Basic Concepts and Tools of Analysis 1 Utility and Value

In order to determine which state of society will lead to the socially desirable goal of welfare maximisation, we need to posit a criterion to refer to. Here, the idea of utility is useful, although it is a rather subjective concept used to mean satisfaction, happiness, pleasure or welfare as defined by B e n th a m .T h e notion o f value, by contrast, is more objective and denotes, in relation to certain goods or services, how much someone is willing to pay for the resources (or, if he already has them, how much he would charge to part with them), and in relation to a certain risky situation, how much he is willing to pay to avoid it.2^ The distinction between these two concepts inevitably leads to two major conflicts with the use of the two terms interchangeably: economical and e th ical.B arrin g such constraints, we may in most cases be allowed to use the two identically.

As was just mentioned, the concept of utility may be subjective in the sense that since an individual is assumed to be the best judge of his own interest, the utility he derives from his

J S Mill, Collective Works o f John Stuart Mill (U Toronto Press 1973), vol 7 (A System o f Logic: Ratiocinative and Inductive), Bk VI, ch XII, sec 7; id. Utilitarianism, ch V, paras 26-31; Rawls, A Theory o f Justice, A \ff.

E.g. J Rawls, Justice as Fairness, 67 Phil Rev (1958) 164. For a brief account o f the relations between the utilitarian tradition and distributive justice, see J Eatwell, M Milgate & P Newman (eds), The New Palgrave: A Dictionary o f Economics (London: Macmillan 1987), vol 2, p. 1039 on justice.

Sec 2.2 below.

See J A Mirrlees, The Economic Uses o f Utilitarianism, in Sen & Williams, n .l6 above, at 63. In this vein, the term 'welfare' is taken to mean not a set of governmental programmes designed to aid the less advantaged but rather the aggregate well-being of consumers.

"By utility is meant that property in any object, whereby it tends to produce benefit, advantage, pleasure, good or happiness...to prevent the happening o f mischief, pain, evil or unhappiness to the party whose interest is considered: if that party be the community in general, then the happiness o f the communit} : if a particular individual, then the happiness of that individual". Bentham, n. 19 above, at 2.

Posner, 10; id, (1986) 11: Stapleton, Product Liability, 101.

See Posner (1986) 11-12. One potential conflict is that a risk-neutral party will perceive the expected value o f a risk to be almost identical to his utilit)' (subjective satisfaction), whereas a risk-averse party will not (see sec 6 below). Another is that something may be more valuable to the 'rich' in terms o f the willingness to pay but may give more satisfaction or happiness to the 'poor'.

choice depends on his preferences. Thus, one may ask how can we calculate and compare the utilities gained to the parties from a certain transaction in order to be confident that the social welfare function as the sum of aggregate individual utilities has improved or not?^^ The answer is that if we assume that rational individuals and firms would have similar, if not identical, preferences over their choice, we can give weights to these preferences in numbers in accordance with their priority order and make interpersonal comparisons of utilities. So if a person prefers the consequence of action A to action B, we can assign a higher number of utility to action A. As such, the advantage of the idea o f utility is that under certain assumptions, it can be measured, compared, and increased.^^

2.2 Efficiency and Equity

2.2.1 Efficiency: In a world of scarce resources, individual human needs have to be

satisfied in accordance with the principle of efficiency as the primary rule. For inefficiency begets unnecessary cost, which reduces social wealth defined as the aggregate total of

individual utilities. Broadly speaking, the term efficiency is used to describe a state of

optimal resource allocation or a state of equilibrium where no further benefits can be derived to either party to a particular transaction, a point maximising total utility or s a tis fa c tio n .A production process is regarded as efficient if it yields a given level of output at least cost, i.e. if the given level of output cannot be produced at lower cost. Likewise, in a world o f uncertain risk and harm, a behaviour is considered efficient if it is conducive to reducing risk arising from an activity and thus minimising accident costs.

As such, the efficiency criterion as a means of gauging the utility maximisation or cost minimisation goal has two elements: resource/risk allocation and incentive creation.

Efficient allocation of resources or allocative efficiency means a situation where resources

are assigned among the parties to a transaction to their most valuable use through the process o f voluntary, mutually advantageous exchanges. For each rational individual as

P J Hammond, Utilitarianism, Uncertaint) and Information, in Sen & Williams, n .l6 , at 85, 87; Cooter & Ulen, 23. This means that an individual's welfare depends only on the goods and services assigned to him.

Sec 1.2 above. For a succinct account of theories of individual preference, total utility or social welfare, see J L Coleman, Efficiency, Utilit>', and Wealth Maximisation. 8 Hofstra LR (1980) 509. 516; A K Sen, Collective Choice and Social Welfare (Amsterdam: North-Hoiland 1970).

Bentham. n .l9 above.

Polinsk) . 7. Cooter & Ulen. 17-18; Stapleton. Product Liabilit\\ 100 & 160. Polinsk)'. ch 15.

This assumes that parties have perfect information and that everyone affected by the transaction must be a party to it, a requirement o f no third-part)' effect. Posner. 11 n.2; id,(1986) 12; id.The Ethical and Political Basis o f the Efficiency Norm (1980). at 490: Cooter & Ulen. 17-18; Rawls, A Theory o f Justice. 88. Again, free exchange, even though voluntary, may not increase utility. Exchanges only involving the

the best judge o f his own interest will act on the theory o f expected utility,^"* and such voluntary exchanges will increase aggregate utilities o f both, or at least will make neither o f them worse off. Even though we do not know exactly how much utility has increased by such exchanges, we can be reasonably sure that aggregate utilities have increased through the exchanges, for the parties would not have entered into the transaction had they not expected it to make them better off To say that a situation is allocatively efficient is thus to say only that all the potential or actual gains from a trade have been exhausted and that no further exchange will benefit one party without causing disadvantage to the other. Stated differently, a misallocation occurs when a situation can be improved by further bargains or transactions or when costs are externalised.

This allocative efficiency can best be achieved in the market where the price mechanism induces parties to engage in a voluntary, mutually beneficial exchange at the equilibrium

price, as reflected in the consumer willingness to pay. A significant advantage o f the

market mechanism is that it is consistent with equal liberties and equal opportunities by decentralising the exercise o f economic p o w e r . I t is not left to the market to discriminate between individuals or between consumer and producer. Information is equally accessible and available to all, thus incurring least transaction costs. However, given that many o f the transactions affected or effected by legal liability rules and legal judgements (including legal entitlements) are involuntary,^'^ how can wc determine whether such involuntary transactions increase or decrease utility? Although we are not as much sure as in voluntary transactions, it can be fairly stated that if all the gainers o f relevant resources agree to the proposed legal change and are willing to compensate the losers for their losses, then the change is regarded as improving efficiency.^*

2.2.2 Equity and distributional consideration; Despite the primacy of the market

mechanism for achieving allocative efficiency in the welfare maximisation scheme, the problem o f the imperfect market may stand in the way o f efficient resource assignment. The imperfect market is caused by externality,^^ imperfect information about risk or imperfect competition in the industry, all of which would have adverse impact on parties'

price can increase wealth. Voluntary exchanges will include such transactions as sale and purchase of carriage by air services and of insurance policies on the market.

Under this theoiy, an individual or firm is assumed to choose an action which he expects to lead to the consequence o f yielding greater utility than others. Shavell, 2.

The only constraint is the initial distribution o f ealth among individuals. Ogus & Veljanovski, 22. Rawls, A Theory o f Justice, 272.