Divided

Modern economics operates from certain assumptions, two of which stack the deck in favor of the rich, an economist shows.

Economic laws are not made by nature. They are made by human beings.

—Franklin D. Roosevelt

The search for a definition of economic efficiency began with the emergence of democracy.

With democracy came, for the first time in history, the need to ask explicitly whom government should serve. Kings were never bothered by this question. “L’état, c’est moi,” Louis XIV of France declared in the early eighteenth century—“the state is me.” But who should a government “of the people” and “for the people” serve, when some of the people are rich and some are poor?

In 1793 the French “people” executed Louis XVI and proceeded to ratify in a referendum a constitution that guaranteed income redistribution in the form of public relief and public schooling. (“People” is in quotation marks because not all the French wanted the king executed, nor did all of them vote for the constitution.)

But how much should be redistributed? The constitution of 1793 did not say, and the political process that could have determined it was thwarted by the government before it started. A group of citizens, “The Conspiracy of Equals,” demanded that the constitution be implemented, but the group was disbanded when its leader, François Noël Babeuf, was sent to the guillotine. Luckily, a contemporary of Babeuf, the wealthy British philosopher Jeremy Bentham (1748–1832), addressed the question.

Bentham based his theory of the efficient degree of redistribution on three building blocks:

the happiness of a society consists of the sum of the happiness of each of its members,

an efficient allocation of resources is one that maximizes the happiness of society, and

the happiness that a person gets from an additional dollar (or English pound) decreases as the number of dollars that person has increases.

In the language of economics, “happiness” has long since been replaced by “utility,” and Bentham’s theory is known, therefore, as Utilitarianism. Utility, which in the algebra of economists is shown as U, is made of tiny units called “utils.” Utils are derived from money. Each additional dollar buys additional utils, and the number of utils that each additional dollar buys is called “the marginal utility of money.”

More income yields more utility, but while an extra dollar always brings additional utility, this additional utility gets smaller as a person’s income increases. Because each added dollar is less significant to one’s well-being, the marginal utility of money decreases with the amount of money a person has. Think about how much an extra dollar might mean to someone scraping by with not enough to afford food on the last day of the year compared to a billionaire having one more dollar. That extra dollar is worth a great deal to the poor person who can quell his hunger, but is immaterial to the billionaire.

Because a rich person has more money than a poor person, if a dollar is transferred from the rich to the poor, the loss of utility to the rich will be less than the gain in utility to the poor. The transfer of a dollar from the rich person to the poor person will therefore increase the sum of utilities of these two individuals.

Where should the process of redistribution stop?

Bentham believed that redistribution should stop when each person has the same amount of money, because this will maximize the sum of their utilities. To Bentham, the pie of happiness is biggest—and therefore Utilitarian efficiency is achieved—when it is divided exactly equally.

Bentham was an effective agitator for equality. But Utilitarianism as a yardstick for economic efficiency did not survive the century in which it was developed. It was supplanted wholly and with complete success by another definition of efficiency, one invented by an Italian economist, Vilfredo Pareto (1848–1923). If Utilitarianism is still mentioned in economics textbooks at all, it is summarily dismissed as a historical curiosity on the way to the truth: Pareto efficiency.

How and why did Pareto dismiss Utilitarianism? Let’s begin with the why.

At the end of the nineteenth century, inequality in Europe was so extreme that a socialist revolution had become a real possibility. Pope Leo XIII was moved enough by the prevailing economic disparity that in 1891 he issued an encyclical letter, Rerum Novarum [Of New Things], which was devoted to “The Condition of the Working Classes,” and in which he wrote: “The whole process of production as well as trade in every kind of goods has been brought almost entirely under the power of a few, so that a very few rich and exceedingly rich men have laid a yoke almost of slavery on the unnumbered masses of non-owning workers.”

This would seem to lay the groundwork for a call to redistribute “the whole process of production.” In fact, though, the pope objected strongly to redistribution through the power of the state. The rich should have no legal obligation to assist the poor, the pope asserted: “These [assisting the poor] are duties not of justice, except in cases of extreme need, but of Christian charity, which obviously cannot be enforced by legal action.”

Pareto also opposed redistribution, arguing that Bentham was not necessarily right in his analysis. Bentham assumed that the only difference between a rich person and poor person was in how much money they had: given the same amounts of money they would have similar amounts of utility. It is this similarity between the rich and the poor that led Bentham to conclude that transferring a dollar from the rich to the poor would hurt the rich less than it would help the poor.

But according to Pareto rich people and poor people may be fundamentally different. In this scenario transferring money from the rich to the poor could actually hurt the rich more than it would help the poor. Pareto used an extreme hypothetical example to illustrate this possibility: What if the rich actually enjoy the poverty of the poor?

If that is so, reducing poverty by redistribution may hurt the rich more than it would help the poor, Pareto argued. “Assume a collectivity made up of a wolf and a sheep,” Pareto explained. “The happiness of the wolf consists in eating the sheep, that of the sheep in not being eaten. How is this collectivity to be made happy?”

Economists do not usually cite this passage in explaining Pareto’s objection to Utilitarianism. Instead they ask what if the rich and the poor do not have the same utility function but instead, by chance, the rich happen to derive greater utility from a given quantity of money than the poor do.

This theory argues that just like a poor person, a rich person also derives greater utility from her first dollar than from her last one. But a rich person’s utility from her last dollar may exceed the poor person’s utility from her first dollar.

Economists do not claim that this situation actually exists, only that it may exist. Because utility is not measurable, this possibility simply cannot be ruled out. And if this is indeed the situation, then Bentham’s argument does not hold, and redistribution is therefore not justified.

Bentham acknowledged this possibility. “Difference of character is inscrutable,” he said. But, he argued, a large difference in character between the rich and the poor was so unlikely that the government would make fewer mistakes if it operated under the assumption that the rich and the poor are similar, than if it operated under the assumption that they are fantastically different.

The economist Abba Lerner (1903–82) noted that Bentham was just applying the first principle of statistics: when it is not known that things that appear the same are really different, the best we can do is to assume that they are the same. This is why, with gambling dice, we assign the probability of 1/6 to each face of a die.

Unlike Bentham or Lerner, Pareto did not concern himself with the question of how likely it was that redistribution would hurt the rich more than it would help the poor. For him this theoretical possibility, no matter how remote, was reason enough to reject the level of equality as a yardstick of economic efficiency. And based solely on this theoretical possibility, the entire economics profession removed the distribution of resources from its definition of economic efficiency and replaced it with Pareto’s own definition.

Like Bentham, Pareto also equated efficiency with maximizing the well-being produced by society’s resources. But while Bentham allowed for the possibility that this would require the redistribution of these resources from the rich to the poor, Pareto ruled this possibility out from the start. According to him, an allocation of resources is efficient if it cannot be changed in a way that will make at least one person better off without making anybody else worse off. This definition is indifferent to the distribution of society’s resources. Today we call this Pareto efficiency, but economists usually omit the name Pareto. They equate efficiency with Pareto efficiency, ignoring the existence of competing definitions, including that of Utilitarian efficiency.

The concept of Pareto efficiency is a critical building block of all modern-day economics. A related and equally important concept is known as a Pareto improvement. A reallocation of resources is a Pareto improvement if it makes at least one person better off without making anybody worse off. When a Pareto improvement is possible, the allocation of resources is NOT Pareto efficient.

To use an extreme example that illustrates the concept, if the total income of a society were concentrated in the hands of just one person while everybody else went hungry, this would be Pareto efficient. Why? Because it would be impossible to feed the hungry without taking some money away from the rich.

We can see how economists use Pareto efficiency in actual policy making by looking at what happened during a food crisis and how a president of the American Economic Association wanted to reform the health care system.

In 1997 several Asian countries experienced a financial crisis that started when foreign investors slowed the pace of their investments in these countries. Indonesia was particularly sensitive to the decline in the inflow of dollars because all of its wheat, one-third of its sugar, and one-tenth of its rice are imported, and all of a sudden the country did not have enough dollars to pay for basic food. The government of Indonesia asked the IMF for a loan, but the IMF saw this request as an opportunity to enforce Pareto efficiency. The government of Indonesia subsidized food prices at the time, but these subsidies violate Pareto efficiency; the IMF made the loan contingent upon the abolition of the subsidies.

Why are food subsidies Pareto inefficient? Because in many cases it would be possible to give poor people cash directly instead of paying for subsidies, and the result would be both a lower cost to the taxpayer and higher utility to the poor. To see why, suppose that the world price of a loaf of bread is two dollars but that the subsidized local price to the consumer is only fifty cents (the taxpayer pays the extra four and a half dollars). Suppose also that with this low price a poor person buys three loaves of bread and pays for them a dollar and a half, but that she would have preferred to have not three, but only two loaves of bread, provided she could also have an extra dollar in her pocket. Under these conditions, the food subsidy would be Pareto inefficient. To see why, let’s examine a possible Pareto improvement.

Let the government abolish the subsidy and give the poor person three and a half dollars in cash instead. The poor would then buy two loaves of bread for two dollars each and because she would be spending only fifty cents of her own money instead of a dollar and a half, would have an extra dollar in her pocket. The taxpayer would also be better off because she would spend only three and a half dollars for the transfer payment instead of spending four and a half dollars on the subsidy. Since both the poor and the taxpayer would be better off, this would be a Pareto improvement. And since a Pareto improvement is possible, food subsidies are not Pareto efficient.

Of course, people are the best judges of what they need and therefore giving poor people money directly is no doubt better than subsidizing a particular good that they buy. No policy is better for dealing with the consequences of inequality than reducing inequality itself. The only problem is that we live in a world in which it is much easier for governments to give things than to give money. In the United States, for instance, there is much less resistance to the food-stamps program than there is to welfare payments. Therefore, when subsidies are abolished, people are rarely adequately compensated for their loss, and Indonesia was no exception to this rule. When the IMF economists demanded that the government end its food subsidies in order to establish “market-based pricing,” Larry Summers, the deputy U.S. secretary of commerce, backed them, and President Clinton even called President Suharto of Indonesia from Air Force One to demand that he comply. And comply Suharto did.

In the riots that ensued, five hundred people died in the capital, Jakarta, alone.

The Nobel Prize–winning economist Joseph Stiglitz, who was the chief economist of the World Bank at the time, called the food riots in Indonesia “the IMF Riots.” “When a nation is down and out,” Stiglitz told the London newspaper the Observer, “the IMF takes advantage and squeezes the last pound of blood out of them. They turn up the heat until finally the whole cauldron blows up.” The Observer obtained secret International Monetary Fund documents in which the IMF’s managers revealed that they expected “social unrest” in response to the policies they would impose, and that they decided to respond to these riots with “political resolve.”

How does utilitarianism apply to food subsidies? If poor people will experience hunger without subsidies, it is clear that the gain in utility from the subsidies to the poor would exceed the loss in utility to the rich who would pay for them. Of course, utils are not measurable. Weighting the relative gains and losses requires judgment, and mistakes are possible. But food subsidies may be Utilitarian efficient even if they are not Pareto efficient.

Now let’s look at the two definitions of efficiency as they apply to health care, which in the United States, until Obamacare, not only the poor but most middle class people could not afford. In 2004 Martin Feldstein, who had served as President Reagan’s chair of the Council of Economic Advisers, received the highest recognition that economists give to one of their own: presidency of the American Economic Association. Feldstein devoted a large part of his presidential address to health insurance.

Health insurance was, of course, a very fitting topic for the president of the American Economic Association to address, since some fifty million Americans were without health insurance at the time, despite the fact that many of them worked full-time and despite the fact that even families with insurance were often crushed financially when they were faced with a catastrophic illness. Given the crisis in health care, one might have expected Feldstein to talk about how to provide health insurance to more Americans or, perhaps, how to remove unhealthy limitations on health care put in place by health maintenance organizations or HMOs.

Instead, Feldstein told the audience that health insurance in United States faced a problem because deductibles and co-payments were too low, and as a result people went to the doctor too many times: “They [low co-payments] also lead to an increased demand for care that is worth less than its cost of production.”

To a noneconomist, the prime example of inefficient medical care would probably be cosmetic surgery, because it diverts doctors, nurses, and operating rooms away from real medical problems. But to an economist, cosmetic surgery is actually the prime example of efficient medical care. Why? Because cosmetic surgery is not medically necessary.

Because cosmetic surgery is not necessary, it is not covered by insurance. Without insurance a patient will never have cosmetic surgery, unless he is able to pay for it. This guarantees that the surgery is not “worth less than its cost of production.” Real medical care is covered by insurance, and this is why, according to Martin Feldstein, it may be “worth less than its cost of production.”

The following example illustrates Feldstein’s argument that low co-payments lead to medical care that is “worth less than its cost of production.” Suppose that the cost of a doctor’s visit is $100 and that Poor, who is uninsured, cannot pay more than $20 for the visit. This means that the doctor’s visit will not take place.

Now, let’s change the example by assuming that Poor is insured and there is no co-payment, so insurance covers the $100. Under these circumstances the visit would take place, even though it is “worth less than its cost of production,” which is the $100 that Poor cannot pay.

Is the visit Pareto inefficient? In other words, had the insurance company offered Poor a sum that is less than the cost of the visit—say, $95—to not visit the doctor, would Poor have accepted it? After all, Poor would have $95 in her pocket for a visit for which she was willing to pay $20.

It would be wrong to simply assume that she would, because Poor may nevertheless prefer to see the doctor than to take the money. In that case the visit to the doctor would be Pareto efficient even if without health insurance it would have been skipped. Economists are so accustomed to equating the worth of a good to a person with how much that person can afford to pay for it that Martin Feldstein could make this equation the pivotal element of his American Economic Association presidential address. The two are not the same, and this is precisely why insurance exists: to let people see the doctor when they cannot afford to.

Keep in mind that not seeing the doctor may mean that a treatable condition can worsen, causing a more severe illness and even death. But in his speech Feldstein did not consider such matters. Economists often do this, looking at hypothetical examples without context.

Currently, an employer who provides health insurance to her employees may deduct the premium payments from the company’s income for tax purposes. Feldstein wanted to disallow this deduction in order to make health insurance more expensive because this would make it Pareto efficient. When insurance becomes more expensive to employers, Feldstein explained, poor employees will be forced to settle for higher deductibles and higher co-pays, which means that they will use less medical care. If Feldstein’s advice were followed, the poor would have paid with their lives, because increases in co-pays lead patients to forgo immunization, cancer screening, and lifesaving drugs.

Needless to say, according to Feldstein’s logic, while medical care for the poor may be worth less than its cost, this does not hold for the rich. To continue our example, let’s suppose that Rich is willing to pay $101 for a doctor’s visit. To dissuade Rich from going to the doctor, the insurance company would have to offer her this sum or more; but the doctor’s fee is less than that, so an offer will not be made. In other words, a low co-payment rate for the rich would be Pareto efficient because the rich don’t really need it.

Feldstein’s recommendations were ignored, and under Obamacare co-pays for preventive medical procedures were abolished altogether. Does tax-subsidized health insurance increase the sum of utilities in society? Nothing gives greater utility to people than their health. The gain in utility to a patient who visits the doctor probably exceeds the loss in utility to those who pay for it. As for people who would make excessive visits to the doctor, there are other ways to channel behavior than a price mechanism that denies care.

Economists object to the redistribution of goods because giving poor people cash would achieve an even greater good. To reiterate, when dealing with the consequences of inequality, no policy is more effective than reducing the inequality itself. But to oppose policies that would alleviate shortages of food, housing, health care, or many other goods ostensibly because they are not as effective as income redistribution is duplicitous.

People are poor because under the banner of economics, the deck is stacked. What we need is economics for the rest of us.

Adapted from Economics for the Rest of Us: Debunking the Science That Makes Life Miserable.