Economists ’ Preoccupation with “ Efficiency ”

Throughout this book, I have emphasized the notion of Pareto effi-ciency. When it comes to policy, the related notion of Pareto improve-ment is of central relevance. This term means what it sounds like: a change that all households prefer. These changes are hard to come by:

almost any policy will create winners and losers, and absent any com-pensation of losers by winners, will not yield Pareto improvements.

Still, economists are usually more interested than policymakers in the extent to which a policy would yield even a potential Pareto improve-ment, where losers from a policy change could be compensated in principle, even if they are not, to make them better off. In fact, we seem, at least superficially, ready to promote even those policies that would appear to increase inequality, so long as they appear to be potential Pareto improvements. Examples include economists ’ frequent advo-cacy for policies that allow market processes to work unimpeded — such as letting the prices of essentials spike in disaster areas, eliminating minimum-wage laws, or in macroeconomic cases, urging the removal

or alteration of policies like taxes on capital income or luxury goods — policies that society explicitly created to achieve distributional aims.

So is it that economists do not share the same distributional goals as the average (or median) voter? Surely some do not, but there are several other reasons for the high priority most economists give to the pursuit of Pareto efficiency, and each of these is informed by our ADM-based perspective. First, the most important reason: once (macro) economists start lobbying for non-Pareto improvements, they are making judg-ment calls about the distribution of well-being across members of a society. On this issue, they should have no greater claim to anyone ’ s attention than anyone else. However, our tools are suited for a more prosaic task: they can analyze a trading arrangement, or a policy, or a combination of the two, and determine the extent to which it is waste-ful or productive for various classes of an (model) economy ’ s partici-pants. ⁴ This type of work, which is the bread and butter of macroeconomic policy analysis, can assist in locating the least wasteful way to achieve whatever distributional goals society elects to pursue. ⁵

A second reason for economists ’ focus on efficiency is that policy, if it is trying hard, ought to look for Pareto-optimal outcomes. To do otherwise is to admit that in the end, outcomes under the policy will be ones where everyone can be made further off! But locating a Pareto-optimal allocation to target is very hard: policymakers would need to know essentially everything about consumers and producers that we have argued is impractical for them to know. Moreover, it would almost surely be undesirable for them to have the requisite amount of informa-tion, barring an (unrealistic) ironclad guarantee that policymakers would not use the information to manipulate or blackmail the citizenry.

Thus, our ability to choose a Pareto-efficient outcome is exceedingly limited. Unless we are able to generate, via policy, the preconditions for the First Welfare theorem: In this case, letting decentralized trade occur and deliver a Walrasian outcome would yield us a Pareto-optimal outcome. But this would only be so for whatever the initial endow-ments were, and thus might be grotesquely unequal.

In general, unless they simply are lucky, policymakers will almost certainly select outcomes that while perhaps more equitable than the status quo, will leave at least some mutually beneficial exchanges unre-alized. And here is where this informational hurdle creates a serious problem for redistribution in particular, and for policy in general:

unless we know that the costs of inefficiency will not be borne substan-tially by the relatively poor, the distributional consequences of policies

may be perverse (I will describe some textbook examples, those of rent control and “ luxury ” taxes, further below). As a result, economists always fear, at least a little, interventions lacking solid upside for poten-tial Pareto improvement, or ones that do not represent a move toward meeting the preconditions of the First Welfare Theorem.

A third reason for economists ’ general perspective on inequality is that in some, though emphatically not all, instances in which inequality arises from market dysfunction, policy authorities may not be able to do much. For example, take a case where households face individual-level labor market risk that they cannot fully insure against. Think of trying to buy a contract from an insurance company to be used in the event that you get laid off. If you cannot obtain such protection, you may have to save money for a rainy day. But this means that as time goes by, those who avoid a layoff will likely have larger bank balances those who did get laid off. As a result, workers ’ own personal histories of employment outcomes will affect how unequal their wealth is at any given moment.

Now consider the case where the lack of comprehensive privately provided income insurance occurs because an insurer cannot observe how much effort an insured worker exerts if and when she is laid off.

This is known as moral hazard . As a result, if the insurer were to offer a contract that fully replaced earnings losses upon layoff, it might not be able to do it at prices the worker would find attractive. In this instance, any well-meaning publicly funded government unemploy-ment insurance program will indeed help the recipients, and, by elimi-nating the need to accumulate “ precautionary ” savings, the program could make society even more equal in its wealth and consumption.

However, society at large will see a lowering of work incentives that may well lower total societal income and indirectly hurt many. Of course, this is a tradeoff that most might find well worth it, and the widespread existence of publicly funded safety nets worldwide sug-gests that most do. However, it is very unlikely to be without negative implications. In the presence of such insurance, the overall economic pie is likely to be smaller than it otherwise would be.

Or think of a situation where the average person cannot obtain credit at low interest rates because lenders do not trust him to repay debts.

The government can certainly help this group as well, and by equal-izing credit access, can help equalize household standards of living.

However, such help, especially if it comes in the form of subsidies that effectively allow lenders to relax credit standards, will lead to credit

flowing away from other, more productive uses, and will almost neces-sarily lead to an increase in loan default rates and generate the negative side effects such events seem to carry.

The examples above capture what economists believe to be the two main sources of market dysfunction: privately held information and/or a limited ability to commit to acting as initially promised. Unless we think policymakers are particularly privileged with information or particu-larly able to commit to punishing a breach of contract severely, they may not be able to improve on the organic mechanisms that private trade has evolved to deal with such problems (sometimes with only partial success).

Thus, in all realistic settings, there is almost certainly an equity-efficiency tradeoff . ⁶ Chapter 5 will discuss some models used by mac-roeconomists to quantify this tradeoff, and will show how active this area of research is. For now, though, we simply note that the mere existence of this tradeoff will lower the extent to which most people, including economists, value redistribution.

I ’ ve now given several reasons for the concern that equality may come at the price of efficiency and therefore might be costly to all members of a society. The goal of reaching a Pareto-efficient outcome — or at the very least, chasing after Pareto improvements — then seems to gain ground relative to the promotion of policies aimed more directly at altering inequality. So it is fortunate for those worried that a great deal may be lost by pursuing efficiency alone that improving efficiency actually sometimes helps to equalize. In these cases, equity consider-ations are best dealt with via the pursuit of efficiency. As we ’ ll see in chapter 5, a good deal of recent work suggests that much observed inequality can be interpreted plausibly as a symptom , or consequence, of missing markets, especially those offering protection or insurance against certain risks. These include the absence of easily available private insurance against unemployment (especially disability), imped-iments in the market for unsecured consumer credit, and the risk of having poor, or sometimes, simply incompetent, parents. From the perspective of a new entrant into society, this last risk is arguably by far the most important.

There are also clear instances in which the absence of some markets may allow other markets to perpetuate inequality. For example, a lack of an insurance market for some risks may leave relatively rich agents more willing to take on certain higher-risk – higher-return projects that their poorer counterparts would not (such as incurring debt to send

even their less well-prepared children to college in hopes that they will complete a degree and attain the high earnings that seem to go with it, a risk that poorer parents might not be able to tolerate). In the longer run, the former may then get relatively (and absolutely) richer, all else being equal. In fact, as will be discussed in chapter 5, it is an extremely general point that once certain markets are missing, Walrasian out-comes will not be efficient even given the limited capabilities of the remaining markets! This is called “ constrained inefficiency ” and offers a negative view of laissez-faire that is more sophisticated than the usual arguments.

In instances where we know that trading is hindered not by moral hazard, as in the earlier unemployment example, but rather by the ability of some to not participate in the market, public policy can help.

For instance, if most people knew their own risk of unemployment in a way that an insurer did not, the ones with little risk might not purchase any unemployment insurance, and so might leave the pool seeking insurance relatively riskier. This would necessitate higher premiums for private insurers to break even, which would further lower the incen-tives of the remaining relatively low-risk persons to stay in the pool, and so on. In such instances of so-called adverse selection , policy can assist efficiency by simply making participation in some insurance schemes mandatory . This is the basic idea behind the mandates one sees in auto insurance (and now in health insurance as well). Similarly, if we know that limited commitment to honoring contractual obligations is what prevents some mutually beneficial exchanges in a given market, we might be able to help with policy. For example, to the extent that uncol-lateralized credit is expensive for poor households, public policy might be able to help efficiency. A direct route would be to credibly commit poor households to repayment by making loan default more legally onerous. These interventions will be case-specific, of course. ⁷ It is inter-esting to notice that in both of these examples, while the policy responses were aimed at enhancing efficiency and not deliberately at alleviating inequality per se, they both can potentially help households remain more equal to each other than they otherwise would be.

In the two examples above, people would become unequal simply because of the presence of uninsurable risks and their resulting attempts to “ self-insure ” through wealth accumulation or credit use. The inequal-ity in wealth or indebtedness that would follow from the different labor market experiences of different households is surely something we might all view as reflective of an inefficient system of markets.

This view of inequality as indicating the inefficient function of a given trading system is a powerful one, as I will emphasize in chapter 5. It is to my mind a real and coherent way to reconcile certain kinds of policy that, while superficially appearing merely redistributive, might be best viewed as implementing insurance arrangements that all would agree on, and therefore as Pareto improvements. And while purely redistributive transfers may reflect either corrupt political pro-cesses or potentially quite arbitrary judgments on the importance of different citizens ’ well-being, the “ before the fact ” perspective offers a different view. A reader may detect the ideas of the philosopher John Rawls (1971) in the preceding, and they would be partially correct. In Rawls ’ s maximin prescription, well-being cannot rise under a policy change unless the well-being of society ’ s worst-off member rises. The version I will give is due to John Harsanyi (1975), and while it nests Rawls ’ s preferred recipe as one rather extreme case, it does not commit one to it.

The reasoning above, when taken as a whole, means we must think carefully before advocating large-scale redistribution that is not moti-vated by efficiency-related concerns. It leads macroeconomists, in the main, to focus on remedying market dysfunction wherever possible, and to be less likely than many others in society to support aiming directly at inequality. Moreover, in the cases where macroeconomists support explicitly redistributive goals, they will usually look for ways to equalize primarily through policies which affect not market prices but rather the “ initial ” endowments that people bring into the markets in which they trade. The feasibility of the latter strategy is suggested by the so-called Second Fundamental Theorem of Welfare Economics, to be introduced further below. First, though, it ’ s useful to provide intuition about what is wrong with any tax that alters the prices faced by buyers and sellers in any single market.