Chapter 19 SOCIAL WELFARE AND PUBLIC CHOICE
A.
The Social Welfare Function .................................................................................... 1
1. The Pareto Criterion................................................................................................ 2
Pareto Optimality ........................................................................................................ 2
2. Compensation ............................................................................................................ 2
3. Potential Compensation ............................................................................................. 2
Kaldor Criterion .......................................................................................................... 2
Scitovsky criterion ...................................................................................................... 2
4. Arrow's Impossibility Theorem ................................................................................. 3
(1) Efficiency and the Pareto Rule. ......................................................................... 3
(2) Comprehensive Applicability............................................................................ 3
(3) Independence of Irrelevant Alternatives ........................................................... 3
B. Theory of the Second Best ............................................................................................ 4
The Pigovian Approach .............................................................................................. 4
The Coasian Approach ................................................................................................ 5
transaction costs ........................................................................................................ 6
C. Constitutions and Voting Rules .................................................................................. 7
Robert's “Rules of Order ............................................................................................. 8
1. Unanimity .......................................................................................................... 8
2. Dictatorship ........................................................................................................ 8
3. Majority Rule ..................................................................................................... 8
4. Plurality Rule ..................................................................................................... 8
5. Ladders:........................................................................................................... 9
6. Condorcet Procedure .......................................................................................... 9
7. Social Rankings ................................................................................................. 9
In making collective choices, two questions must be addressed; what choice
should be made (the normative question) and what choices are made (the positive
question). In examining the collective choices made through our legal system economists
try to establish what normative criteria to use in deciding collective choices (sections A
and B below). They also study in Public Choice theory, what choices are actually made
(section C). To illustrate such choices it is useful to examine the case of the Montreal
Protocol which banned CFCs (chlorofluorocarbons) and how Dupont, one of the chief
producers of CFCs had to react.
A.
The Social Welfare Function
Economists have tried to find a way to determine the optimum choices for society.
Ideally, we would want a social welfare function which for any set of alternatives would
be able to rank the alternatives according to their contribution to social welfare. With
such a ranking, it would then be possible to choose the best social choice.
1
1. The Pareto Criterion
There are a few criteria which have gained acceptance as the basis for social
choices. The Pareto criterion has unquestioning acceptance. It states:
A change is desirable for society if it makes at least one
person better off without making anyone worse off.
If society is at a point where no further Pareto changes can be made then it has achieved
Pareto Optimality. Such a criterion is acceptable as far as it goes, but it does not go very
far. How many important issues provide a choice where no one is made worse off
compared to the other choices? If there were such a choice, it wouldn’t be an issue that
would take much time to solve.
Society needs to make decisions on many issues where someone will be made
worse off for each alternative choice. The CFC phaseout is an example of such an issue;
to make the world safe against ultraviolet radiation the producers and consumers of CFCs
have to make substantial sacrifices.
2. Compensation
If someone is to be made worse off, it might be possible to compensate them for a
socially desirable change. In other words, a choice might be structured where the people
who are made worse off receive enough money that they are happy with the change. But
the issue returns back to the Pareto criterion; taking into account the compensation, is
everyone better off with the change or not? Compensation involves its own burden; there
are costs of making transactions including the costs of transferring resources from one
group to another, the costs of deciding who should receive the transfers, and the costs of
studying the problem in the first place. Compensation can actually make society less
efficient, causing some people to be worse off than if no action were taken.
In the CFC issue, the government could compensate Du Pont, other producers,
and even users for their material losses due to a CFC prohibition. However, such
compensation might be too costly and make compensation impractical.
3. Potential Compensation
Perhaps, a social change might be considered desirable if it could be shown that
losers could potentially be compensated. Compensation would not actually have to be
made. This criterion, is often referred to as the Kaldor Criterion. However, suppose
compensation were made and then the losers could find a way to return the compensation
to get their way back again. The problem of such contradictory directions in
compensation can be corrected by the Scitovsky criterion. Scitovsky suggested that a
change could be superior if it met the Kaldor criterion and it was not possible for the
losers to compensate back to stop the change.
2
Society could decide that it would be willing to pay $200 billion to compensate the
producers and users of CFCs for ending CFC use. If the producers and users were willing to accept
such compensation for ending production then the Kaldor criterion would be satisfied. If
compensation were not actually made, society might be potentially better off without the CFCs, but
be simultaneously actually worse off by failing to compensate the producers and users. If the
producers would not be willing to compensate all of those losing their lives if CFCs were continued
to be used, the Scitovsky Criterion would declare in favor of regulating CFCs. But suppose, after
receiving $200 billion, the producers and users could turn around and compensate everyone made
ill by CFC production. Now both the Kaldor Criterion and the Scitovsky Criteria would fail to
make a choice.
4. Arrow's Impossibility Theorem
Kenneth Arrow, a winner of the Nobel prize in Economics, has shown that it is
not possible to establish preference rankings for a group of individuals based solely on
the preference rankings of the individuals in the group. He introduced several basic
criteria that should not be violated by any such social preference ranking:
(1) Efficiency and the Pareto Rule. If everyone prefers one choice to another, then the
social preference ranking should correctly choose that rule. This means that the social
preference ranking should be efficient in choosing what all individuals unanimously rank
as most desirable.
(2) Comprehensive Applicability. The social preference ranking should apply to any
combination of possible individual preference rankings.
(3) Independence of Irrelevant Alternatives. The choice between any two alternatives
should be decided only on the basis of individual preferences for the two choices and
should be independent of any other alternatives. For example, vote trading and logrolling
practiced by legislators would not be possible by this criterion.
The only rule which satisfies these criteria is the rule of dictatorship. However, such a
rule is clearly a socially and politically undesirable way to run a household, a corporation
or a government.
Without the possibility of defining a social welfare function, it is no longer
possible to define what the “public interest” might be. This is potentially a problem
when crucial cases, such as Munn v. Illinois, which are the cornerstone to legal economic
regulatory theory define and depend upon the concept of “public interest.” Arrow’s
Impossibility Theorem leads to the conclusion that there will be some point at which an
arbitrary decision must be made which determines what the public interest is.
From a legal perspective, such arbitrariness means that it may not be possible to
determine what is in the best interest of society, even if we were to know the desires and
priorities of every member of society- which, of course, we almost never know anyway.
American legal practice has evolved through time in how the public interest is to be
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defined. Attempts by the court to determine what is in the public interest have been
frequent and have frequently been failures. For example, the attempt to define a “fair”
rate of return in Smyth v. Ames1 resulted in decades of complex judgments and confusion
until the court finally relented in Hope Natural Gas.2 As a result, the court increasingly
defers to the judgments of agencies in the Executive Branch of government to make
determinations of what is in the public interest. When such agencies fail to use “due
process” in determining what is in the public interest they may be accused of
“arbitrariness and capriciousness.” In other words, in their role as the dictators who
determine the public interest they are not using adequate procedures for deciding public
choices.
B. Theory of the Second Best
Can there be any system of law or public choice if the public interest- and social
welfare- cannot be defined? Even if a welfare function could be defined, we might not be
able to use it- virtually any change would require a revaluation of all possible choices to
determine how the public interest changes.
Instead we must look for “second best” solutions which can be used without
requiring constant recalculation of social welfare. Rather than trying to redistribute all
resources with every change in social welfare, it is more reasonable to choose
incrementally- in other words, to choose what departures are to be made from the current
distribution of resources and wealth, which are called “endowments.” Such changes in
endowments recognize that people have property rights in resources that must be
respected and that any departures from the current endowment must meet certain criteria.
But what criteria should be used? While it may not be possible to argue from a
global perspective what is in the best interest of a community when examining a range of
different choices, it may be possible to use an efficiency argument for determining
responsibilities of members of a society. In this section two economic approaches are
presented. One, the approach of Pigou, simply defines what property rights are and
assigns responsibility for property losses on the basis of what private party causes the
property loss. Such an approach is efficient because it is relatively simple to determine.
The other, the approach of Coase, seeks to minimize social costs when property rights
must be violated, which can become quite complex, particularly private costs are
intangible.
1.
The Pigovian Approach
1
Smyth V. Ames, 169 U.S. 466 (1898)
2
Federal Power Com'n v. Hope Natural Gas Co., 320 U.S. 591 (1944)
4
Arthur Pigou3 provided a “second best” approach to the public interest in defining
how negative externalities should be treated. He suggested that the person who causes an
externality should be the person who pays for getting rid of that externality. Economists
refer to this as the internalization of externalities. It can be accomplished through
taxation, prohibition, or any number of other government interventions, but it also can be
taken care of by simply compensating the third parties who are affected by the
externalities.
However, the problem of externalities depends upon two people, not just one. For
example, a pioneer in the early days of the West might pollute a river with the waste of
farmyard animals without anyone feeling the effect of the externality. It is not until
someone moves in downstream who must use the polluted water that the externality
becomes a problem. Pigou’s criterion would require the polluter to pay the downstream
user or stop polluting. If the polluter doesn’t pay then the downstream user experiences
costs. Someone must lose out.
2.
The Coasian Approach
Table A. Options for Solving the Rancher-Cowboy Problem using the Coase Approach
transaction
Cost
Cost
Homesteader
owns land
Cowboys have
right to graze
(res communes)
a. Allow cattle to roam
(cowboy pays damages)
b. Put up fences
c. Pay homesteaders not to
plant
d. Don't run cattle through
ranches
MIN social cost
a. Allow cattle to roam
(homesteader suffers
damages)
b. Put up fences
c. Don't plant crops
d. Pay cowboys not to run
cattle.
MIN social cost
Total
Cost
90
110
0
0
90
110
100
0
100
200
0
200
90
90
110
100
0
0
0
90
110
100
200
0
200
90
Ronald Coase recognized that the different solutions to such a problem lead to
different social costs. The social cost of a solution is the sum of the private costs to the
different parties. Coase recommended that the social cost be minimized. For example,
Table A represents a problem faced in the Midwest during the last half of the 19th
century. Ranchers wanted to put up barbed wire to protect their property from grazing by
passing herds being run between Texas and Kansas by Cowboys. Suppose the Ranchers
are entitled to the right to enclose their land in barbed wire. Then four options might be
3
Arthur Pigou. The Economics of Welfare 9New York: AMS Press, 1978 [1924]
5
those shown in the top four rows in Table A. On the other hand, the same options shown
in the bottom four rows of that table apply to the situation where the Cowboys are
entitled to the use of the land. Minimizing total cost is the same regardless of who has
the entitlement!
If the parties to the transaction have complete information and there are no “transaction”
costs- costs of researching, deciding and making any compensations or exchanges-,
Coase was able to show that entitlements didn’t matter to the minimum social cost
solution. It would result in the same choice- although there would be a change in who
would be compensated (ie. There is a change in endowments).
On the other hand, Table B shows what might happen if there are transaction
costs. Now the minimums of total costs are different, depending upon who owns the
property right to the land.
Table B. Change in Choices with transaction costs.
Options
Homesteader
owns land
a. Allow cattle to roam (cowboy
pays damages)
b. Put up fences
c. Pay homesteaders not to plant
d. Don't run cattle through ranches
Cost
90
Transaction
Cost
25
Total
Cost
115
110
100
200
0
25
0
110
125
200
MIN social
cost
Cowboys have
right to graze
MIN social
cost
110
a. Allow cattle to roam
(homesteader suffers damages)
b. Put up fences
c. Don't plant crops
d. Pay cowboys not to run cattle.
90
0
90
110
100
200
0
0
25
110
100
225
90
In Table B each of the four options have a different transactions cost, depending upon
who owns the entitlement to the use of the land. For example, option “a” which allows
the cattle to roam might involve $25.00 of transaction costs to the ranchers because they
would have such a high cost of getting the cowboys to pay. But if the cowboys had the
entitle to roam, they would need to do nothing; the only costs would be the private costs
of the ranchers who would have to pay for the damages from the grazing. On the other
hand, option “d” which would require the farmers to pay the cowboys for not running
cattle would be tough to collect by the cowboys. But, if the farmer owned the
entitlement, there would be no compensation needed if the cowboys didn’t run their
cattle. These differences in transaction costs depend upon who owns the entitlement.
Now entitlement ownership does make a difference in which option is chosen.
Even defining who has an entitlement has transaction costs. Legal cases often are
about defining property rights and legal costs are important transaction costs. Choices by
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legislatures usually involve issues of defining entitlements. Lobbying often imposes
large transaction costs. Decision making in the legislature imposes large transaction
costs on society, if not the direct parties to a dispute. Because of large transaction costs
the socially optimal choice may never be made and many potentially beneficial
compensations may never occur.
C.
Constitutions and Voting Rules
Combined with Arrow's Impossibility theorem, the compensation principles
provide an inadequate basis for justifying cost-benefit analysis or other types of
government studies. The lack of theory has not slowed the evolution and development of
new types of government studies. Each agency has developed its own format for
different kinds of studies. Because of the large number of different kinds of studies, Cost
benefit analysis or any other type of study are rarely the final word to decision making
because decision making is inherently a political process. A general manager must be
adept in this political process, but there often is little in the experience in lower tiers of a
firm which prepares a manager for the political battles that face the firm. Irv Shapiro of
Du Pont once characterized the difference as follows:
"In the business world, we optimize; in the political world, we
compromise. In business, you look for efficiency. The financial analysis
tells you that if you do this, you will get these results; if you do that, you
will get other results. At that point, a businessman makes a decision."4
But in the political world, that's just the beginning of the analysis. Then you ask, 'Where
are the political pressures? What is the political interest? What are the constituency
groups? How do you respond to everybody's aspirations?' And so you're always working
out compromises. In business, your goals are more precise and measurable.
Everybody in a company has the same objective. “... it's quite different than it is in the
public sector, where compromise is the only way to make progress."5 In this process of
compromise, the general manager must find allies, convert others to the firm's point of
view, and decide what the firm must give up to get what it needs.
The focus on the number of people needed to reach an agreement is not a choice
on the merits of a decision, but a choice about the procedure used to make a decision. In
a football game, the question is not which team is better (decision on the merits), but
rather which rules should they play by (decision on procedure). In fact the appeals
procedure in our judicial system is designed not to review the merits of a case,
but only to analyze whether proper procedure was used to decide the case. Decisions
about procedure are decisions about how to make choices, not decisions about what
choice to make.
4
5
Shook, op. cit. p. 226
Shook, op. cit. p. 226
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Often the choice of the way to make decisions will determine the outcome of
decisions. This is as true for the political process outside of the firm as it is for the
political process within the firm. A manager must understand how to set up and
control the rules of how decisions are made in order to maintain control over the content
of the decisions.
The format for decision making is established by a constitution. The constitution
may take the formal shape of the U.S. Constitution in our political system, the Robert's
“Rules of Order” in a parliament or meeting, or the standard operating procedures
(S.O.P.) of a firm. A constitution sets out priorities for handling different issues and the
voting procedures for coming to agreement.
Unfortunately economists have found that no one voting procedure can be
efficient in making the correct, socially most desired choice, decisive in insuring that
a choice is in fact made, and equitable in the treatment of all individual decision makers.
In fact organizations use a variety of different rules for making group decisions, each of
which has at least one deficiency in meeting the criteria of efficiency,
decisiveness, and equity:
1. Unanimity: All members of the group must agree. This is the criterion implicitly
required by the Pareto rule. While it is the best rule for the purpose of efficiency and
equity, it rarely leads to decisive choices. Unanimity may allow any individual
to impede everyone else and to extract a payment for cooperation. Unanimity is so
obstructive to action that it often breeds the frustration which overturns it, and replaces it
with its opposite, dictatorship.
2. Dictatorship: When one individual dictates the choices for the whole group,
decisiveness is achieved. However, such decision making is completely inequitable,
since no one else has a contribution to make. It is also highly inefficient since there is no
channel for taking into account the preferences of others. Dictatorship is popular in wars
or battles for the survival of companies, but over long periods of time it is likely
to breed corruption and inefficiency.
3. Majority Rule: Fifty percent of the population plus one person can determine a
social choice. However, if that many people are not able to come to an agreement on
matters, then the majority rule becomes indecisive. The rule is inefficient since as much
as 50% minus one person do not have preferences that are consistent with the social
choice. The rule is inequitable to the extent that these people can be ignored if the
majority so
decides.
4. Plurality Rule: Whoever receives the highest vote wins. It is usually decisive. This
rule is identical to the majority rule whenever there are only two choices. However,
when there are more than two choices, then the choice backed by a strident minority can
win, even though a majority would have chosen one of the other choices in any two-way
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election. Plurality is therefore extremely inefficient. It is also inequitable since it
potentially excludes an even greater population than the majority rule.
5.
Ladders: In football, baseball, tennis and many other sports, playoff ladders are
used to successively eliminate teams in a series of playoffs that eventually narrow to a
winner; such ladders are decisive. However, ladders often produce winners who few
people would consider the best teams or the best players. Perhaps the winner had an
"easy draw" of opponents in one side of the ladder or perhaps the best player was
eliminated early because of a bad day and never had a chance to play the eventual
winner. The ladder is therefore inefficient and often inequitable. To improve equity and
efficiency, the Condorcet procedure should be used.
6. Condorcet Procedure: Every possible pairing of choices is made and the choice that
wins in all of its paired contests wins. Unfortunately it's rare that someone wins in all
contests which means the rule is indecisive. However, the rule is efficient in reflecting
the truly desired choice and is equitable in allowing all possible choices to be considered.
7. Social Rankings (Borda Count): Different choices can be ranked by different
members of an organization and then these ranks can be combined and compared for each
possible choice. While being fairly equitable, such rankings permit extensive gaming by
individuals who learn how to give rankings that do not reflect their actual preferences but
which will give added likelihood for their choice to win; such rankings can therefore
be inefficient in reflecting what is socially desirable.
Between the extremes of dictatorship and unanimity there is a range of choices about how
many people are needed to decide an issue. The majority rule requires that any choice be
made by 50% of the people plus one. However, some decisions, such as the changing of
the U.S. Constitution requires a 3/5 vote of the states. To start a meeting it is sometimes
necessary to have a certain minimum number of people in attendance, called a quorum.
In each of these cases, a choice has been made about where the cost minimum can be
achieved when both the costs of gathering people together to agree and the external costs
of excluding people are considered.
In the social choice on the CFC issue, we can see examples of several of the
voting procedures. The Montreal Protocol set down a voting rule by which countries
would ratify the phaseout of CFCs. If eleven countries ratified the treaty and those
eleven accounted for at least 2/3 of CFC production then the Protocol would go into
effect.6 Such a rule reflected the tension between considering countries as political units
and considering the size of their impact© a tension reflected in the set up of the U.S.
Congress which distinguishes between the Senate (the political units) and the House of
Representatives (chosen on the basis of the size of population).
Philip Shabecoff."Industry Acts to Curb Peril in Ozone Loss" in ”The New York Times” (March 21,
1988) p. 11
6
9
When the Senate considered the Montreal Protocol it voted 83-0 in favor of
ratifying the Protocol. Such a unanimous decision was not required; only two-thirds of
the senators were needed to ratify a treaty. Here we have a rare example of a unanimous
decision. The very fact of the unanimity in the Senate suggests what a lopsided issue the
problem of CFCs had become by 1988. Nevertheless, from the point of view of Du Pont,
the issue was not so clear. A firm favors a much more decisive decision making process
than U.S. society as a whole. Usually they appoint a CEO who seems to have the powers
of a dictator. But let's look at a the decision making process at Du Pont as described by
the late former CEO Irv Shapiro:
In all companies ,...., the chief executive has a board that's looking over
his shoulder and holding him accountable. If he tried to play the game of
creating short-term gains that would make him look good but would
hurt the company years from now, the directors would soon raise the
question, 'Are you doing the right thing?' So he'd be held accountable. But
if the selection process has worked properly, the person in the job knows
better than to play the game that way, in any case. 7
We have evidence here of something less than dictatorship. The board is a representative
of the stockholders. If the board exerts its power, a firm can rapidly be governed by a
representative government, not a dictatorship.
It was Du Pont's chairman of the board, R. E. Heckert, who announced to the U.S.
Senate that it was premature for Du Pont to end CFC production. It was also R. E.
Heckert, who two weeks later, after the meeting on the Montreal Protocol and more
evidence from the National Air and Space Administration (NASA) on ozone damage,
who reversed Du Pont's position. Du Pont agreed to phase out its CFC production. One
of the advantages of a dictatorship or a small number of decision makers is the speed
with which action can be taken.
7
op. cit. pp. 211-2
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