Legal Theory Lexicon 060: Efficiency, Pareto, and Kaldor-Hicks
Introduction Almost every law student get's some introduction to normative law and economics in their first year of law school. One of the basic ideas of normative law and economics is that the law should be "efficient." But what does efficiency mean? For economists, "efficiency" is a technical idea--with only a tangential connection to the use of "efficiency" in ordinary speech. In order to understand economic efficiency, we will look at what are called the Pareto principles and a related idea that is sometimes called Kaldor-Hicks efficiency.
In addition to explicating the idea of efficiency, we will take a qucik look at some of the criticisms that might be made of this concept. Although many economists operate on the assumption that "efficiency" is an uncontroversial good, that conclusion is controversial both inside and outside of the discipline of economics.
As always, the Legal Theory Lexicon is aimed at law students, especially first-year students, with an interest in legal theory. This is very much a "quick and dirty" look at a topics upon which whole books can be written.
The Idea of Utility and the Problem of Measurement There are several plausible formulations of normative economics, but almost all of normative economics begins with the fundamental idea of utility as a conception or measure of the good. Economists may disagree about the nature of utility, the relationship of utility to social welfare, and the role of welfare in public policy, but most (if not all) economists would assent to the abstract proposition that ceteris paribus more utility is a good thing.
Beyond such very general agreements, there are many disagreements within economic theory. One key divide is between cardinal and ordinal interpretations of utility. An ordinal utility function for an individual consists of a rank ordering of possible states of affairs for that individual. An ordinal function tells us that individual i prefers possible world X to possible world Y, but it doesn’t tell us whether X is much better than Y or only a little better. A cardinal utility function yields a real-number value for each possible world. If we assume that utility functions yield values expressed in units of utility or utiles, then individual i’s utility function might score possible world (or "state of affairs") P at 80 utiles and possible world Q at 120 utiles.
The distinction between cardinal and ordinal utilities is potentially important for utilitarianism, at least on certain interpretations. As a theory of evaluation, utilitarianism is the view that an action is the best action if and only if the action maximizes utility when compared with all possible alternative actions. For technical reasons, utilitarianism requires both cardinality and full interpersonal comparability. But both cardinality and interpersonal utility comparisons are problematic. It is difficult to measure cardinal utilities for even a single individual.
And it is even more difficult to compare utilities among different persons. How can we compare the value that I assign to consuming a glass of fine wine with the value that you assign to imbibing a fine single-malt scotch? And some things seem even more incommensurable: how do we compare the value that Ben derives from viewing a beautiful photograph by Ansel Adams to the joy that Alice takes in serving meals to the homeless on Thanksgiving Day? Or Ben's satisfaction from solving difficult math problem with Alice's pleasure in a new pair of Jimmy Choo's? These examples suggest that the problem of interpersonal comparison may be compounded by the problem of incommensurability--the idea that some preferences may not be comparable on the same scale.
This point about the difficulties faced by utilitarianism is closely related to the history of welfare economics, the explicitly normative branch of economic theory. Both cardinality and interpersonal comparability pose measurement problems for economists. The challenge for welfare economics was to develop a methodology that yields robust evaluations but does not require the cardinal interpersonally comparable utilities.
The Pareto Principles This is the point at which the Pareto principles arrive on the scene. Suppose that all the information we have about individual utilities is ordinal and not interpersonally comparable. In other words, each individual can rank order states of affairs, but we (the analysts or policymakers) cannot compare the rank orderings across persons. The weak Pareto principle suggests that a state of affairs P is socially preferable to state of affairs Q, if everyone’s ordinal ranking of P is higher than their ranking of Q. Weak Pareto doesn’t get us very far, because such unanimity of preferences among all persons is rare.
The strong Pareto principle suggests that state of affairs P is socially preferable to state of affairs Q, if at least one person ranks P higher than Q and no one ranks Q higher than P. Or to put it more colloquially: strong Pareto says that it is good to make one person better off if no one will be made worse off. Unlike weak Pareto, strong Pareto does permit some relatively robust conclusions. The so-called new welfare economics was based on the insight that market transactions without externalities satisfy strong Pareto. If the only difference between state P and state Q is that in P, individuals i1 and i2 engage in an exchange (money for widgets, chickens for shoes) where both prefer the result of the exchange, then the exchange is Pareto efficient—and hence satisfies the strong Pareto principle. A state of affairs where no further Pareto efficient moves (or trades) are possible is called Pareto optimal. The assumption about externalities is, of course, crucial. If there are negative externalities of any sort, then the trade is not Pareto efficient.
From Pareto to Kaldor Hicks Because Pareto efficiency assumes no negative externalities, it has significant limits as a normative concept. For example, there are many questions of legal policy in which externalities are particularly important--pollution is a class example. If I operate a factory that pollutes the air or water, my action may cause harms to my neighbors. If even one person would lose by the move from state P to state Q, then that move is not Pareto efficient. So if Pareto efficiency were the only normative principle available to law and economics, the consequence would be that economics would have nothing to say about many of the most important legal questions, e.g. questions of environmental law.
Kaldor-Hicks is a technique for extending the normative implications of economic analysis. Here is how it works. We take a situation in which their are externalities, e.g. pollution that affects third parties. Let's assume that markets can't reach a Pareto-efficient outcome. That assumption might be accurate because of high transactions costs, as in the case where the pollution impacts on so many individuals that bargaining is impractical or costly. Counterfactually, however, we can imagine that there were zero transaction costs. We can then ask what outcome would occur if those who were effected by the externality (the pollution) were compensated. Outcomes that would be Pareto-efficient if there were zero transaction costs are Kaldor-Hicks efficient.
Kaldor-Hicks extends normative law and economics to a wide range of situations in which externalities and transaction costs prevent markets from reaching Pareto-efficient outcomes.
Criticisms of Efficiency Does efficiency (either Pareto or Kaldor-Hicks) provide an attractive normative yardstick by which legal policies may be judged? That's a complex question, but we can quickly explore a few critical ideas:
Wealth Effects When Pareto is applied to market transactions, preferences (or utility) is interpreted as a function of willingness to engage in market transactions (or willingness to pay). But willingness to pay is a function of wealth. Thus, someone who is very poor may be willing to engage in degrading or dangerous work, because they have no real alterantive. But this does not mean that the efficient transaction is better than the alternative, which might involve a redistribution of wealth that would obviate willingness to engage in degrading work.
Bad Preferences Pareto and Kaldor-Hicks assume that state A is better than state B on the basis of individual preferences. But preferences aren't fixed. Preferences can change for a variety of reasons and some preferences may be better than others. For example, the preference to sexually abuse children is considered evil--satisfying it is not a moral good. Efficiency takes preferences as a given: it can't tell us whether the law should attempt to shape or alter preferences.
Kaldor-Hicks and Rights Kaldor-Hicks characterizes a move from state P to state Q as efficient even if a third party is injured by the move. That injury may involve unfairness or a violation of the third party's rights. From a consequentialist perspective, rights violations may have no significance in themselves, deontological normative theories do afford moral signficance to rights.
Efficiency & Social Welfare Functions Some economists move beyond Pareto and Kaldor-Hicks and embrace what are called "Bergson-Samuelson Social Welfare Functions." There is a separate entry (Social Welfare Functions) in the Legal Theory Lexicon, but the general idea is to reintroduce interpersonal comparability for individual utilities.
Conclusion Efficiency is one of the bedrock ideas for normative law and economics. The point of this Lexicon entry is to give you the tools to understand what economists mean by efficiency.
(This entry was last revised on October 28, 2007.)
