Wednesday, May 27, 2015

The unexplained and the unexplainable

I demonstrated yesterday how the idea of externalities as defined by the presence of external costs relies on the externality going partially unexplained. External costs are necessarily unexplained because they are unexplainable.

The same thing can be said of Pareto inefficiency. Pareto efficiency means no one has any feasible alternatives that can make them better off without making anyone else worse off. Pareto inefficiency, therefore, means that someone can do something to make themselves better off without making anyone else worse off.

But they don't.

To me the very definition of an economic actor is someone who, when they can make themselves better off, does so. The very definition of inefficiency says that they don't.

There are two ways to reconcile this contradiction:

1. The improving alternative is actually infeasible.

2. The feasible alternative is actually not improving.

Or both, of course. And of course both reconciliations reveal the supposed Pareto inefficiency as Pareto efficiency.

Imagine trying to explain Pareto inefficiency. Suppose someone asked why people don't do the thing that makes them all better off. What could be said in explanation?

I have never seen an explanation myself, despite years of searching. I think it's because Pareto inefficiency can't be explained.

Tuesday, May 26, 2015

Externalities as acausal phenomena

Yesterday I discussed how market failure originated as an acausal phenomenon. Externalities are no different.

The basic intuition underlying the idea of externalities is that people impose costs on each other. This is a bit weird since cost, in the economic sense, is necessarily something contained within the choosing individual, but the intuition is understandable. Yet, as is so often the case in economics, unpracticed intuition is not very reliable.

It might seem weird to suggest that economists have treated externalities as acausal phenomena. After all, externalities and the external costs that defines them have a clear cause. Pollution is produced by firms. Careless neighbors reduce the surrounding property values. And so on. One party imposes a cost on another.

Yet Coase showed things are not so simple. Economists had utterly ignored the question of why the seeming victim simply put up with the imposed cost. Externalities, Coase explained, are not caused by one party but by two.

Pre-Coase, economists did not bother to explain half of what is necessary to create an externality. There was the active, choosing party that imposed a cost, and the passive victim whose behavior went unexplained.

Understanding the full cause of externalities allows us to make sense of the concept of external costs, or rather, it allows us to see the nonsense of it. If the "victims" of externalities are passive agents, not really economic actors at all, then it makes some sense to talk of costs being imposed on them. But if they are active economic agents choosing to bear the cost as the best of their alternatives, then the external cost is not external at all. They internalize it.

Maybe it seems like the cost is still created by the "aggressor," even if the "victim" chooses to bear it. This is also wrong. The cost is created by both of them, the aggressor by making smoke, for example, and the victim, by choosing to stay in the smoke-infested area. Nothing external is going on, just two parties choosing their best alternatives based on the costs, which are thus internalized.

From the perspective of the "victim" the externality is clearly irrelevant. Imagine a naturally smokey area that someone chooses to live in for some offsetting benefit. We would all understand that this is no externality, and the cost of the smoke is internalized by its "victim." Why should anything be different if the source of the smoke is unnatural?

Monday, May 25, 2015

Acausal phenomena in economics

Scott Sumner points out how strange it is that many economists take for granted macroeconomic instability. One would think that knowing the cause of macroeconomic instability is crucial to achieving macroeconomic stability, yet economists are often content to accept the instability as simply a fact of life and look for crude solutions.

The same thing happens in welfare economics. In Pigou's seminal The Economics of Welfare, he describes many situations in which markets fail to achieve the optimal outcome. One example is congestion on roads. Marginal cost pricing would yield the optimal amount of congestion on the roads, yet marginal cost pricing is not used, QED.  Not long after, in 1924, Frank Knight showed that Pigou was missing a critical piece to his argument: the cause of the supposed inefficiency. Here is Knight, page 12 of the pdf:

Professor Pigou's logic in regard to the roads is, as logic, quite unexceptionable. Its weakness is one frequently met with in economic theorizing, namely that the assumptions diverge in essential respects from the facts of real economic situations. The most essential feature of competitive conditions is reversed, the feature namely, of the private ownership of the factors practically significant for production. If the roads are assumed to be subject to private appropriation and exploitation, precisely the ideal situation which would be established by the imaginary [Pigovian] tax will be brought about through the operation of ordinary economic motives.
 Knight goes on to explain in detail how the roads would achieve the optimal pricing system under private ownership and competition. Pigou didn't describe inefficiency. He observed the consequences of a missing piece of a well-functioning economic system, namely private ownership.

By and large Knight's argument was ignored. Then, 40 years later after The Economics of Welfare, Ronald Coase gave a more general version of the same argument, that Pigou failed to see that so-called externalities are caused by the deliberate decision to create and tolerate them because the alternative is too costly, specifically because of transaction costs. Internalizing the externalities, whatever that means, would not be Pareto improving due to the additional constraints Pigou was unaware of.

Knight and Coase were geniuses, but every economist should have wondered the same. By definition inefficiency means that there is some feasible way to make everyone better off. The question is why they don't take that feasible, improving alternative. Pigou's explanation, and the explanation the economics profession has accepted, is that of inefficiency or market failure, which is no explanation at all. They shrug their shoulders, announce that someone or something "failed" (who failed? Why did they fail?), and talk about the optimal Pigovian tax. In the Pigovian system externalities and inefficiency are acausal. They happen, we accept that, and move on.

Asking why of the Pigovian system is fatal to it. There can only be two answers to the question of why inefficiency exists:

1. The Pareto improvement is not feasible.

2. The Pareto improvement is not a Pareto improvement.

Both these answers resolve the confusion of why people aren't taking the opportunity to make themselves better off. They also resolve the inefficiency itself.

Treating economic phenomena as acausal yields the opposite conclusions of treating the same phenomena as causal. Personally, I think the latter method is the way to go.

Sunday, May 24, 2015

The opportunity cost of reflecting opportunity costs

Commenter J-D asks an interesting question of John Quiggin: when economists say that prices don't reflect the full opportunity costs, whose opportunity costs do they not reflect?

Society is not a good answer because societies do not choose. So who is being left out?

The opportunity cost of a choice is the best alternative not taken. It is inherently tied to the choice of the individual: the opportunity cost to me of someone else choosing not to give me a dollar is not one dollar. The opportunity cost to me is not even zero: I made no choice and thus bore no opportunity cost.

In welfare economics, prices reflecting all the opportunity costs means that all the net utility has been squeezed out of some constrained choice. Prices ideally encourage people to do as much of something as makes everyone better off and to encourage them to pursue alternatives once doing that thing can no longer make everyone better off. What this requires is that the price of every good and service be equal to the marginal cost of consuming it.

Frankly I think P = MC is a really confusing idea. P is in dollars, and MC is in utils. How are they be compared? Prices "reflect" opportunity cost. What does that mean? I know what it means at extrema, but if we are not at an extremum, as John posits, then the idea just confuses me.

We could speak about prices reflecting opportunity costs if we could translate every MC into a P via a market. That would require complete markets, which is certainly not the case if we are talking about market failure. So while I can make sense of optimality in these terms, I can't make sense of suboptimality. Efficiency makes sense, but inefficiency does not.

I suggested in the comments that normally in economics opportunity cost refers to the best foregone alternative in some choice, but in welfare economics opportunity cost is not tied to choice at all. Rather, when we speak of an opportunity cost to society, and so presumably when we speak of prices failing to reflect opportunity costs, we simply refer to some alternative imaginable arrangement of resources. There is an opportunity cost to society, not because society made a choice, thus forgoing its next-best alternative, but because things could be another way.

This runs contrary to the normal meaning of opportunity cost. Normally opportunity cost has no existence in being but only in doing. (Later I will argue that Pigou in fact intended no contradiction. His use of opportunity cost is the normal use of opportunity cost, or at least it is an attempt to be.)

Not just any imaginable superior alternative is supposed to be proof that prices don't reflect opportunity cost. Only a mere rearrangement of resources is. That is, imagining how better off we would be with cheaper steel is not proof of market failure. But being able to imagine that steel could be reallocated to the benefit of all is proof of market failure.

As I suggest above, market failure (prices not reflecting full opportunity costs) only makes sense in the context of complete markets. This isn't as bad as it sounds. We've learned a thing or two about the creation of markets since Pigou. In particular, we've learned that markets don't exist because making them exist is costly. In other words, there is a true and meaningful sense in which all markets exist...but most of them are too expensive to buy from.

So why don't prices reflect all opportunity costs? Because doing so is costly. Therefore, is it wrong to say that prices do reflect all opportunity costs, including the cost of reflecting opportunity costs?

What does this say about treating market failure as a misallocation of resources? When the supply of steel is less than infinite, there is no misallocation of resources even though everyone could be made better off if the supply of steel were infinite. When the supply of markets is less than infinite, that suggests the choices necessary to achieve the imagined superior alternative allocation of resources costs more than the imagined alternative would yield in benefits if realized. In fact, that is just what Coase demonstrated in his famous 1960 paper, "The Problem of Social Cost."

Moving from scarcity of steel to abundance of steel is a Pareto improvement, but infeasible, and thus efficient. Moving from scarcity of markets to abundance of markets is a Pareto improvement, but infeasible. Why is it inefficient?

More on this to come.

Saturday, May 23, 2015

If utility did not exist, it would be necessary to invent it

A very common myth, even one perpetuated by economists, is that utility means happiness, pleasure, satisfaction, the avoidance of pain, or something like those things. That is not what utility means.

To understand and predict behavior, we need to know what people value. For example, will Alice choose green beans or asparagus? That depends on which one she values more. Why did Bob willingly tire himself and expend energy at the gym? Because he values being fit. Instantly we run into two problems:

1. We don't know what people's values are.

2. People value different things.

Most people's values clearly include things like happiness, pleasure, satisfaction, and the avoidance of pain. But there are people who eschew earthly pleasure. There are people who's self-destructive behavior seems almost deliberately aimed at preventing their own happiness. People willingly bear pain for many purposes and even seek pain and painful experiences out, whether something drastic and worrying like cutting themselves, or something more mundane to a degree like punishing themselves at the gym, or even emotional pain like calling up that ex-lover. (See What Do People Want to Feel and Why?) Are all these people and their actions outside the scope of economics?

It is also a mistake to think that all values have to be sensations. Sometimes people make the mistake of thinking that death must carry infinite negative utility. That would be true if the only values were bodily sensations. However, people can also value things external to themselves, like the lives of their children or comrades, even at the expense of being able to feel bodily sensations about them. People suffer and sacrifice to write a novel, to start a business, to build a house, to create democracy, to help the impoverished and the victims of earthquakes, famines, and wars. Are all these people and their actions outside the scope of economics?

People are not happiness maximizers, pain minimizers, pleasure optimizers, or any other such thing, although particular individuals might be. We need a word that simultaneously expresses our ignorance in a concise manner and unites the many diverse values under the economizing paradigm. That word is utility. That way people don't say, "But what are people maximizing?" because a scientific-sounding answer exists, and they don't say, "Economics might work for those values, but it doesn't work for my values," because utility is a placeholder for any value. And that is very important and necessary, but it has clearly caused some confusion among economists.

Interpersonal utility comparisons are impossible not because of some property of utility, because utility has no properties. Utility is not even nothing. It is not a thing. It is a mere placeholder, simultaneously expressing our ignorance of people's values and the proposition that the pursuit of values in general has certain general properties, regardless of the particular value. Interpersonal utility comparisons are impossible because you can't compare [placeholder for ignorance and the idea that all values fit into the economizing paradigm] between people. Rather, you must know that people have the same values, which you very rarely do.

Here's a question for economists who think utility means happiness or some other particular value: if scientists discovered a planet full of sadness maximizers, would you think that the utility maximization paradigm does not apply to them?

Friday, May 22, 2015

The conditions for doing interpersonal utility comparisons

Utility is a deliberately obfuscating concept, so it's not surprising that even economists find interpersonal utility comparisons a bit confusing (see the comments on the last link).

The maximization/optimization paradigm (henceforth just maximization) is very useful and seems like it must be true somehow, or at least is the best way to understand economic phenomena. But then the question is, what are people maximizing? The truth is, we don't know. It's awkward and embarrassing to say "people are I-don't-know-what maximizers," so we say "people are utility maximizers." It's a concise and scientific way of expressing our ignorance.

Utility is not happiness. If we thought people were happiness maximizers, we would say they are happiness maximizers. Utility is not pleasure, or satisfaction, or eudaimonia, or anything else. Utility is utility, a code word for ignorance.

That is why interpersonal utility comparisons are impossible. It isn't because utility is ordinal rather than cardinal. That just assumes the conclusion, that utility is something that can't be compared across people. Rather, IUCs are impossible because there is no sense in which Alice can have more I-don't-know-what than Bob.

We can say that Alice has more happiness than Bob. We can say that Bob has more money than Alice. We can say that Alice has more satisfaction than Bob, and we can say that Bob has more pleasure than Alice. All these comparisons are perfectly valid. But I-don't-know-what? Calling that comparison impossible gives it too much credit. It just doesn't make sense.

Many economists don't know this. They talk about how IUCs might be possible in the future as we learn more about the brain, as if utility is a real thing. Utility is not a real thing. It is a placeholder for ignorance.

So IUCs are not even coherent enough to be impossible. Yet there is this intuition that a poor person gets more utility from a dollar than a rich person. Let's explore this. First of all, on most comparisons of any particular value, the poor person gains more than the rich person from the marginal dollar. The poor person gains more happiness, pleasure, relief, etc., than the rich person in most circumstances. If you replace the placeholder of utility with something concrete, comparisons are valid. This isn't an interpersonal utility comparison, it is an interpersonal happiness//pleasure/relief comparison.

Note that you can't always do this. For example, who gets wealthier from an additional dollar, the poor person or the rich person? Obviously neither.

This possibility shows that substituting any particular value for the utility placeholder does not necessarily get us to the intuition that a poor person gets more utility from an additional dollar than a rich person. People necessarily maximize utility. Utility is the thing people are maximizing. But people do not have to be, say, happiness maximizers, and they often are not. So even if utility were a more substantial concept, any particular thing poor people gain more of than rich people do from an additional dollar would not necessarily maximize utility if people are not trying to maximize that value. And since poor people cannot gain more of every possible value than rich people from an additional dollar (e.g. wealth), then simply knowing what specific value utility is a placeholder for is insufficient to generate our intuition that giving a poor person an additional dollar generates more utility than giving it to a rich person.

Here is another problem: people want different things. If the poor person is a happiness maximizer, and the rich person is a satisfaction, then the comparison is again not even impossible. There is no sense in which a dollar can give a poor person more happiness than it gives a rich person satisfaction. The comparison is only valid if both individuals are trying to maximize the same thing.

So this is what we need to do an interpersonal utility comparison: we need to know what utility is a placeholder for, and we need to know that utility is a placeholder for the same thing for both individuals. Having both of these conditions together is unlikely, to put it mildly.

Yet it really does seem that giving a poor person a dollar generates more utility than giving a rich person a dollar. There is one sense in which this intuition is unambiguously and easily true. If you choose to give a dollar to a poor person rather than give it to a rich person, then giving a poor person a dollar does generate more utility than giving a rich person a dollar. It generates more utility for you!

Most people would rather see a poor person get another dollar than a richer person, even most rich people. Maybe that is because we care about happiness, and a poor person is happier from an additional dollar than a rich person (the fact that neither might be happiness maximizers is happily irrelevant). For many other values we likely share, that argument is true. Thus it is true that what is valuable and good is enhanced more by giving an additional dollar to a poor person than a rich person, and this is because the poor person is made happier/more satisfied/whatever than the rich person by the additional dollar, even though the interpersonal utility comparison is impossible.

Thursday, May 21, 2015

Should you prefer inefficiency to efficiency?

Suppose World 1 is efficient, and you are happy/satisfied/whatever to the tune of 100 utils. Suppose World 2 is inefficient, and you are happy/satisfied/whatever to the tune of 100 utils. Which world should you choose to live in?

The inefficient world, of course. By definition some feasible yet unexploited Pareto improvement exists in the inefficient world, but not in the efficient world. Therefore you can hop into the inefficient world, get the Pareto improvement, and be better off than you would be in World 1. In fact, the more inefficient World 2 is, the more otherwise superior World 1 would have to be for you to be indifferent between the two.

Maybe it seems like cheating to have World 1 be no better than World 2. After all, efficiency versus inefficiency suggests the former should be better. But that's not how efficiency is defined. Efficiency just means that there are no unexploited feasible Pareto improvements. It doesn't say anything about how well a system accomplishes anything or how well-off anyone is. And while it's true that the efficient state resulting from a Pareto improvement in an inefficient state is superior to the inefficient state, so is the efficient state resulting from a Pareto improvement in an efficient state (e.g. a technological improvement dropped into a system of perfect competition). And an inefficient state resulting from a Pareto improvement in an efficient state is superior to the efficient state (e.g. a technological improvement dropped into a system of perfect competition that leads to some degree of market power in some firms).

The Infinite Nobel-Worthy Theorem Generator

Ronald Coase is famous for a theorem George Stigler invented, which states that all mutually desirable transactions happen if there's no reason for them not to happen. The corollary is that if some mutually desirable transactions don't happen, they don't happen for some reason. This theorem won Coase a Nobel prize. Stigler also won a Nobel prize for different reasons.

The Coase Theorem, named after the person who inspired it, is important because it tells us that the mutually-beneficial-transactions-that-didn't-happen that define externalities would happen if there weren't reasons they didn't happen.

Coase's work is particularly interesting because it suggests that externalities can be understood in terms of transactions that didn't occur. For example, the externalities associated with pollution would be resolved to the benefit of all if certain transactions could be arranged at a sufficiently low cost. Unfortunately there are reasons why that does not happen. But if those reasons could be resolved, everyone would be better off. Say, a technological improvement increasing the supply of markets.

Compare that to, say, the wheat market, often considered about as close an example of a "perfect" market as we're ever going to get. Suppose the market's demand for wheat is such that it demands 50 units of wheat at a price of $5, and it demands 100 units of wheat at a price of $3. The market supplies 50 units of wheat at a price of $5, and it supplies 20 units of wheat at a price of $3. If the market could supply 100 units of wheat at a price of $3 and not lose, that would be a Pareto improvement. Unfortunately there are reasons why that does not happen. But if those reasons could be resolved, everyone would be better off. Say, a technological improvement increasing the supply of wheat.

So I propose the Stigler theorem: some potentially Pareto-improving transactions of wheat do not happen because the cost of wheat is not zero.

I propose a more general theorem: some potentially Pareto-improving transactions of anything do not happen because the cost of something is not zero. There are an infinite number of theorems that fall under this general theorem, all of which are presumably worthy of a Nobel.

None of these theorems fall under the Coase theorem. Transaction costs are distinct from wheat costs, without affecting the welfare analysis in principle. Rather, the Coase theorem falls under this more general theorem.

Rainfall isn't an externality, so why is having a bucket of water poured on you an externality?

Say you're walking along and someone pours a bucket of water on you. That's an externality.

Say you're walking along and it starts to rain on you. That's not an externality.

From your perspective, it doesn't matter. Either way, you're soaked. Yet the former situation is inefficient and the latter is efficient. Now let's suppose that you suffer equal disutility from both situations. Then, if the nasty individual who poured water on you is made better off by doing so (why else would he have?), then we learn something interesting: in this case at least, the inefficient situation is preferable to the efficient situation. In fact, it's Pareto superior.

This kind of counterintuitive result happens a lot. If the air somewhere is smoggy and foul, that's unfortunate, but efficient. If the air somewhere is smoggy and foul because a firm is producing pollution as a byproduct of some production process, then the situation is simply better from a utilitarian standpoint, yet it is now inefficient. If someone invents a new product or a better way of making an old product and thus creates monopoly where perfect competition used to exist, the result would be a move from efficiency to inefficiency and an improvement in economic welfare.

Why do we care about inefficiency, if moving from efficiency to inefficiency can be a Pareto improvement? Presumably because inefficiency indicates an opportunity to yield further Pareto improvements. But the same is true of these efficient situations. You could yield a Pareto improvement by arranging some deal between you and the jerk with the bucket of water so that at least one of you is better off and the other no worse off, but you could also carry an umbrella. You could arrange a bargain between the firm and the people in the smog-infested area so that a Pareto improvement occurs. And you could arrange some deal between the people in the naturally smoggy area and some smog-cleaning firm so that a Pareto improvement occurs. Or you could arrange some deal between the people in the naturally smoggy area and landowners in some less smoggy area to relocate the former and yield a Pareto improvement.

It doesn't seem like there's anything special about externalities in terms of suggesting the possibility of further Pareto improvements, even in terms of Coasean bargains. It seems like problems suggest the possibility of further Pareto improvements (solve a problem, make someone's life better).

Externalities don't even appear to be distinct as a class of problems in a way that anyone involved cares about. Whether someone pours a bucket of water on you or you just get rained on, you're still wet. And the question isn't whether these costs are external or not (????) but whether anything can be done to reduce or eliminate them!

Externalities aren't even about the uniquely human interactions - for example, getting upset because you feel slighted or dominated because someone poured a bucket of water on you. People get angry at the rain for daring to pour on them when inconvenient. And people engage in market transactions with firms, getting money in exchange for being dominated by their bosses to some degree, and after being compensated for the disutility they suffer, they still get mad about being dominated.

External costs and benefits and what they mean for externalities

The concept of an external cost is like a square circle: not even wrong. Opportunity costs, the costs that actually determine economic choices, are inherently internal. Opportunity cost is the forgone opportunity of a choice. It doesn't even make sense to speak of imposing the opportunity one forgoes onto another. For example, if a firm chooses to produce another unit of smoke, forgoing the opportunity to, say, buy a snorkel, nothing about the forgone opportunity is in any sense imposed on anyone affected by the smoke. How does that even make sense? There is nothing "external" about the forgone opportunity, there is no sense in which the forgone opportunity is anything but internal.

Of course economists don't mean opportunity costs when they talk about externalities. They mean what Buchanan called pain cost, meaning that externalities happen when someone hurts someone else. Of course, that condition alone is not enough. The harms have to be external, meaning they aren't internal, meaning that the harm is in some way imposed or not chosen by the affected parties as a consequence of the best of various feasible alternatives.

It is very weird to me that this idea survived Coase's famous paper, "The Problem of Social Cost." It is hardly an obscure paper, heavily cited, practically creating the field of law and economics, and earning Coase a Nobel prize. And the lesson (or one of many) is widely taught: externalities are reciprocal and a function of the decisions of every involved party: the person who chooses to live near a smog-producing factory is as much the "cause" of the externality as the factory is. Nothing "external" is happening; people are simply choosing to bear some harm for the sake of avoiding something less desirable.

So economists know that there are no externalized harms. People choose to create externalities as the best of various alternatives, bearing some harm in the pursuit of some more-than-offsetting gain, or at least the avoidance of even worse harms. From the chooser's perspective, there is no difference between accepting the harm of smog in one's local atmosphere because she is being paid to tolerate it versus because the house is cheaper in that location, or the sunsets are very pretty, or because she likes the smell of a factory at work. The source of the compensation is irrelevant.

The idea of externalities is the idea that some of the relevant aspects of choice aren't considered by the affected individuals for no reason. This kind of sudden nonsense is endemic to welfare economics. I'll write more about that soon.

Wednesday, May 20, 2015

What This Blog Is About

Welcome to a new blog on welfare economics. Welfare economics provides the framework economists use to solve real world problems. So it's very important to get welfare economics right. Much of this blog will be about explaining how economists have not got welfare economics right, and what might be right instead.

There are essentially three premises that underlie my view of welfare economics:

 1. Economic agents choose to acquire the most value that is feasible to acquire.

2. That which is not chosen is not feasible, not sufficiently valuable to motivate action relative to cost, or both.

3. Creating markets is costly. In other words, transaction costs exist.

In other words, people do what they want insofar as they can. When they don't do something, it's because they can't or won't. And making markets is a thing that sometimes can't happen or isn't worth doing. All these premises, which are standard accepted truths among economists, yield the following conclusions:

1. Externalities don't exist.

2. Everything is efficient.

3. The task of welfare economics, handed down from Alfred Marshall to Arthur Pigou to the rest of the profession, might literally be impossible.

The first position would strike most economists as utterly asinine. Ronald Coase won the Nobel prize in economics in large part for proving this position in 1960. The second position has a history going back to at least Frank Knight and has been argued for by names like Stigler and Alchian, and Buchanan and Demsetz to some degree. It hasn't caught on. I will spend some time talking about why and where Stigler and Demsetz in particular go wrong. The third position is more speculative. It will be interesting to see how things go.

A note on the normative: although welfare economics is critical to normative considerations, this blog has no normative concerns. Everything is efficient, meaning capitalism is efficient, Communism is efficient, and so is everything in between. Efficiency does not distinguish between states according to normative (or any) considerations, but efficiency is not a normative property. And while externalities do not exist, coordination problems do.