Obviously, the highest type of efficiency is that which can utilize existing material to the best advantage.1
(Jawaharlal Nehru, former Prime Minister of India)
We want the spirit of America to be efficient; we want American character to be efficient; we want American character to display itself in what I may, perhaps, be allowed to call spiritual efficiency – clear disinterested thinking and fearless action along the right lines of thought.2
(Woodrow Wilson, former President of the U.S.)
I don’t like a man to be too efficient. He’s likely to be not human enough.3 (Felix Frankfurter, former Supreme Court Justice)
Of the three basic dimensions of policy analysis emphasized in the introductory chapters of this book (efficiency, equity, and political context), the analysis of efficiency involves the most widely accepted set of concepts among policy analysts. Debates about efficiency occur frequently, but they often involve specific questions about its measurement or its importance relative to other policy goals. There is little debate about its general meaning.
What is efficiency?
The reader will be glad to know that the common-sense definition of efficiency does resemble its formal meaning in policy analysis. In common-sense terms, an individ-ual is working efficiently if she is working to her capacity with a minimum of wasted effort. Alternatively, a person is playing efficiently if he is having the greatest possible time with minimum costs or other negative effects on himself or others.
In a general sense, this concept of efficiency is also applicable to the operation of business, government, and other institutions. A business is operating efficiently if it produces the greatest value of product at the lowest possible cost. A government is operating efficiently if it is providing the greatest possible well-being for its citizens at the least possible cost. And society as a whole is operating efficiently if its citizens are as well off as possible given the society’s resources.
As you can see, the intellectual challenge associated with efficiency does not arise because of problems with its basic meaning, but in how that meaning can be applied to real-world situations.
Because individual utility is not measurable under most circumstances, indi-vidual and societal well-being are both subject to measurement problems. The first set of problems occurs at the individual level. In Chapter 3 the benefits of consumption are defined in terms of marginal value, or the maximum willingness to pay for a particular unit of a good. As noted at the end of Chapter 3, there is a potentially important difference between the maximum a person is willing to pay in order to receive a benefit (compensating variation) and the amount the person is willing to accept in order to forego a benefit (equivalent variation). This meas-urement issue has not become a serious barrier to policy analysis, but does intro-duce a degree of uncertainty into the meaning and accuracy of consumer surplus.
More broadly, an efficient society is presumed to maximize the welfare (or utility) of society as a whole. At the societal level two basic measurement problems exist with this concept. First, individual utilities are only observable in terms of the ranking of different combinations of goods. This limitation means that one cannot easily or accurately compare the intensity of two persons’ preferences, or how strongly a given policy will affect each person’s utility. Secondly, the total well-being of society depends on how much weight each person’s utility receives. The different social welfare functions defined in our discussion of ethics (Chapter 2) produce very different weights for the utility of different individuals. To review, utilitarianism weighs each individual’s utility equally, while John Rawls’ differ-ence principle assigns all weight to the least well-off person. These two problems, among others, make the task of measuring society’s overall well-being more or less impossible in any direct sense.
These measurement problems are real, but they do not and should not preclude the economic analysis of efficiency. Approximate answers to policy questions are all that any discipline can offer, including economics, and a certain degree of humility and care is needed in the process of analyzing public policy from any point of view. With this caution in mind, we can now plow ahead.
Pareto optimality
The most fundamental economic concept in the analysis of societal efficiency is Pareto optimality, named after Vilfredo Pareto (1848-1923). This concept has a wonderful simplicity because it manages to avoid the impossible task of adding the well-being of individuals from the ground up. Instead, Pareto optimality offers a marginal test of allocative efficiency.
Definition: Pareto optimality. A situation is Pareto optimal if it is impossible to make any person better off without making at least one person worse off.
In other words, Pareto optimality requires that all possible opportunities for efficient production and mutually beneficial trade have been fulfilled. A related concept is Pareto improvement.
Pareto optimality relates to Pareto improvement in the following way. If soci-ety, or a relevant portion of socisoci-ety, has achieved Pareto optimality, no Pareto improvements are possible.
Your Turn 4.1:Before proceeding any further, the reader might take a few moments to consider the meaning of these concepts. Consider whether or not the following actions produce Pareto improvements.
(A) Robin Hood robs Prince John to feed his merry men.
(B) The Sheriff of Nottingham arrests Robin Hood, thereby preventing further theft.
(C) The U.S. government increases aid to the homeless, paying for the program with a slight increase in the corporate income tax.
(D) The Salvation Army feeds the hungry with voluntary donations from the well-to-do.
The lesson from these examples is that the redistribution of income, by itself, will not be a Pareto improvement unless it is wholly voluntary. While some people are proud to pay their taxes in order to support public anti-poverty programs, the non-voluntary nature of taxes makes it unlikely that everyone will feel better off when their taxes are due.
Another simple example may aid in understanding the policy implications of the Pareto improvement concept. If a policy costs Jack $10 and provides $20 in benefits to Jill, it is not a Pareto improvement. However, if Jill compensates Jack for his loss by paying him $10 of her benefits, then Jill would still be $10 better off, Jack would be equally well off, and a Pareto improvement is achieved.
Therefore if the winner (Jill) fully compensates the loser (Jack) and has some benefits left over, the policy produces a Pareto improvement. On the other hand, if the policy costs Jack $10 and provides Jill with $10 in benefits, then in order to compensate Jack for his loss, Jill would have to pay him all of her benefits.
After Jack is compensated nobody is worse off, but nobody is better off either.
Definition: Pareto improvement. An action leads to a Pareto improvement if it makes at least one person better off without making at least one person worse off.
A Pareto improvement can also be achieved if anybody who would otherwise lose due to a policy is fully compensated for his or her losses.
This second policy would not be a Pareto improvement. This example indicates that there are two conditions which must be met in order for a policy to be a Pareto improvement.
Together these conditions imply that nobody is made worse off (by condition 2), and that some net gains will remain after the losers are compensated (by condition 1).
More advanced: the Edgeworth box and the meaning of Pareto optimality One theoretical tool for explaining the meaning of Pareto optimality is labeled the Edgeworth box. This model represents an abstract world with two individuals and no production. Instead of production, predetermined quantities of two goods can be traded in order to improve the well-being of the individuals. Therefore, the Edgeworth box also can be labeled as a pure exchange model. While this model has little or no direct use in the analysis of policy, it is useful in the identification of two important concepts that help to explain the meaning of Pareto optimality.
These principles are mutually beneficial exchange and the endowment point.
Mutually beneficial exchange states that informed individuals will not under-take a trade, purchase, or task unless the action makes them better off. The endowment point refers to the initial distribution of income or wealth from which exchange takes place.
The Edgeworth box model assumes that there are two individuals, Dottie and Schwartz, and two goods. Each individual starts with fixed quantities of the two goods. These initial quantities represent the endowment point. In order to identify trade between the two parties, the quantities and utilities of one of two persons are inverted. In the Edgeworth box figure, Schwartz’s quantities of fruit and eggs start at zero on the upper right-hand corner, while Dottie’s quantities start at zero from the bottom left. The dashed indifference curves represent Dottie’s utility function, while the solid curves represent Schwartz’s utility. Turning the book upside down for a moment will demonstrate that Schwartz’s indifference curves are normally shaped.
The endowment point in Figure 4.1 represents the initial distribution of fruit and eggs between Dottie and Schwartz. In this particular case Dottie starts with the majority of the eggs and Schwartz with the majority of fruit. The utility each party receives from this endowment is shown by the indifference curve that passes through the endowment point. The area between these two curves is called the core. The core represents the space within which a Pareto improvement can take place. In other words, any point in the core will make at least one party better off without making the other worse off.
Conditions for a Pareto improvement:
1 Total benefits must be greater than total costs.
2 Losers (if any) must be fully compensated for their net losses.
Within the Edgeworth box model the only way for the two parties to achieve a Pareto improvement is to trade with each other starting from the endowment point. Ideally, this trade will result in a Pareto optimal point. Such a result is displayed in Figure 4.2. In this graph Schwartz gave up some fruit and received eggs in trade, while Dottie gave up some eggs and received fruit. Notice that in this case both have moved to higher indifference curves after the exchange, and that the new allocation of goods at the point represented by the square is a triple Figure 4.1 Edgeworth box
Figure 4.2 Edgeworth box with a Pareto-optimal point
tangency between the dashed line along which they could trade and each person’s indifference curve. From this new allocation of goods it will be impossible to make one person better off without making the other person worse off. Therefore, the square represents a Pareto optimal outcome. Similarly, at tangency points like A or B it would also be impossible to increase one person’s utility without reduc-ing the utility of the other. Therefore, any tangency point between the two persons’ indifference curves is Pareto optimal. In Figure 4.2 the thick line, commonly called a contract curve, represents all possible Pareto optimal points in this Edgeworth box. Notice that the contract curve extends through points A, B, and the square, but also includes the two corner points where one or the other person has no goods at all.
The Edgeworth box is useful in representing two important points regarding the meaning of Pareto optimality. First Pareto optimality can be achieved through the free and informed exchange of goods if the rate at which one good is exchanged for the other equals the slopes of the two persons’ indifference curves at their point of intersection. This means that the slope of both party’s indifference curves (−MUX/MUYin Chapter 3) will equal the rate of exchange, which in a monetary economy equals the slope of the budget line, or −PX/PY. Therefore, individual util-ity maximization is a necessary condition for a Pareto optimal outcome.
Secondly, and more importantly in a policy context, Pareto optimality and Pareto improvement are relative concepts that vary with the initial allocation of goods.
An allocation of goods that leaves one person with everything and another with nothing will be Pareto optimal since transferring goods from the person with everything will cause him or her to be worse off. Therefore, it is often important to include ethical considerations as well as efficiency when analyzing the social impact of a public policy.
Other efficiency concepts
The Pareto improvement principle is an impractical efficiency standard for many public policy decisions. Public programs are often funded by taxation. Since taxes by definition lower the spendable incomes and well-being of taxpayers, programs that allocate tax revenues from the general public to specific groups violate the Pareto improvement principle. Similarly, regulations that restrict the actions of some in order to benefit society as a whole are also likely to make some individuals worse off. Unlike the earlier example of Jack and Jill, identifying and compensating all individuals who suffer losses from a government program is likely to be impractical.
However, those with strong libertarian tendencies tend to approve of Pareto improve-ment as a standard, since it generally limits transfers of wealth or restrictions on free-dom to those which are voluntary, and therefore mutually beneficial.
The Kaldor–Hicks principle
There are two common standards for judging efficiency that are less restrictive than Pareto optimality. The first is labeled the Kaldor–Hicks principle, or the
fundamental rule of policy analysis. The second and even less restrictive crite-rion is labeled the leaky bucket principle. Each will be introduced in this section.
The Kaldor–Hicks principle modifies the wording and meaning of the Pareto improvement criterion in the following way.
Adding the words “in principle” creates a substantial difference between the Pareto improvement concept and the Kaldor–Hicks principle. As stated above, a Pareto improvement requires that total benefits must be greater than total costs and that any losers must be fully compensated for their net losses. However, the Kaldor–Hicks principle does not require that the losers actually be compensated.
The rule for analyzing public policy based on the Kaldor–Hicks principle is often labeled the fundamental rule of policy analysis.
This rule, based on the Kaldor–Hicks principle, provides the basis for benefit–cost analysis, which is discussed in more detail in Chapter 6.
The Kaldor–Hicks principle also has a direct relationship to the utilitarian philosophy discussed in Chapter 2. As you may recall, utilitarianism argues that the well-being of all individuals should be equally weighted when considering the effects of a policy, and that the primary goal of any policy is to maximize the total benefits minus costs, or pleasure minus pain, for all members of society.
Therefore, the Kaldor–Hicks principle is an application of utilitarianism. Because utility is not measurable, however, cost–benefit analysis based on the Kaldor–Hicks principle is usually measured in terms of dollars, or some other monetary measure. Monetary value makes a very useful measurement tool, but it does create one significant difference between utilitarianism and Kaldor–Hicks.
As noted in Chapter 2, the law of diminishing marginal utility implies that trans-ferring income from the rich to the poor without any efficiency losses will tend to make society as a whole better off. This distributional effect is lost when well-being is measured in terms of dollars. This is another reason why ethics should be considered in policy analysis.
The fundamental rule of policy analysis: Adopt a policy if total benefits are greater than total costs.
Definition: The Kaldor–Hicks principle states that a policy should be adopted if the winners could in principle compensate the losers. This principle requires that the total benefits outweigh the total costs but does not require that the losers actually be compensated.4
The leaky bucket principle
While the Kaldor–Hicks principle is widely accepted as a test of the efficiency of a policy, it tends to reject many policies designed to redistribute income to the poor. This is because income redistribution programs are likely to decrease total production in a society somewhat in addition to increasing equality. Because the Kaldor–Hicks principle requires that total net benefits to society be positive for any policy, such a tradeoff between efficiency and equality will be rejected. As part of a brief but wonderfully insightful book entitled Equality and Efficiency:
The Big Tradeoff,5Arthur Okun developed a model for analyzing redistribution programs based on a version of the following story.
A leaky bucket tale
When one transfers income through government policy, some of the spending does not end up directly benefiting the poor. Okun refers to any other use of a program’s funds as “leaks.” Leaks exist when the amount of money taken in taxes for a redistribution program is more than the increased income of the poor. Let’s consider an example. It is a cold day, and kerosene is in short supply. Jill has two buckets of kerosene, and Jane has none. The mayor comes to Jill’s house to take a bucket of kerosene to Jane. Jill reluctantly agrees to give up a bucket of the precious kerosene, but on the way to Jane’s house some of the kerosene leaks out, leaving less than one bucket of kerosene for Jane. Clearly this process is likely to violate both the Pareto and Kaldor–Hicks principles because Jill’s loss is greater than Jane’s gain.
Most ethical principles require that such a tradeoff at least be considered in order to keep Jane from freezing. However, if Jane is getting far less kerosene than Jill is giving up, society may judge the transfer of kerosene to be too waste-ful to be worthwhile. For example, no reasonable ethical principle could require that the transfer take place if all of the kerosene leaked on the way to Jane’s house, because the only effects are that a bucket of kerosene is lost, and someone has wasted the effort to carry the bucket to Jane’s house. Okun makes no judgment regarding the maximum acceptable leak. Rather, Okun’s emphasis is on identify-ing the sources of leaks, or inefficiencies, associated with a redistribution program, and designing public policies to minimize these leaks.
Sources of leaks
Okun identifies several sources of leaks that may occur in a program which trans-fers income. One source of leaks is administrative costs. The salaries of govern-ment workers, computer costs, paper, printing, and other expenditures divert some tax revenue from the poor. A second category of leaks involves the disin-centive to work caused by taxes and transfer payments. If the rich expect to sacri-fice a substantial portion of their income in taxes, their incentive to earn income is reduced. Similarly, if the poor expect to receive adequate income through
government transfer payments without having to work, their work incentive is also reduced. Okun also mentions two other possible leaks which he finds less well supported by statistical evidence. The first is the disincentive to save and
government transfer payments without having to work, their work incentive is also reduced. Okun also mentions two other possible leaks which he finds less well supported by statistical evidence. The first is the disincentive to save and