...Archive for July 2014

Welfare economics: housekeeping and links

A correspondent asks that I give the welfare series a table of contents. So here’s that…

Welfare economics:
  1. Introduction
  2. The perils of Potential Pareto
  3. Inequality, production, and technology
  4. Welfare theorems, distribution priority, and market clearing
  5. Normative is performative, not positive

I think I should also note the “prequel” of the series, the post whose comments inspired the exercise:

Much more interesting than any of that, I’ll add a box below with links to related commentary that has come my way. And of course, there have been two excellent comment threads.

Welfare economics: normative is performative, not positive (part 5 and conclusion of a series)

This is the fifth (and final) part of a series. See parts 1, 2, 3, and 4.

For those who have read along thus, far, I am grateful. We’ve traveled a long road, but in the end we haven’t traveled very far.

We have understood, first, the conceit of traditional welfare economics: that with just a sprinkle of one, widely popular bit of ethical philosophy — liberalism! — we could let positive economics (an empirical science, at least in aspiration) serve as the basis for normative views about how society should be arranged. But we ran into a problem. “Scientificoliberal” economics can decide between alternatives when everybody would agree that one possibility would be preferable to (or at least not inferior to) another. But it lacks any obvious way of making interpersonal comparisons, so it cannot choose among possibilities that would leave some parties “better off” (in a circumstance they would prefer), but others worse off. Since it is rare that nontrivial economic and social choices are universally preferable, this inability to trade-off costs and benefits between people seems to render any usefully prescriptive economics impossible.

We next saw a valiant attempt by Nicholas Kaldor, John Hicks, and Harold Hotelling to rescue “scientificoliberal” economics with a compensation principle. We can rank alternatives by whether they could make everybody better off, if they were combined with a compensating redistribution (regardless of whether the compensating redistribution actually occurs). At a philosophical level, the validity of the Kaldor-Hicks-Hotelling proposal requires us to sneak a new assumption into “scientificoliberal” economics — that distributive arrangements adjudicated by the political system are optimal, so that any distributive deviation from actual compensation represents a welfare improvement relative to the “potential” improvement which might have occurred via compensation. This assumption is far less plausible than the liberal assumption that what a person would prefer is a marker of what would improve her welfare. But we have seen that, even if we accept the new assumption, the Kaldor-Hicks-Hotelling “potential Pareto” principal cannot coherently order alternatives. It can literally tell us that we should do one thing, and we’d all be better off, and then we should undo that very thing, because we would all be better off.

In the third installment, we saw that these disarming “reversals” were not some bizarre corner case, but are invoked by the most basic economic decisions. To what goods should the resources of an economy be devoted? What fraction should go to luxuries, and what fraction to necessities? Should goods be organized as “public goods” or “club goods” (e.g. shared swimming pools), or as private goods (unshared, personal swimming pools)? These alternatives are unrankable according to the Kaldor-Hicks-Hotelling criterion. The resource allocation decision that will “maximize the size of the pie” depends entirely on what distribution the pie will eventually have. It is impossible to separate the role of the economist as an objective efficiency maximizer from the role of the politician as an arbiter of interpersonal values. The efficiency decision is inextricably bound up with the distributional decision.

Most recently, we’ve seen that the “welfare theorems” — often cited as the deep science behind claims that markets are welfare optimizing — don’t help us out of our conundrum. The welfare theorems tell us that, under certain ideal circumstances, markets will find a Pareto optimal outcome, some circumstance under which no one can be made better off without making someone worse off. But they cannot help us with the question of which Pareto optimal outcome should be found, and no plausible notions of welfare are indifferent between all Pareto optimal outcomes. The welfare theorems let us reduce the problem of choosing a desirable Pareto optimal outcome to the problem of choosing a money distribution — once we have the money distribution, markets will lead us to make optimal production and allocation decisions consistent with that distribution. But we find ourselves with no means of selecting the appropriate money distribution (and no scientific case at all that markets themselves optimize the distribution). We are back exactly where we began, wondering how to decide who gets what.

In private correspondence, Peter Dorman suggests

Perhaps the deepest sin is not the urge to have a normative theory as such, but the commitment to having a single theory that does both positive and normative lifting. Economists want to be able to say that this model, which I can calibrate to explain or predict observed behavior, demonstrates what policies should be enacted. If these functions were allowed to be pursued separately, each in its own best way, I think we would have a much better economics.

We’ve seen that positive economics (even with that added sprinkle of liberalism) cannot serve as the basis for a normative economics. But if we toss positive economics out entirely, it’s not clear how economists might have anything at all to say about normative questions. Should we just leave those to the “prophet and the social reformer”, as Hicks disdainfully put it, or is there some other way of leveraging economists’ (putative) expertise in positive questions into some useful perspective on the normative? I think that there is.

They key, I think, is to relax the methodological presumption of one way causality from positive observations and normative conclusions. The tradition of “scientific” welfare economics is based on aggregating presumptively stable individual preferences into a social welfare ordering whose maximization could be described as an optimization of welfare. Scitovsky and then Arrow showed that this cannot be done without introducing some quite destructive paradoxes, or letting the preferences of a dictator dominate. It is, however, more than possible — trivial, even — to define social welfare functions that map socioeconomic observables into coherent orderings. We simply have to give up the conceit that our social welfare function arises automatically or mechanically from individual preferences characterized by ordinal utility functions. At a social level, via politics, we have to define social welfare. There is nothing “economic science” can offer to absolve us of that task.

But then what’s left for economic science to offer? Quite a bit, I think, if it would let itself out of the methodological hole its dug itself into. As Dorman points out, economists so entranced themselves with the notion that their positive economics carries with it a normative theory like the free prize in a box of Cracker Jacks that they have neglected the task of creating a useful toolset for normative economics as a fully formed field of its own.

A “scientific” normative economics would steal the Kaldor-Hicks-Hotelling trick of defining a division of labor between political institutions and value-neutral economics. But politicians would not uselessly (as a technical matter) and implausibly (let’s face it) be tasked with “optimal” distributional decisions. Political institutions are not well-suited to making ad hoc determinations of who gets what. We need something systematic for that. What political institutions are well suited to doing, or at least better suited than plausible contenders, is to make broad-brush determinations of social value, to describe the shape of the society that we wish to inhabit. How much do we, as a society, value equality against the mix of good (incentives to produce and innovate) and bad (incentives to cheating and corruption, intense competitive stress) that come with outcome dispersion? How much do we value public goods whose relationship to individual well-being is indirect against the direct costs to individuals required to pay for those goods?

A rich normative economics would stand in dialogue with the political system, taking vague ideas about social value and giving them form as social welfare functions, exploring the ramifications of different value systems reified as mathematics, letting political factions contest and revise welfare functions as those ramifications stray from, or reveal inconsistencies within, the values they intend to express. A rich normative economics would be anthropological in part. It would try to characterize, as social welfare functions, the “revealed preferences” of other polities and of our own polity. Whatever it is we say about ourselves, or they say about themselves, what does it seems like polities are actually optimizing? As we analyze others, we will develop a repertoire of formally described social types, which may help us understand the behavior of other societies and will surely add to the menu we have to choose from in framing our own social choices. As we analyze ourselves, we will expose fault lines between our “ideals” (preferences we claim to hold that may not be reflected in our behavior) and how we actually are. We can then make decisions about whether and how to remedy those.

The role of the economist would be that of an explorer and engineer, not an arbiter of social values. Assuming (perhaps heroically) a good grasp of the positive economics surrounding a set of proposals, an economist can determine — for a given social welfare function — which proposal maximizes well being, taking into account effects on production, distribution, and any other inputs affected by the proposal and included in the function. Under which of several competing social welfare functions policies should be evaluated would become a hotly contested political question, outside the economist’s remit (at least in her role as scientist rather than citizen). Policies would be explored under multiple social welfare functions, each reflecting the interests and values of different groups of partisans, and political institutions would have to adjudicate conflicting results there. But different social welfare functions can be mapped pretty clearly to conflicting human values. We will learn something about ourselves, perhaps have to fess up something about ourselves, by virtue of the social welfare functions whose champions we adopt. And perhaps seeing so clearly the values implied by different choices will help political systems make choices that better reflect our stated values, our ideals.

Coherent social welfare functions would necessarily incorporate cardinal, not ordinal, individual welfare functions. Those cardinal functions could not be fully determined by the results of strictly ordinal positive economics, though they might be defined consistently with those results. Their forms and cardinalities would structure how we make tradeoffs between individuals along dimensions of consumption and risk.

What if they get those tradeoffs “wrong”? What if, for example, we weight individual utilities equally, but one of us is the famous “utility monster“, whose subjective experience of joy and grief is so great and wide that, in God’s accounting, the rest of our trivial pleasures and pains would hardly register? How dare we arrogate to ourselves the power to measure and weigh one individual’s happiness against some other?

In any context outside of economics it would be unsurprising that the word “normative” conjures other words, words like “obligation” or “social expectation”. Contra the simplistic assumption of exogenous and stable preferences, the societies we inhabit quite obviously shape and condition both the preferences that we subjectively experience and the preferences it is legitimate to express in our behavior. Ultimately, it doesn’t matter whether “utility monsters” exist, and it doesn’t matter that the intensities of our subjective experiences are unobservable and incommensurable. Social theories do not merely describe human beings. Tacitly or explicitly, as they become widely held, they organize our perceptions and shape our behavior. They become descriptively accurate when we are able, and can be made willing, to perform them. And only then.

So the positive and the normative must always be in dialogue. A normative social theory, whether expressed as a social welfare function or written in a holy scripture, lives always in tension with the chaotic, path-dependent predilections of the humans whose behavior it is intended to order. On the one hand, we are not constrained (qua traditional welfare economics) by the positive. Our normative theories can change how people behave, along with the summaries of behavior that economists refer to as “preferences”. But if we try to impose a normative theory too out of line with the historically shaped preferences and incentives of those it would govern, our norms will fail to take. Our project of structuring a “good” society (under the values we choose, however arbitrarily) will fail. The humans may try to perform our theory or they may explicitly rebel, but they won’t manage it. Performativity gives us some latitude, but positive facts about human behavior — susceptibility to incentives, requirements that behavior be socially reinforced, etc. — impose constraints. Over a short time horizon, we may be unable to optimize a social welfare function that reflects our ideals, because we are incapable or unwilling to behave in the ways that would require. Intertemporal utility functions are a big deal in positive economics. The analog in normative economics should be dynamic social welfare functions, that converge over time to the values we wish would govern us, while making near-term concessions to the status quo and our willingness and capacity to perform our ideals. (The rate and manner of convergence would themselves be functions of contestable values constrained by practicalities.)

This performativity stuff sounds very postmodern and abstract, but it shouldn’t. It impinges on lots of live controversies. For example, a few years ago there was the kerfuffle surrounding whether the rich and poor consume such different baskets of goods that we should impute different inflation rates to them. Researchers Christian Broda and John Romalis argued that the inflation rate of the rich was higher than that of the poor, and so growth in real income inequality was overstated. I thought that dumb, since the rich always have the option of substituting the cheaper goods bought buy the poor into their consumption basket. Scott Winship pointed out the to-him dispositive fact that, empirically, they seem not to substitute. In fact, if you read the paper, the researchers estimate different utility functions for different income groups, treating rich and poor as though they were effectively distinct species. If we construct a social welfare function in which individual welfares were represented by the distinct utility functions estimated by Broda and Romalis, if in the traditional manner we let their (arguable) characterization of the positive determine the normative, we might find their argument unassailable. The goods the poor buy might simply not enter into the utility functions of the rich, so the option to substitute would be worthless. If we took this social welfare function seriously, we might be compelled, for example, to have the poor make transfers to the rich if the price of caviar rises too steeply. Alternatively, if we let the normative impose an obligation to perform, and if we want our social welfare function to reflect the value that “all men are created equal”, we might reject the notion of embedding different individual welfare functions for rich and poor into our social welfare function and insist on a common (nonhomothetic) function, in which case the option to substitute hot dogs for caviar would necessarily reflect a valuable benefit to the wealthy. But, we’d have to be careful. If our imposed ideal of a universal individual welfare function is not a theory our rich could actually perform — if it turns out that the rich would in fact die before substituting hot dogs for caviar — then our idealism might prove counterproductive with respect to other ideals, like the one that people shouldn’t starve. Positive economics serves as a poor basis for normative economics. But neither can positive questions be entirely ignored. [Please see update.]

I’ve given an example where a normative egalitarianism might override claims derived from positive investigations. That’s comfortable for me, and perhaps many of my readers. But there are, less comfortably, situations where it might be best for egalitarian ideals to be tempered by facts on the ground. Or not. There are no clean or true answers to these questions. What a normative economics can and should do is pose them clearly, reify different sets of values and compromises into social welfare functions, and let the polity decide. (Of course as individuals and citizens, we are free to advocate as well as merely explore. But not under the banner of a “value neutral science”.)

This series on welfare economics was provoked by a discussion of the supply and demand diagrams that lie at the heart of every Introductory Economics course, diagrams in which areas of “surplus” are interpreted as welfare-relevant quantities. I want to end there too. Throughout this series, using settled economics, we developed the tools by which to understand that those diagrams are, um, problematic. Surplus is incommensurable between people and so is meaningless when derived from market, rather than individual, supply and demand curves. Potential compensation of “losers” by “winners” is not a reasonable criterion by which to judge market allocations superior to other allocations: It does not form an ordering of outcomes. Claims that ill-formed surplus somehow represents a resource whose maximization enables redistribution ex post are backwards: Under the welfare theorems, redistribution must take place prior to market allocation to avoid Pareto inferior outcomes. As I said last time, the Introductory Economics treatment is a plain parade of fallacies.

You might, think, then, that I’d advocate abandoning those diagrams entirely. I don’t. All I want is a set of caveats added. The diagrams are redeemable if we assume that all individuals have similar wealth, that they share the similar indirect utility with respect to wealth while their detailed consumption preferences might differ, and the value of the goods being transacted is small relative to the size of market participants’ overall budget. Under these assumptions (and only under these assumptions), if we interpret indirect utilities as summable welfare functions, consumer and producer surplus become (approximately) commensurable across individuals, and the usual Econ 101 catechism holds. Students should learn that the economics they are taught is a special case — the economics of a middle class society. They should understand that an equitable distribution is prerequisite to the version of capitalism they are learning, that the conclusions and intuitions they develop become dangerously unreliable as the dispersion of wealth and income increases.

Why not just throw the whole thing away? Writing on economics education, Brad DeLong recently, wonderfully, wrote, “modern neoclassical economics is in fine shape as long as it is understood as the ideological and substantive legitimating doctrine of the political theory of possessive individualism.” An ideological and substantive legitimating doctrine is precisely what the standard Introductory Economics course is. The reason “Econ 101″ is such a mainstay of political discussions, and such a lightning rod for controversy, is because it offers a compelling, intuitive, and apparently logical worldview that stays with students, sometimes altering viewpoints and behavior for a lifetime. For a normative theory to be effective, people must be able to internalize it and live it. Simplicity and coherence are critical, not for parsimony, but for performativity. “Econ 101″ is a proven winner at that. If students understand that they are learning the “physics” of an egalitarian market economy, the theory is intellectually defensible and, from my value-specific perspective, normatively useful. If it is taught without that caveat (and others, see DeLong’s piece), the theory is not defensible intellectually or morally.

It would be nice if students were also taught they were learning a performative normative theory, a thing that is true in part because they make it true by virtue of how they behave after having been taught it. But perhaps that would be too much to ask.

Update: Scott Winship writes to let me know that some doubt has been cast on the Broda/Romalis differential inflation research; it may be mistaken on its own terms. But the controversy is still a nice example of the different conclusions one draws when normative inferences are based solely on positive claims drawn from past behavior versus when normative ideas are imposed and expected to condition behavior.

Update History:

  • 8-Jul-2014, 10:45 a.m. PDT: Inserted, “if we interpret indirect utilities as summable welfare functions,”; “Potential compensation of ‘winners’ by ‘losers’ of ‘losers’ by ‘winners’
  • 8-Jul-2014, 11:40 a.m. PDT: Added bold update re report by Scott Winship that there may be problems with Broda / Romalis research program on its own terms.
  • 8-Jul-2014, 3:25 p.m. PDT: “The tradition of ‘scientific’ welfare economics is based on aggregating…”; “It would try to characterize, as social welfare functions…”; “that converge over time to the values we wish would govern us”; “If we too took this social welfare function seriously” — Thanks Christian Peel!
  • 11-Jul-2014, 10:45 a.m. PDT: ” a useful toolset for a normative economics as a fully formed field of its own.”