The Connection Between Economic Efficiency and Utility

A commenter on my first externalities post wrote: “I'm confused, and suspect the difficulty is in our ethical assumptions, not your math.” She was mistaken, but the fault was mine. I have been analyzing issues of externalities in terms of economic efficiency without ever explaining what it is or why anyone should care about it. I will now do so.

We start with a simple but important question: If something benefits some people and hurts others, how can one decide whether the net effect is loss or gain, cost or benefit? How can you add people up?

More than a hundred years ago an economist named Alfred Marshall proposed a solution to that problem. It is not a very good solution. It is merely, for many although not all purposes, better than any alternative that anyone has come up with since. The result is that economists continue to use Marshall’s solution, sometimes concealed behind later and (in my view) less satisfactory explanations and defenses.  

Marshall’s argument starts by considering some change—the imposition or abolition of a tariff, a revision of the tax code, a shift in tort law from strict liability to negligence. The result of the change is to make some people better off and some worse off. One could imagine measuring the magnitude of the effects by asking each person affected how much he would, if necessary, pay to get the benefit (if the change made him better off) or prevent the loss (if it made him worse off). If the sum was positive, if total gains were larger than total losses, we would describe the change as an economic improvement, if it was negative, an economic worsening. 

Marshall’s approach to defining economic efficiency has three major virtues:   

1. It sometimes makes it possible to answer questions such as whether a carbon tax can make us better off or what its optimal level would be.

2. Since values are revealed in actions, it is sometimes possible to construct institutions to maximize efficiency.

3. Although whether a change increases efficiency does not tell us for certain wheter it is desirable or utility increasing, it is close enough so that the answer to the question “What is efficient?” is at least relevant, although not necessarily identical, to the answer to the question “What should we do?”  

It has three obvious faults:

1. It assumes that all values are values to humans.

2. It assumes that the appropriate values are values to individuals as expressed in their actions, that there is no essential difference between the value of insulin and of heroin. 

3. It assumes that, in combining values across people, the appropriate measuring rod is willingness to pay, that a gain that one person is willing to pay ten dollars to get just balances a loss that another is willing to pay ten dollars to avoid.   

Defining value by what I act to get may not always give the right answer but it is hard to see how one can do better. If value to me is not defined by my actions it must be defined, for operational purposes, for controlling what actually ends up happening, by someone else’s actions. As long as God remains in his heaven instead of stepping down and taking charge, people’s actions are the only tools available for moving the world. That leaves us with the problem of finding a “someone else” who both knows my interest better than I do and can be trusted to pursue it. 

The third criticism may be the most serious. Marshall’s response was that, since most economic issues involve costs and benefits to large and heterogeneous groups of people, differences in individual value for money (in the language of economics, the “marginal utility of income”) were likely to average out.

Marshall was a utilitarian, proposing economic improvement as an imperfect proxy for a utility increase. Another utilitarian economist, my friend Quang Ng, has offered a different argument for basing decisions on economic efficiency.¹ It starts by asking how one would design a society to maximize total utility.

One way of doing so suggested by this discussion is income redistribution, transfers from the low marginal utility of income rich to the high marginal utility of income poor. Income redistribution  has a cost, since it reduces the incentive to do things other people value and will pay you for — why go out and work if you get paid just as much to stay home and play video games? At the optimal level of redistribution, the utility gain from transferring one more dollar just balances the dead weight loss, the utility cost of the increased inefficiency doing so produces. That is why a utility maximizing government stops at that point.

Now consider a proposal such as a tariff that imposes a dollar cost greater than its dollar gain. Someone might defend it by claiming that although dollar cost is larger than dollar gain the utility gain is greater than the utility loss because the gains go to poorer people than the losses.

Acting on that argument, however, is a form of income redistribution and will have the same dead weight loss as direct redistribution plus the additional cost of giving fewer dollars to the gainers than it takes from the losers. Hence, Ng concludes, the utility-maximizing government should do all of its redistribution through direct transfers and adopt, for all other decisions, the heartless criterion of economic efficiency.

It is a lovely argument. Its relevance to the behavior of real-world governments is perhaps a little unclear.

Enough, however, on externalities and economic efficiency. My next post will be my solution to a religious puzzle.

---

Past posts, sorted by topic

A search bar for past posts and much of my other writing

1. Yew-Kwang Ng, “Wealth Maximization for Welfare: Efficiency and Equality Considerations.”