We’ve been talking about economic efficiency and why it’s a good thing to care about. Today I want to look at this hardest of cases through the efficiency lens.
Let’s suppose Bill’s water is worth, say, $10,000 to him. He’d be willing to pay that much for it, and he wouldn’t cheerfully sell it for less. Why such a high number? It’s not because Bill enjoys his water any more than you or I do — it’s just because Bill happens to be filthy rich.
And the dying fellow? He’s willing to pay up to $100 for that water. He’d pay more if he had it, but $100 happens to be all he has in the world.
Should the law require Bill to give up his water? And regardless of the law, what’s his moral obligation?
A few observations:
First, there are multiple versions of the efficiency criterion, and they usually all give the same answer — but not always. So we have to specify which version of the efficiency criterion we’re talking about. I’ll stick with the simple version that says $10,000 beats $100, so Bill gets to keep the water.
But that’s not the end of the story. Suppose our dying man (call him “Fred”), who slept through his economics class and never learned about the efficiency criterion, manages forcibly to snatch the bottle out of Bill’s hand. Now that he’s got the bottle, he wouldn’t sell it for anything less than $50,000. Now $50,000 beats $10,000 so Fred gets to keep the water.
So according to the efficiency criterion, the water is rightfully Bill’s — unless Fred manages to steal it, at which point it becomes rightfully Fred’s. Unless of course Bill manages to steal it back again, in which case it’s rightfully Bill’s. Here the efficiency criterion flirts with incoherence, and we have good cause to mistrust it.
Second, where’s the incoherence coming from? Answer: it comes entirely from the difference between Fred’s Willingness to Pay, which is constrained by his bank balance, and in this case is only $100, and his Willingness to Accept, which is $50,000. In informal accounts of the efficiency criterion, we (or at least I) sometimes talk about “what the water is worth to Bill” versus “what the water is worth to Fred”. But “what the water is worth to Fred” is an ambiguous phrase. Does it mean Willingness to Pay or does it mean Willingness to Accept? In this example, the answer matters. A lot.
Third: We rarely have to worry about such discrepancies. That’s because Willingness to Pay and Willingness to Accept are in most cases nearly equal. They are nearly equal whenever the stakes are small compared to people’s incomes — which is most of the time. (In our example, the stakes are high relative to Fred’s income, which is why the two Willingnesses can differ so drastically.)
Why do I say that Willingness to Pay and Willingness to Accept are in most cases nearly equal? Because I know how to prove it. I prove it every year to my “Topics in Microeconomics” students, using about two hours of classroom time.
I can’t give that proof in a blog post, but take my word for it — when the stakes are small compared to your income, your WTP and WTA will be nearly equal. And most of the things you care about, most of the time, represent pretty small fractions of your income. So most of the time, the efficiency criterion is a whole lot more coherent than in the case of Bill and Fred.
Fourth, economists are therefore most comfortable using the efficiency criterion when the stakes are small. We recognize that the criterion becomes a lot harder to swallow when the stakes are large, and we have a good theory of why that’s so.
Fifth, in matters of economic policy, the stakes are usually small, even when they involve human lives. For example: Should we spend $10,000,000 to build a guard rail that we are (somehow) certain will save exactly one life? If there are a million people affected, and you are the average person among them, then your share of the cost is $10, and your share of the benefit is a one-in-a-million chance that your life will be saved. That one-in-a-million chance is a small thing, so your Willingness to Pay and your Willingness to Accept are nearly equal. If that common value is $5, you’ll consider the guard rail an extravagance; if it’s $15, you’ll consider it a wise investment. Here the efficiency criterion can be an excellent guide to giving the people what they want.
Sixth, it’s important to distinguish between policy recommendations and moral stances. The efficiency criterion is a guide to policy. In The Big Questions, I introduced the Economist’s Golden Rule, which is a guide to personal morality, using the same calculations that go into the efficiency criterion. Like the efficiency criterion, the EGR flirts with incoherence when the stakes are large but not when they’re small.
Seventh, I have one more thing to say about this example but I think it’s worth saving for a separate blog post, later in the week.