Uwe E. Reinhardt is an economics professor at Princeton.



Although economists are the butt of endless jokes and have skidded into disrepute after failing to predict the recurrent asset booms and busts in the economy — some even apologized to the queen of England — many decision-makers in the public and private sectors continue look to economists for advice.

What these decision-makers seek are not only economic forecasts but insights on the efficiency of proposed public policies. Efficiency is one concept economists are assumed to understand.

Efficiency is the seemingly value-free standard economists use when they make the case for particular policies — say, free trade, more liberal immigration policies, cap-and-trade policies on environmental pollution, the all-volunteer army or congestion tolls. The concept of efficiency is used to justify a reliance on free-market principles, rather than the government, to organize the health care sector, or to make recommendations on taxation, government spending and monetary policy.

All of these public policies have one thing in common: They create winners and losers among members of society.



Therefore, an overarching question (on which economists themselves seem unable to agree) is whether economists in their role as social scientists should make recommendations on such issues at all — even if these recommendations are driven by the quest for greater efficiency. In fact, what does efficiency actually mean in economic analysis?

In exploring these questions with my students, I use this highly stylized hypothetical example:

Here we assume that someone (e.g., the invisible hand of a free market, or a democratic government, or a benevolent dictator) allocates a given set of real resources to the production of goods and services, which are then distributed somehow to the two people, A and B, who inhabit this society.

This hypothetical drives home the point that in the lexicon of economists, efficiency is a concept applied to both the production of goods and services and to their distribution among members of society. That’s because economists view human welfare (or “happiness”) as the overarching objective of all productive economic activity. I refer to this two-faceted process simply as “resource allocation.”

We assume in the chart that one can measure whether a change in the allocation of resources, which might result from a public policy, makes one or both people feel happier or less happy. Movements to the right on the horizontal axis signify that person A is happier. Movements up the vertical axis signify that person B is happier. A given point in the graph thus illustrates a particular distribution of happiness between the two people, which in turn reflects a particular underlying allocation of real resources in the economy.

Suppose initially that the available resources were allocated so as to land A and B at point X in the chart.

Now assume that it were possible to reallocate productive resources so that person B would be happier but person A no less happy. Perhaps it is possible to increase productivity in the growing of broccoli, which A hates but B craves, without sacrificing the production of any other good or service, and that B got all the additional broccoli. A and B might then land at point Y, where B is happier and A no less happy. One could concoct a similar story that would land the pair at point Z, where A is much happier and B no less happy.

Economists would call any resource allocation that would land A and B anywhere in the line segment Y-Z “Pareto superior” to point X, in honor of the Italian economist Vilfredo Pareto (1848-1923), who formalized the problem this way. Policies that move the economy from an inefficient point X toward line segment Y-Z will enhance overall social welfare, because they make some people better off and no one worse off. One can recommend them to policy makers with a good conscience.

Note that every welfare distribution falling on line segment Y-Z satisfies the following condition: it would be impossible at any such distribution to increase further the welfare of one person without making the other person feel less well off.

Economists call resource allocations that meet this condition “Pareto efficient,” or, as the Nobel laureate Kenneth Arrow notes in his seminal paper discussed last week, “Pareto optimal.”

The word optimal derives from the Latin “optimum,” which means best. It must strike readers as an odd term for economists to use in this context. After all, how can both point Y and point Z, or any particular point in between them on line segment Y-Z, be best?

To put it another way, would A necessarily agree that welfare distribution Y represents the optimal use of society’s available resources, given that welfare distribution Z could also be attained with the same real resources? In a similar vein, would B judge point Z best? How can one use the word best in this context, when so many alternative welfare distributions are candidates for that label?

One suspects that the term optimal came into widespread use among economists as a marketing device to promote their normative propositions based on efficiency. But as Professor Arrow warns his colleagues on this point:

A definition is just a definition, but when the definiendum is a word already in common use with highly favorable connotations, it is clear that we are really trying to be persuasive; we are implicitly recommending the achievement of optimal states.

Alas, it gets worse. Astute readers will have figured out by now that literally every point falling on the entire solid curve in the graph must be “Pareto optimal” by the economist’s definition of that term, not only those falling on line segment Y-Z. That circumstance makes the economist’s use of the word optimal even more dubious.

Can it be assumed, for example, that individual A (and his or her political representatives) would judge a move from the inefficient welfare distribution X to the efficient distribution R as optimal, and similarly for B and point U? Opening the border to foreign workers willing to accept lower wages than do American workers might be such a policy.

Indeed, can it be said that a more efficient resource allocation is better than a less efficient one, given the changes in the distribution of welfare among members of society that these allocations imply?

These are not idle academic ruminations. Suppose a restructuring of the economy has the effect of increasing the growth of average gross domestic product per capita, but that the benefits of that growth accrue disproportionately to a minority of citizens, while others are worse off as a result, as appears to have been the case in the United States in the last several decades. Can economists judge this to be a good thing?

Indeed, how useful is efficiency as a normative guide to public policy? Can economists legitimately base their advocacy of particular policies on that criterion?

That advocacy, especially when supported by mathematical notation and complex graphs, may look like economic science. But when greater efficiency is accompanied by a redistribution of economic privilege in society, subjective ethical dimensions inevitably get baked into the economist’s recommendations.