EFFICIENCY AND

BEYOND
- DR. AASHITA DAWER
We begin with the idea that there are
scarce resources and unlimited wants.
Limited resources need to be
allocated to competing usage.

 Therefore,the
question-HOW TO
ALLOCATE
RESOURCES?
Perfectly Competitive Markets
allocate resources the best
(efficiently)!
 In the last few weeks, we learnt that “perfectly competitive markets”
allocate resources “efficiently”.
 To recapitulate, it is under perfect competition, consumer’s gain
and producer’s gain are maximized, and there is no other way to
increase one party’s gain without reducing other’s gain.
Economic analysis is not a value
neutral science!
 More often than not, economic analysis is based on normative
values like efficiency.
 Normative analysis means the discussion on what ought to be there
in the world.
 Based on these normative criterion, economics studies and predict
human behaviour and their implications.
Efficiency and Beyond

 “Efficiency” is one of the various values based on which one can

judge how resources are allocated.
 Other values include- “Equity”, “Justice”, “Fairness”, “Equality” etc.
 Beyond Efficiency will include-
 Understanding the concept of efficiency.
 Problematizing “efficiency” and its (ir)relevance in the real world
marketplace.
 What about other values?
Both parties are better off when
they trade, voluntarily!
 Maria value the car at $10,000, while Piper is willing to pay $15,000
for it.
 Maria sells the car to Piper at $12,500.
 Assuming their initial utility level was 0.
 Maria is better off by $2,500.
 Piper is better off by $2,500.
 Both are better off, therefore this situation is a Pareto improvement
over the initial situation.
 Because both the seller and the buyer are better off as a result of
the trade. In this case, they are better off by the same amount:
$2,500.
Defining Pareto Efficiency!

 The efficiency criterion of Pareto

Efficiency – the situation in which no one
can be made better off without making
at least one other person worse off.
Pareto Efficiency is independent of
distribution.
 Imagine you and a friend are walking down the street and a $100
bill magically appears. You would likely share the money evenly,
each taking $50, deeming this the fairest division.
 Is this allocation Pareto efficient?
 Think when you keep $70 and your friend $30?
 What if you keep entire $100 with yourself and your friend gets
nothing?
 According to Pareto efficiency, however, any allocation of the $100
would be optimal.
 In all the above cases, in relation to the initial condition, where both
of you had nothing, all the situations are Pareto efficient.
Pareto improvement

 a Pareto improvement is any change to

the economy which leaves…
 everyone at least as well off, and
 someone strictly better off

 example of a Pareto improvement

 your car is worth $3,000 to you, $4,000 to me
 I buy it for $3,500

 an outcome is Pareto superior to another,

or Pareto dominates it, if the second is a
Pareto improvement over the first
Pareto efficiency and total wealth
creation!
 Jim (0)
 Harry (0)
 Plan A: Jim set up a factory and hires Harry.
 Jim (1000$ per month)
 Harry (100$ per month)
 Plan B: Jim set up a factory and does not hire Harry
 Jim (800$)
 Harry(0)
 Plan C: Jim set up a factory and snatches away a piece of land from
Harry.
 Jim (2000$)
 Harry (-500$)
Pareto superiority is not that useful
a measure!

 Pareto improvements are “win-win”

 but most new laws create some winners and some losers
 so the Pareto criterion usually can’t tell us whether one policy is
“better” than another

 so we need another way to compare outcomes

 Another criterion: Kaldor-Hicks
improvement

The British economists Nicholas Kaldor and Sir John Hicks

suggest a normative criterion under which a change is a good
thing if it would be possible in principle for the winners to
compensate the losers for their losses and still remain winners.
Now this is efficient (Kaldor-Hicks)

 Plan C: Jim set up a factory and snatches away a piece of land

from Harry.
 Jim (2000$)
 Harry (-500$)

 I hope winners compensate the losers.

 I really hope…
Thus, economic efficiency focusses
on maximizing total wealth!
 Wealth maximization is valued over all other criterion!
 Even if we focus on wealth maximization, there are certain
limitations of this concept-
 How does one compare the losses and gains of the winners and the
losers?
 In other words, interpersonal comparisons of preferences is not
possible.
 Example: While the gainers may have made a huge monetary
profit, losers might have been devoid of things of cultural
significance (non-monetray losses).
Arguments in the favour of free
market
 Maximizes efficiency-while the free market advocates invokes the
idea of efficiency to support it, they also invoke more basic
principles based on which the idea of efficiency is based.
 Natural
 Spontaneous
 Freedom
 Democracy
 Just and Fair
Freedom or control?

 According to a whole range of critics, capitalism subverts the

individual’s needs and aspirations to the demands of an economic
system which is controlled by, and works in the interests of, a few.
 It is individuals – and the natural environment – which continually adjust
to the demands of a profit-driven system and not the other way round.
 Capitalism does not “free” individuals but constrains the majority to
work according to the dictates of a system over which it has no control.
 For some critics this means that capitalism, as an economic system,
must be reformed, managed or controlled to keep its destructive
powers in check.
 For other, more radical, critics, it means that capitalism must be
replaced by a different type of economic system, one which is not
premised on the dominance of the market, private property and the
profit motive.
Animal Spirits
 Keynes showed that due to lack of effective demand, the economy can
undergo serious trouble like the Great Depression where the national income fell
and there was massive unemployment.
 There are other natural tendencies intrinsic to human nature that may result in
chaos.
 Economic Crises-currency volatility, massive unemployment
 He identified the volatility of investment as the key cause of instability under
capitalism. This instability arose because investment decisions were based on
entrepreneurs’ “animal spirits”. Natural? Quiet so.
Speculation

 New forms of instability have emerged and “casino capitalism” is

what we have today. Or so its critics say, referring to the gambling
mentality that leads to wild swings in the values of stock markets and
currencies.
 Keynes argued in favor of government intervention by increasing
public expenditure and stimulating job creation and thereby
income and demand.
 To prevent the destabilizing excesses of international financial
markets, various proposals have been made to tame the markets.
The most famous of these is the “Tobin tax”
Hard work or do nothing?

 According to an estimate-
 In 2000, the world’s three richest people possess assets worth more
than the combined gross domestic product of all of the least-
developed countries.
 The wealthiest 500 people own as much wealth as half of the
population of the globe.
 Stephen Haseler, a British Academician, found that in today’s global
capitalism, rewards often tend to be higher for doing nothing, or
next to nothing – accruing and using capital through inheritances –
than for the hard work of securing skills in order to work for a living.
Possible Government Intervention

 The solutions proposed by socialists such as John Stuart Mill were

inheritance taxes designed to eliminate family wealth and high
taxes on non-labour (or “unearned”) income.
 These policies were adopted to various degrees by social
democratic governments throughout Western Europe in the last half
of the twentieth century.
 While the agenda for many governments now is for tax cuts to
restore “incentives” and “fairness” to the tax system, it was not
always thus.
Markets for Human Organ?
Or for that matter, markets for
human!
BEYOND EFFICIENCY
UTILITARIANISM
 Bentham (1789), John Stuart Mill (1861), And Henry
Sidgwick (1907)
 Act is morally right if and only if that act maximizes the
good - if and only if the total amount of good for all
minus the total amount of bad for all is maximized
 “THE GREATEST HAPPINESS FOR THE GREATEST NUMBER.”
 Measure each persons utility, or happiness, by a number.
 Comparisons Across People - If Your Utility Is 4 And Mine Is
3, Then You Are Happier Than I Am.
UTILITARIANISM
 Assign a weight to each person and maximize the
weighted sum of their utilities. If jack has weight 2 and jill
has weight 3, then we choose the outcome that
maximizes twice jack’s utility plus 3 times jill’s
 How to assign weights?
 Utility is defined as sum of all pleasures minus suffering
 An act can increase happiness for most (the greatest
number of) people but still fail to maximize the net good
in the world if the smaller number of people whose
happiness is not increased lose much more than the
greater number gains.
CONSEQUENTIALIST THEORY

 Classic Utilitarianism Reduces All Morally Relevant Factors (Kagan

1998, 17–22) To Consequences
 Based On The Consequence Of The Act
 Moral Rightness Of Acts - Whether An Act Is Morally Right Depends
Only On The Consequences Or Motive Behind The Act
 Suppose That By Ordering The Execution Of One Innocent Man You
Could Save The Lives Of Five Others, Equally Innocent. Should You
Do It?
 One Lost Life Is Less Bad Than Five Lost Lives
 The Sacrifice Of One Happy Life Versus The Sacrifice Of Five
Unhappy Lives
CONSEQUENTIALIST THEORY
 Natural Rights?
 Man Has A Natural Right To Live And That There Can Be No Justification
For Depriving Him Of This Right, Regardless Of The Consequences.
 “Right To Choose,” Vs. “Right To Life.” – Abortion
 Consequentialist - Discard Any Discussion Of “Rights”
 Judge The Desirability Of Legalized Abortion Strictly On The Basis Of Its
Implications For Human Happiness.
 The Efficiency Criterion
 Which Kind Of World Is Better: One With 10 People, Each Earning $50,000
Per Year, Or One With 10 People, Of Whom 3 Earn $30,000 And 7 Earn
$100,000?
 Total Income Is $790,000 Instead Of $500,000. – Second World Is Better
 MAJORITY RULE
 The Better Of Two Outcomes Is The One That Most People Prefer
 Sharon, Lois, And Bram Plan To Order A Pizza With One Topping. Their Preferences:

 Sharon And Bram Prefers Peppers To Anchovies

 Sharon And Lois Prefers Anchovies To Onions
 Lois And Bram Prefers Onions To Peppers
 No Matter What Topping Is Chosen, There Is Some Majority That Prefers A Different
One.
 If 60% Of The People Vote To Torture And Maim The Other 40% For Their Own
Amusement
FAIRNESS

 Allocating fixed supplies

 6 apples and 6 oranges – Jack and Jill each have 3 of each fruit.
 But Jack may prefer Apples and Jill may prefer oranges?
 Envy-free allocation
 An outcome in which nobody would prefer to trade baskets with anybody
else.
 Envy Involves An Envier (“Subject”), A Party Who Is Envied (“Rival”)—this
May Be A Person Or Group Of Persons—and Some Possession, Capacity Or
Trait That The Subject Supposes The Rival To Have (The “Good”).
 The Good Might Be Something That Only One Party Could Possibly Possess.
FAIRNESS: ENVY FREE ALLOCATION

 The good may even be utility, happiness, or some psychological state

that Subject could attribute to Rival even if there were no material
difference in their possessions or capacities.
 A distribution of goods is said to be “envy-free” when no one prefers
anyone else’s bundle of resources to her own.
 The suggestion here is not that envy is the psychological motivation for
the concern with equality, but rather that, where a distribution in fact
produces envy, this is grounds to doubt the fairness of the distribution.
 Any allocation of apples and oranges is envy-free if neither Jack nor Jill
would want to trade places with the other, given the choice.
THE VEIL OF IGNORANCE

 Rawls Assumes That The Imagined Deliberators Are Not Motivated

By Various Psychological Propensities.
 Principles Of Justice Are Chosen Should Not Be Affected By
Individual Inclinations, Which Are Mere Accidents
 The Tendency To Envy Will Undermine The Arrangements Of A Well-
ordered Society
 To Insure Impartiality Of Judgment, The Parties Are Deprived Of All
Knowledge Of Their Personal Characteristics And Social And
Historical Circumstances.
THE VEIL OF IGNORANCE

 Two Principles Of Justice:

 The First Guarantees The Equal Basic Rights And Liberties Needed
To Secure The Fundamental Interests Of Free And Equal Citizens
And To Pursue A Wide Range Of Conceptions Of The Good.
 The Second Principle Provides Fair Equality Of Educational And
Employment Opportunities Enabling All To Fairly Compete For
Powers And Positions Of Office; And It Secures For All A
Guaranteed Minimum Of All-purpose Means (Including Income
And Wealth) Individuals Need To Pursue Their Interests And To
Maintain Their Self-respect As Free And Equal Persons.
THE VEIL OF IGNORANCE
 Which Kind Of World Is Better: One With 10 People, Each Earning $50,000 Per
Year, Or One With 10 People, Of Whom 3 Earn $30,000 And 7 Earn $100,000?
 Imagine Two Planets: On Planet X Everyone Earns $50,000; On Planet Y 70% Earn
$100,000 And The Rest Earn $30,000. On Which Planet Would You Rather Be
Born?
 Your Honest Answer Reveals Which Income Distribution Is Morally Preferable
 Veil Of Ignorance – Which Planet?
 A Policy - One Billionaire By $10,000 While Costing 8 Impoverished People $1,000
Each.
 Efficiency Criterion – Good Policy
 Rawls – If You Don’t Know Whether You Will Be The Billionaire Or The
Impoverished – You Will Oppose Such Policy
THE VEIL OF IGNORANCE

 Social Insurance – Insurance Against Misfortune Yet To Happen Vs. Insurance For
The Misfortune Which Happens At Birth.
 Those Born Into The Best Circumstances Will Transfer Income To Those Born Into The
Worst - Behind The Veil, We All Will Agree!

 The Maxmin Criterion

 Maximize the welfare of the worst-off member of society
 Policy for equalizing Distribution of Income