  Ex: If everyone has identical preferences and endowments.

III.                  Pareto Efficiency, II

A.                 Even so, there is a strong argument that, in the real world:

1.                  Everything is Pareto efficient.

2.                  Pareto improvements are impossible.

B.                 Why?  Almost any change hurts someone, and it is highly unlikely in practice that literally everyone can be compensated, that absolutely no one will be missed.

C.                Ex: I buy your watch.  How will we compensate everyone who might have asked you the time?

D.                Rothbard's strange variant: Only count "demonstrated preferences."  Then Pareto improvements happen all the time.  But especially for an Austrian, this is bizarrely behavioristic.  (See my The Austrian Search for Realistic Foundations).

E.                 More fruitful variant: Analyze the Pareto efficiency of ex ante rules instead of ex post results.  But even then, someone is very likely to slip through the cracks.

IV.               Kaldor-Hicks Efficiency, I

A.                 In practice, then, economists almost always switch to Kaldor-Hicks efficiency, aka "cost-benefit efficiency."

B.                 A situation is Kaldor-Hicks efficient iff the dollar value of social resources is maximized.

C.                A Kaldor-Hicks improvement is any change than raises the dollar value of social resources.

D.                Every Kaldor-Hicks efficient situation is Pareto efficient, but most Pareto efficient situations are NOT Kaldor-Hicks efficient.

E.                 Ex: You value a watch at $20, I value it at $30, the strangers you will encounter value my having the watch at $.10, the (different) strangers I will encounter value my having the watch at $.10.

1.                  If I have the watch, the situation is K-H and Pareto efficient.

2.                  If you have the watch, the situation is Pareto but not K-H efficient.  Social value on the watch rises from $20.10 to $30.10, but your time-askers lose $.10.

F.                 Every Pareto improvement is a Kaldor-Hicks improvement, but most Kaldor-Hicks improvements are not Pareto improvements.  (Return to above example).

G.                K-H efficiency is often described as "potentially Pareto efficient" because if the value of social resources rises, then (assuming perfect continuity), you could compensate all of the losers by sharing the gain in surplus.

H.                 But what exactly does this "could" mean?  Essentially, you could if transactions costs of arranging compensation were zero.

I.                     This bothers many people - why shouldn't the transactions costs count just as much as other costs?  Ultimately, though, this is just another way of saying that Kaldor-Hicks improvements don't have to be Pareto improvements.  No one said ever said they were.

1.                  When you judge whether something is a K-H improvement, you do count the transactions costs for the move itself.

J.                  Further complication: Willingness to pay and willingness to be paid can starkly diverge.  Willingness to pay always has limits; willingness to be paid doesn't.  Why?

1.                  Wealth effects

2.                  Endowment effects

3.                  Moral principles

V.                 Kaldor-Hicks Efficiency, II

A.                 K-H efficiency naturally gives rise to another concept: deadweight costs.  If the value of social resources is not maximized, deadweight costs exist.

B.                 Everyone knows that you can transfer resources from one person to another.  That's obvious.

C.                Economists' marginal product: It is far less obvious that resources can be destroyed, leaving no one better off.

D.                Ex: Piracy.  It is obvious that pirates transfer treasure from victims to themselves.  The deadweight costs of piracy are far less obvious.  What are they?  Treasure that gets lost in the fight, damage to ships, lost lives on both sides, etc.

1.                  The point is not that pirates make themselves worse off by piracy.  At least ex ante, they don't.  The point is that the pirates only gain a fraction of what the non-pirates lose.

2.                  This assumes, of course, that people don't directly enjoy fighting, watching gold sink to the ocean floor, etc.

E.                 Now let's examine Landsburg's K-H analysis of drug legalization.  Main insights:

1.                  Taxes raised are a transfer, not a "benefit."

2.                  Imprisonment and effort spent avoiding imprisonment is a deadweight cost.

3.                  Theft is a transfer, but resources (time, tools, etc.) used to steal are a deadweight cost.

4.                  Voluntary consumption is a benefit!

5.                  Internalized losses (like loss of productivity) are already counted in consumption decisions.

F.                 Economists often criticize non-economists for thinking in terms of a "fixed pie" of wealth.  In this sense, economists are more optimistic than the public.  However, a corollary is that the pie can also shrink!  In this sense, economists are more pessimistic than the public.  With a fixed pie of resources, conflict at least has to benefit SOMEONE.

G.                Reducing deadweight costs is always a K-H improvement; if a situation is K-H efficient, deadweight costs are zero.

VI.               Kaldor-Hicks Efficiency versus Utilitarianism

A.                 Kaldor-Hicks efficiency is based on dollar valuations, not utility or happiness. 

1.                  You can know that I'm willing to pay $100 for something without having any idea about how much happiness it brings me.

2.                  Similarly, you can know that something makes me very happy even if I have a low willingness to pay for it.

B.                 Utilitarianism, in contrast, is precisely about maximizing happiness or pleasure.  The main reason economists rarely officially use it is that it requires "interpersonal utility comparisons."  Simply: How do you "add happiness"?

C.                People often say that utilitarianism just factors in the marginal utility of wealth, unlike K-H.  There is a point here, though it is not necessarily true: People might be willing to pay for things other than happiness. 

1.                  As Nietzsche says, "Man does not seek happiness, only the Englishman."

D.                Utilitarianism is often used to justify redistribution, but even on its own terms, this doesn't necessarily follow.  The "utility monster" is the standard philosophers' counter-example.

E.                 There is a further tension between total and average utilitarianism.  Both have paradoxes.

VII.              Allocative, Productive, and Lobbying Inefficiency

A.                 There are several different ways for K-H inefficiency to manifest itself.

B.                 Most discussed: allocative inefficiency.  With uniform pricing, allocative inefficiency normally arises if P>MC.

C.                Main intuition: Landsburg on "Why Taxes Are Bad."  Units consumers buy anyway involve only a transfer; units that are no longer bought involve a deadweight loss.

D.                Allocative inefficiencies are normally quite tiny, however, because they arise only on the marginal units, or DW loss "triangle."

E.                 Far less discussed: productive inefficiency.  A situation is productively inefficient iff the AC of producing a given quantity is above the minimum AC.

F.                 Productive inefficiencies can easily be large, because they exist on ALL units produced, yielding a whole DW loss trapezoid.

G.                Lobbying inefficiency, or "rent-seeking" cost, is the least discussed of all.  It arises when people use resources to effect the transfer of other resources.

H.                 If lobbying is competitive, then entry continues until TB=TC, aka "full dissipation."

I.                     Examples:

1.                  Grants of monopoly privilege

2.                  Competition for monopoly privilege

3.                  Regulated monopoly

4.                  Air pollution

5.                  Prohibition

VIII.            The Comparative Institutions Approach and "Second Best"

A.                 Demsetz famously complained about the "Nirvana fallacy" - doing (K-H) efficiency comparisons while selectively relaxing important constraints.

B.                 His target was old-style welfare economics, where the solution to any market shortcoming was government involvement.  The shortcomings of government - and even its basic overhead - were almost never factored in.

C.                Classic example: P>MC.

1.                  Standard solution: Impose P=MC price control.

2.                  Secondary problem: With fixed costs, firms now lose money.

3.                  Standard solution: Subsidize them.

4.                  Tertiary problem: How can the subsidies be funded?

5.                  Standard solution: Taxes

6.                  But what about the DW cost of the taxes?!

7.                  And of course this still overlooks a wealth of problems.  What is MC?  Who awards subsidies, and what are their incentives?  Etc.

D.                Demsetz's lesson is that economists should use a "comparative institutions approach."  Nothing in the real world is perfectly efficient.  What fails least badly?

1.                  The Tale of the Emperor

E.                 When you add more constraints to a standard problem, the original optimum is usually no longer feasible.  Economists frequently refer to the original optimum as a "first-best solution," and the new, worse optimum as a "second-best solution."

F.                 Example: Pricing subject to a P=AC constraint in a decreasing cost industry.

IX.               Moral Philosophy and Efficiency

A.                 Who cares about efficiency anyway?  Does anyone seriously believe that the right action is always the one that does the most for K-H efficiency?

B.                 One popular reply: K-H efficiency combined with redistribution.

1.                  That still seems highly inadequate to me.  What about desert and entitlement?

C.                More moderate view: Efficiency is probably ONE of many consequences worth thinking.  Why then should economists concentrate on it?  Because they have special training for distinguishing transfers from DW costs, but no special training in moral philosophy.  Economic analysis thus becomes a potentially useful input into the moral thinking of others.