Source: The New York Times, Aug. 20, 2010 (displayed here under Fair Use)

In a recent post on the New York Times blog Economix, Uwe Rhinehardt discusses the way the economists’ concept of Pareto Efficiency distorts public policy debates. He begins with the concept of a perfectly competitive market here, which I discussed here. There aren’t any markets with the characteristics required to meet the definition of a perfectly competitive market, as economists define that term, certainly not health care. That didn’t stop economists from using that model and Pareto Efficiency to demand that the markets be allowed to operate freely in health care.

What is Pareto Efficiency? Rhinehardt explains it with the chart at right, which he calls a “highly stylized hypothetical”.
We assume that there are two people, A and B. We assume that they live in a society that produces goods and services, and allocates them between A and B in some way. We measure the happiness of A and B, and plot that on the chart, A on the x-axis, and B on the y-axis.

Suppose that the initial distribution of resources puts the happiness of A and B at point X. If we could figure out some way to change the allocation of resources properly, we could increase B’s happiness without decreasing A’s at all. That would be at point Y. Similarly, we can increase A’s happiness without affecting B’s happiness by moving to point Z. We could move to some point between them on that curve, and increase the happiness of both. Economists claim each of these new allocations is Pareto Efficient. Of course, so is point R, and so is Point U, and so is every point on the line. They are efficient in the same sense, namely, that moving off the line makes both people less happy.

The fascinating thing about this chart is from a 1963 paper by Kenneth Arrow on the health care market. He says that economists agree that in a perfectly competitive market, given an initial allocation of money, the market will automatically reallocate resources between A and B until happiness reaches an Optimal Pareto point, somewhere on that curve. In economics talk, that means that markets make things Optimal or Efficient. Non-economists don’t think like this.  . . .

Rhinehardt says that it is a mistake to call this efficiency, or optimality, because it doesn’t take into account non-monetary gains from the operation of markets. If the point of health care is to keep members of society healthy, as opposed to making a pile of money, then this chart and the concepts it represents are a big distraction from the goal. The only thing it considers is the initial allocation of money, not the needs of specific people. Arrow agrees with Rhinehardt. He cautions economists against redefining words with generally accepted meanings in ways that might mislead non-economists.

There is a deeper error here. There are no perfectly competitive markets, and the ways in which markets are uncompetitive are complex and impossible to unravel. So why would we think that changing something about an uncompetitive market would make things more efficient, even in the silly way the Pareto curve is said to be efficient? The answer is that we don’t and can’t know. That is the point of the Lipsey-Lancaster theory of the second best solution.

It says that fixing one of the problems in a market to make it more competitive won’t work. Instead you have to make a bunch of changes, and it is very difficult to find the second best solution, or even to know where to look for one*. This rule applies to actual markets, not something as touchy-feely as happiness, or social welfare. Let’s think about why this would be so.

There are markets in an enormous number of products and services, ranging from the highly local, like nail salons, to national, like TV channels. Each participant in each market, including buyers and sellers, operates under a large number of constraints. The constraints are both natural, like geography, and societal, like regulations and social prohibitions. The constraints interact with each other. The Lipsey-Lancaster theorem says that changing a single constraint won’t work. How would you know which constraints need to be adjusted? Guessing? Why would an economist be better suited to this than a politician or an expert in the production field? It certainly isn’t because of their wonderful models, which couldn’t even spot the coming Great Recession.

What is it that we get from economists besides affirmation of the power of money?
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*Here is their statement of the theorem:

It is well known that the attainment of a Paretian optimum requires the simultaneous fulfillment of all the optimum conditions. The general theorem for the second best optimum states that if there is introduced into a general equilibrium system a constraint which prevents the attainment of one of the Paretian conditions, the other Paretian conditions, although still attainable, are, in general, no longer desirable. In other words, given that one of the Paretian optimum conditions cannot be fulfilled, then an optimum situation can be achieved only by departing from all the other Paretian conditions.

Id. at 11.