Legal Theory Blog

Introduction 

Almost every law student get's some
introduction to normative law and economics in their first year of law
school.  One of the basic ideas of normative law and economics is that
the law should be "efficient."  But what does efficiency mean? 
For economists, "efficiency" is a technical idea–with only a
tangential connection to the use of "efficiency" in ordinary speech. 
In order to understand economic efficiency, we will look at what are
called the Pareto principles and a related idea that is sometimes called Kaldor-Hicks efficiency.

In addition to explicating the idea of efficiency, we will take a
qucik look at some of the criticisms that might be made of this
concept.  Although many economists operate on the assumption that
"efficiency" is an uncontroversial good, that conclusion is
controversial both inside and outside of the discipline of economics.

As always, the Legal Theory Lexicon is aimed at law students,
especially first-year students, with an interest in legal theory.  This
is very much a "quick and dirty" look at a topics upon which whole
books can be written.

The Idea of Utility and the Problem of Measurement 

There
are several plausible formulations of normative economics, but almost
all of normative economics begins with the fundamental idea of utility
as a conception or measure of the good. Economists may disagree about
the nature of utility, the relationship of utility to social welfare,
and the role of welfare in public policy, but most (but not all)
economists would assent to the abstract proposition that ceteris
paribus more utility is a good thing.

Historically, one of the
most important interpretation of utility is associated with the great
English philosopher and legal theorist Jeremy Bentham.  Bentham defined
utility in terms of pleasure (and the absence of pain).  Bentham argued
that laws and policies could be evaluated by a "hedonic calculus"–the
best policy produces the greatest number of "hedons"–units of
pleasure.  But Bentham's idea does not provide a workable basis for the
science of economics, because there is no workable method for measuring
hedonic values.

Economists have interpreted the idea of "utility" as
a function of preferences–the subjective values that individuals place
on states of affairs.  If individual I prefers state of affairs X to
state of affairs Y, then X produces more utility for I than does Y.

The
move to preferences as the basis for utility offered economists the
possibility of solving the problem of measurement.  How can we measure
preferences?  In order to understand the way that economists answer
this question, we need to distinguish between cardinal and ordinal interpretations of utility. An ordinal utility
function for an individual consists of a rank ordering of possible
states of affairs for that individual. An ordinal function tells us
that individual I prefers possible world X to possible world Y, but it
doesn’t tell us whether X is much better than Y or only a little
better.  A cardinal utility
function yields a real-number value for each possible world. If we
assume that utility functions yield values expressed in units of
utility or utiles, then individual I’s utility function might score
possible world (or "state of affairs") P at 80 utiles and possible
world Q at 120 utiles.

The distinction between cardinal and ordinal utilities is
potentially important for utilitarianism, at least on certain
interpretations. As a theory of evaluation, "utilitarianism" can be
stipulated to refer to the view that an action is the best action if
and only if the action maximizes utility when compared with all
possible alternative actions. For technical reasons, utilitarianism
requires both cardinality and full interpersonal comparability.  But
both cardinality and interpersonal utility comparisons are
problematic.  It is difficult to measure cardinal utilities for even a
single individual. 

And it is even more difficult to compare utilities among different
persons.  How can we compare the value that I assign to consuming a
glass of fine wine with the value that you assign to imbibing a fine
single-malt scotch?  And some things seem even more incommensurable:
how do we compare the value that Ben derives from viewing a beautiful
photograph by Ansel Adams to the joy that Alice takes in serving meals
to the homeless on Thanksgiving Day?  Or Ben's satisfaction from
solving difficult math problem with Alice's pleasure in a new pair of
Jimmy Choo's?  These examples suggest that the problem of interpersonal
comparison may be compounded by the problem of incommensurability–the
idea that some preferences may not be comparable on the same scale.

This point about the difficulties faced by utilitarianism is closely
related to the history of welfare economics, the explicitly normative
branch of economic theory. Both cardinality and interpersonal
comparability pose measurement problems for economists. The challenge
for welfare economics was to develop a methodology that yields robust
evaluations but does not require the cardinal and
interpersonally-comparable utilities.

The Pareto Principles  This is the point at which the Pareto
principles arrive on the scene. Suppose that all the information we
have about individual utilities is ordinal and not interpersonally
comparable.  In other words, each individual can rank order states of
affairs, but we (the analysts or policymakers) cannot compare the rank
orderings across persons. The weak Pareto principle
suggests that a state of affairs P is socially preferable to state of
affairs Q, if everyone’s ordinal ranking of P is higher than their
ranking of Q. Weak Pareto doesn’t get us very far, because such
unanimity of preferences among all persons is rare.

The strong Pareto principle
suggests that state of affairs P is socially preferable to state of
affairs Q, if at least one person ranks P higher than Q and no one
ranks Q higher than P.  Or to put it more colloquially: strong Pareto
says that it is good to make one person better off if no one will be
made worse off. Unlike weak Pareto, strong Pareto does permit some
relatively robust conclusions. The so-called new welfare economics was
based on the insight that market transactions without externalities
satisfy strong Pareto. If the only difference between state P and state
Q is that in P, individuals I1 and I2 engage in an exchange (money for
widgets, chickens for shoes) where both prefer the result of the
exchange, then the exchange is Pareto efficient—and
hence satisfies the strong Pareto principle. A state of affairs where
no further Pareto efficient moves (or trades) are possible is called Pareto optimal.
The assumption about externalities is, of course, crucial. If there are
negative externalities of any sort, then the trade is not Pareto
efficient.

From Pareto to Kaldor Hicks  Because Pareto efficiency
assumes no negative externalities, it has significant limits as a
normative concept.  For example, there are many questions of legal
policy in which externalities are particularly important–pollution is
a classic example.  If I operate a factory that pollutes the air or
water, my action may cause harms to my neighbors.  If even one person
would lose by the move from state P to state Q, then that move is not
Pareto efficient.  So if Pareto efficiency were the only normative
principle available to law and economics, the consequence would be that
economics would have nothing to say about many of the most important
legal questions, e.g. many questions of environmental law.

Kaldor-Hicks is a technique for extending the normative implications
of economic analysis.  Here is how it works.  We take a situation in
which their are externalities, e.g. pollution that affects third
parties. Let's assume that markets can't reach a Pareto-efficient
outcome.  That assumption might be accurate because of high
transactions costs, as in the case where the pollution impacts on so
many individuals that bargaining is impractical or costly. 
Counterfactually, however, we can imagine that there were zero
transaction costs.  We can then ask what outcome would occur if those
who were effected by the externality (the pollution) entered into a
Pareto-efficient bargain that compensated them for their losses. 
Outcomes that would be Pareto-efficient if there were zero transaction costs are Kaldor-Hicks efficient.

Kaldor-Hicks extends normative law and economics to a wide range of
situations in which externalities and transaction costs prevent markets
from reaching Pareto-efficient outcomes.

Criticisms of Efficiency  Does efficiency (either Pareto or
Kaldor-Hicks) provide an attractive normative yardstick by which legal
policies may be judged?  That's a complex question, but we can quickly
explore a few critical ideas:

Wealth Effects  When
Pareto is applied to market transactions, preferences (or utility) is
interpreted as a function of willingness to engage in market
transactions (or willingness to pay).  But willingness to pay is a
function of wealth.  Thus, someone who is very poor may be willing to
engage in degrading or dangerous work, because they have no real
alternative.  But this does not mean that the efficient transaction is
better than non-Pareto-efficient alternatives, which might involve a
redistribution of wealth that would obviate willingness to engage in
degrading work. (These alternatives will not be Pareto efficient,
assuming that redistribution would not be preferred by all, including
those whose wealth is being redistributed.)

Bad Preferences  Pareto and Kaldor-Hicks assume that state A
is better than state B on the basis of individual preferences.  But
preferences aren't fixed.  Preferences can change for a variety of
reasons and some preferences may be better than others.  For example,
the preference to sexually abuse children is considered
evil–satisfying it is not a moral good.  Efficiency takes preferences
as a given: it can't tell us whether the law should attempt to shape or
alter preferences.  But outside of the discipline of economics, there
is almost universal agreement that satisfaction of evil preferences is
intrinsically bad.  And many people believe that society has a
legitimate interest in undertaking measures that will change such
preferences.

Kaldor-Hicks and Rights  Kaldor-Hicks characterizes a move
from state P to state Q as efficient even if a third party is injured
by the move.  That injury may involve unfairness or a violation of the
third party's rights.  From a consequentialist perspective, rights
violations may have no significance in themselves, but deontological
normative theories do afford moral signficance to rights.  From a
deontological point of view, taking rights seriously may require
government to forbid some Kaldor-Hicks efficient transactions.

Efficiency & Social Welfare Functions  Some
economists move beyond Pareto and Kaldor-Hicks and embrace what are
called "Bergson-Samuelson Social Welfare Functions."  There is a
separate entry on this idea (Social Welfare Functions)
in the Legal Theory Lexicon, but the general idea is to reintroduce
interpersonal comparability for individual utilities.  The key
difference between Kaldor-Hicks and Berson-Samuelson arises in cases
where the hypothetical compensation seems unusually large, and an
extreme version of this would be the case of someone who would not
accept any level of compensation–the hold out problem. 
Bergson-Samuelson permits us to assign an interpersonally comparably
utility value to the welfare that the "hold out" would lose, and that
value may be much lower than the demanded compensation would suggest.

Conclusion  Efficiency is one of the bedrock ideas for normative law and economics.  The point of this Lexicon entry is to give you the tools to understand what economists mean by efficiency.

Related Entries

Legal Theory Lexicon 002: The Coase Theorem

Legal Theory Lexicon 008: Utilitarianism

Legal Theory Lexicon 025: Social Welfare Functions

References

Lawrence B. Solum, Public Legal Reason

(This entry was last revised on January 25, 2008.)