Kaldor-Hicks efficiency (click to embiggen)

Uwe Rhinehardt wrote four pieces for the New York Times blog Economix on the theories economists rely on to make value judgments about social policy issues*. In this one, he describes two camps of economists. The Strict Constructionists say that the profession should focus on what they call descriptive analysis. They believe that economists can say who will win and who will lose if a specific policy is enacted, but do not make judgments about policy, leaving that to politicians.

Welfare Economists, on the other hand, say that they can make judgments about the best policies based on neutral standards. These people have dominated the business of economics, and have taught a number of principles that now dominate discussions of the economy. The primary practitioners of this school are the darlings of the conservatives, because they teach the wonders of the markets.

Rhinehardt says the Welfare Economics people base their welfare judgments on a theory put forward by two economists, Nicolas Kaldor and John Hicks, and called the Kaldor-Hicks criterion. Wikipedia tells us:

Under Kaldor–Hicks efficiency, an outcome is considered more efficient if a Pareto optimal outcome can be reached by arranging sufficient compensation from those that are made better off to those that are made worse off so that all would end up no worse off than before.

Rhinehardt explains that this means that if the rich could bribe the poor into accepting a policy that favors the rich, then everyone would be better off, so the policy is a good social policy. In fact, it isn’t even necessary to pay the bribe; this is just a thought experiment. He quotes from a book by Steven Landsburg describing Kaldor-Hicks:

When Jack gains $10 and Jill loses $5, social gains increase by $5, so the policy is a good one. When Jack gains $10 and Jill loses $15, there is a deadweight loss of $5, so the policy is bad.

Rhinehardt says that only economists would agree that this idea could be the basis for social policy. He links to two formal examples, which are fairly easy to follow, in his post.

Here’s an informal example. Suppose there is a medicine in short supply. The drug company demands $1,000 for a dose. HFO, a hedge fund operator, thinks maybe it would be nice to have a dose just in case, and bids $1,000. FFW, who works at a fast food restaurant, needs the drug. FFW doesn’t have $1,000. This is not a problem for economists. HFO buys the drug, and everyone is better off. This is a Pareto Optimal outcome*, because HFO got what HFO wanted at a price HFO was willing to pay. FFW isn’t any worse off than before the transaction. The market has worked, and economists are proven right.

Now let’s try another version. The government has a drug plan that gives FFW a voucher for $1000 to buy in the market. Let’s assume H really wants the drug, and is willing to pay $1100, again just in case. The drug company sells the drug to HFO, and everyone is thrilled, except FFW. But again, FFW is no worse off, and HFO is happier, so this is a Pareto Optimal point.

Now suppose the government decides to ration the drug, so that HFO, who doesn’t need the drug, can’t buy it. Suppose HFO cuts a deal with FFW to buy the drug and sell it to HFO for $1075, leaving FFW with $1075 and no drug. The Kaldor-Hicks criterion is met, so long as FFW is satisfied. Who, besides an economist, would think that was a good way to run a country?

Here’s another informal example. Suppose HFO wants to get into the market place of ideas. HFO has an idea for a tax structure that will dramatically lower HFO’s taxes. HFO finds a bunch of economists to tout a theory that says that HFO’s favored tax structure will increase tax revenues and reverse unemployment. A bunch of politicians listen to the economists and feel justified in voting for it. HFO is pleased and rewards all of them with some nice money. No individual is worse off, and HFO, the economists and the politicians are happier. Who thinks that would be a good way to run a country?
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*I discussed the competitive market definition here, and the Pareto Optimality theory here.