The most misleading definition in economics (draft excerpt from Economics in Two Lessons)

After a couple of preliminary posts, here goes with my first draft excerpt from my planned book on Economics in Two Lessons. They won’t be in any particular order, just tossed up for comment when I think I have something that might interest readers here. I’ll update as I go, in response to comments and criticism; this may create some difficulties reading the comments thread, but hopefully the improvement in the final product will be worth it.

To remind you, the core idea of the book is that of discussing all of economic policy in terms of “opportunity cost”. My first snippet is about

Pareto optimality

The situation where there is no way to make some people better off without making anyone worse off is often referred to as “Pareto optimal” after the Italian economist and political theorist Vilfredo Pareto, who developed the underlying concept. “Pareto optimal” is arguably, the most misleading term in economics (and there are plenty of contenders). Before explaining this, it’s important to understand Pareto’s broader body of thought, one which led him in the end to embrace fascism.

Pareto and the libertarian path to dictatorship

Pareto sought to undermine the version of liberalism that dominated 19th century economics, according to which the optimal (most desirable) economic outcome was the one that contributed most to human happiness, often (if somewhat loosely) summed up as ‘the greatest good of the greatest number’. Particularly as developed by the great philosopher and economist John Stuart Mill, this is a naturally egalitarian doctrine.
The egalitarian implications of the classical framework reflect the fact that the needs of poor people are more urgent than those of the better off. So, the happiness of the community as a whole all be increased by policies that benefit the poorest members of the community, even if these benefits come at the expense of those who are better off. It follows that a substantial degree of income redistribution will be social desirable and that large accumulations of individual wealth, which contribute only marginally to the happiness of a small number of people are undesirable in themselves, though they may in some circumstances be a by-product of desirable policies.
Pareto’s big achievement, further developed by a large number 20th century economists, was to show that much of economic analysis could be undertaken without invoking the concept of utility. Hence, interpersonal comparisons of happiness, which invariably lead to the conclusion that redistributing wealth more equally is beneficial, could be dismissed as ‘unscientific’.
Pareto didn’t stop with an attack on the economic implications of Mill’s approach. Mill’s philosophical framework implied support for political democracy, including the enfranchisement of women. Since everyone’s welfare counts equally in the classical calculus, the political process should, as far as possible, give everyone equal weight.
Pareto reversed this reasoning, arguing that a highly unequal distribution of income was both inevitable and desirable; he proposed what he called a power law, described by a statistical distribution which also bears his name. Pareto’s “Law” may be summed up the 80-20 proposition, that 20 per cent of the population have 80 per cent of the wealth.
The supposed constancy of income distribution implies that any attempt at redistribution must be essentially futile. Even the aim is to benefit the poor at the expense of the rich, the effect will simply be to make some people newly rich at the expense of those who are currently rich. Pareto called this process ‘the circulation of elites’. (In his dystopian classic 1984, Orwell has the Trotsky-like character Emmanuel Goldstein present the same idea as the starting point of The Theory of Oligarchical Collectivism. Orwell almost certainly derived the idea from James Burnham, an admirer of Pareto whose work Orwell saw as the embodiment of ‘power worship))
All of this led Pareto to become one of the first advocates of a political position combining an extreme free-market position on economic issues with hostility to political liberalism and democracy. Pareto welcomed the rise of Mussolini’s fascist regime, and accepted and accepted a “royal” nomination to the Italian senate from Mussolini. However, he died in 1923, less than a year after
Pareto was not really a fascist however. Rather, he developed a version of liberalism similar to that of his more famous successors, Hayek and Mises, both of whom embraced and worked for murderous regimes that had come to power by suppressing democratic socialist parties. Like Pareto, neither Hayek nor Mises can properly be described as fascists – they weren’t interested in nationalism or in the display of power for its own sake. Rather, their brand of liberalism was hostile to democracy and indifferent to political liberty, making them natural allies of any authoritarian regime which adheres to free market orthodoxy in economics. (Fn Supporters of Hayek and Mises commonly describe themselves as “libertarians”, but their alliance with brutal dictators makes a travesty of the term – they have been derisively described as “shmibertarian”).

Pareto optimality

Now back to “Pareto optimality”, and why it is such a misleading term. Describing a situation as “optimal” implies that it is the unique best outcome. As we shall see this is not the case. Pareto, and followers like Hazlitt, seek to claim unique social desirability for market outcomes by definition rather than demonstration.

If that were true, then only the market outcome associated with the existing distribution of property rights would be Pareto optimal. Hazlitt, like many subsequent free market advocates, implicitly assumes that this is the case. In reality, though there are infinitely many possible allocations of property rights, and infinitely many allocations of goods and services that meet the definition of “Pareto optimality”. A highly egalitarian allocation can be Pareto optimal. So can any allocation where one person has all the wealth and everyone else is reduced to a bare subsistence.

Recognising the inappropriateness of describing radically unfair allocations as “optimal”, some economists have used the description “Pareto efficient” instead, but this is not much better. It corresponds neither to the ordinary meaning of “efficient” nor to the meaning with which the term is commonly used in economics, which is also misleading, but in a different way.

The concept of opportunity cost gives us a better way to think about the possibility of making some people better off while no one is worse off. If such possibilities exist, then there are potential benefits that have no opportunity costs. Conversely, if there is a positive opportunity cost for any benefit, then we can’t make anyone better off without making someone else worse off. So, a “Pareto optimal” situation may be described, more simply as one where all opportunity costs are positive.

33 thoughts on “The most misleading definition in economics (draft excerpt from Economics in Two Lessons)

  1. JQ: I’ve been economics averse since reading Das Kapital, all three volumes, and then Ricardo, Smith, Bentham, Malthus, Locke, Bentham. I could go on. I never read anything from economists thta had the explanatory power of Marcuse and the rest of the Frankfurt School, Habermas and Honneth in particular.

    So, thanks for the plain lingo intro to the current orthodoxy in economics. I have ignored that dialogue to my own peril.

    However, if you don’t mind, you appear to me to be approaching the entire field from a first principles basis without going dep enough into the matter of ‘what are the first principles?’

    I suggest that what stalks your approach is the idea of the market. I could provide a summary of the problems but in this instance offer instead the ideas of Claus Offe: who reasonably asserts that ‘markets’ are nothing supernatural, they are not even natural, rather, they are the superstructural encrustations of human institutions and all of the classed, monied, gendered, ‘raced’ and powered relations that went into their construction in the first instance.

    That they are meerly the products of human culture and activity is the key to understanding that their current forms are contingent, specific and malleable. They contain as much truth about the human condition as the beliefs of the belief system that extinguished itself on the Easter Islands.

    Surley rationality can defeat this insanity but only by cleaving to its principles which excludes reifying multitudes of meaningless interctions as a ‘market’ consciousness.

  2. 1. “.. core idea of the book is that of discussing all of economic policy in terms of “opportunity cost”.

    2. ” The situation where there is no way to make some people better off without making anyone worse off is often referred to as “Pareto optimal”

    Factual situation: V. Pareto (wealthy) married a Russian woman (said to have been peniless) who later left him for a servant. Divorce was not possible for legal reasons.

    How would you describe this situation in terms of opportunity costs?

    3. “Now back to “Pareto optimality”, and why it [1 above] is such a misleading term. Describing a situation as “optimal” implies that it is the unique best outcome.”

    Pareto might agree with you regarding [1] being misleading because, according to Maurice Allais:
    “Pareto defined a situation of maximum efficiency (1906, chapter 6, sec. 33, and Appendix, sec. 89; 1911a, sec. 28) as one in which it is impossible to increase the index function of one individual without decreasing that of some other individual. According to this definition, a situation of maximum efficiency is one in which any index function is a maximum subject to (a) the condition that the index functions of the other consumers be maintained at given levels and (b) the ruling production functions.”

    Allais notes and discusses the similarity to Edgworth’s work on index functions.

    [Source: Maurice Allais, http://www.encyclopedia.com/topic/Vilfredo_Pareto.aspx%5D

    PS: J.S. Mill as well as his father, James, worked for the East India Company during colonial times. Does this mean they ’embraced’ colonialism? (I don’t know. I assume they had to make a living because, in contrast to Pareto, they were not born into wealth, but, not unlike described by Pareto, in his circulation of elites, worked very hard as described in J.S. Mill’s autobiographical note. Pareto had the means to do what he wanted, including switching from engineering to economics, collecting statistics on the distribution of land ownership in Italy and then wealth distributions over time and space and then to social systems. He could afford, financially, to ignore his place in the social pecking order for the apparent pleasure in observing what is going on and exploring the limits of scientific methods in social sciences.)

  3. @Ernestine Gross

    ‘Factual situation: V. Pareto (wealthy) married a Russian woman (said to have been peniless) who later left him for a servant. Divorce was not possible for legal reasons.
    ‘How would you describe this situation in terms of opportunity costs?’

    Is this a trick question?
    For Pareto, the opportunity cost of getting married was that he gave up the opportunity of continuing his lifestyle as a single man.
    For his wife, the opportunity cost of leaving him was that she gave up the opportunity of continuing her lifestyle as his wife.
    For the legislators, the opportunity cost of maintaining the divorce laws was that they gave up the opportunity of giving people access to divorce.

  4. John,

    I agree that Pareto optimality is a highly misleading concept, one that has been much misunderstood and abused by economists to advance policies they could not otherwise defend. And you are right that efficiency does not tell us much if anything about what states of affairs we should prefer. If your book can do something to expose the inconsistencies and illogic, then I look forward to buying a copy.

    It might be that economists are more wrong about welfare economics than anything else. For example, as economists define it, inefficiency might be preferable to efficiency. Problems like the one you discuss are abundant in welfare economics.

  5. I believe it is now established that V. Pareto did not undermine ‘utility’ (in the sense of ‘satisfaction’, which poetically may be called happiness), nor ignore it. As for later authors, G. Debreu proved that under specified conditions on ‘preferences’ (ordering of alternatives), a utility function with specified properties is obtained. All this, however, does not exclude the possibility that the zombies re-surrected their religion without having read either J.S. Mill or V. Pareto and in particular none of the authors from Keynes onward.

  6. John,

    Perhaps it’s just me, in which case you should ignore the point, but I think less is usually more when it comes to killer polemical points. The basic facts about your characters should be left to speak for themselves as much as possible. Instead you provide us with a full interpretation of the facts (admittedly with some caveats to follow which restrain the picture somewhat). But I think more simple facts and, given that at least some reasonable people might not agree with them, I’d prefer less spoon-feeding with definitive interpretations.

    I found the guilt by association via Orwell and Burnham had a tendentious flavour to it.

  7. Another suggestion at the risk of being an ecological nag. I would like to see you include in your book a section on the ecological economics pespective (doesnt have have to be pro – just a discussion.) A possible focus could be the views of Herman Daly nicely summarised in this collection of essays.

    http://www.worldeconomicsassociation.org/downloads/essays-against-growthism/

    Most relevant to your book seems to be chapter 5 which deals with the concept of utility which is covered in this section of your forthcoming book.

    This section is quite short so I’ve reproduced it below to help you decide on whether its worth incorporating. Hopefully its short enough to be “fair dealing”. In any case I suspect you entitled to get it free from RER.

    Chapter 5
    Three limits to growth
    As production (real GDP) grows, its marginal utility declines, because we
    satisfy our most important needs first. Likewise, the marginal disutilitiy inflicted
    by growth increases, because as the economy expands into the ecosphere
    we sacrifice our least important ecological services first (to the extent we know
    them). These rising costs and declining benefits of growth at the margin are
    depicted in the diagram below.
    From the diagram we can distinguish three concepts of limits to growth.
    1. The “futility limit” occurs when marginal utility of production falls to zero.
    Even with no cost of production, there is a limit to how much we can consume
    and still enjoy it. There is a limit to how many goods we can enjoy in a given
    time period, as well as a limit to our stomachs and to the sensory capacity of
    our nervous systems. In a world with considerable poverty, and in which the
    poor observe the rich apparently still enjoying their extra wealth, this futility
    limit is thought to be far away, not only for the poor, but for everyone. By its
    “non satiety” postulate, neoclassical economics formally denies the concept of
    the futility limit. However, studies showing that beyond a threshold selfevaluated
    happiness (total utility) ceases to increase with GDP, strengthen the
    relevance of the futility limit.
    2. The “ecological catastrophe limit” is represented by a sharp increase to the
    vertical of the marginal cost curve. Some human activity, or novel combination
    of activities, may induce a chain reaction, or tipping point, and collapse our
    ecological niche. The leading candidate for the catastrophe limit at present is
    runaway climate change induced by greenhouse gasses emitted in pursuit of
    economic growth. Where along the horizontal axis it might occur is uncertain. I
    should note that the assumption of a continuously and smoothly increasing
    marginal cost (disutility) curve is quite optimistic. Given our limited
    understanding of how the ecosystem functions, we cannot be sure that we
    have correctly sequenced our growth-imposed sacrifices of ecological
    services from least to most important. In making way for growth, we may
    ignorantly sacrifice a vital ecosystem service ahead of a trivial one. Thus the
    marginal cost curve might in reality zig-zag up and down discontinuously,
    making it difficult to separate the catastrophe limit from the third and most
    important limit, namely the economic limit.
    3. The “economic limit” is defined by marginal cost equal to marginal benefit
    and the consequent maximization of net benefit. The good thing about the
    economic limit is that it would appear to be the first limit encountered. It
    certainly occurs before the futility limit, and likely before the catastrophe limit,
    although as just noted that is uncertain. At worst the catastrophe limit might
    coincide with and discontinuously determine the economic limit. Therefore it is
    very important to estimate the risks of catastrophe and include them as costs
    counted in the disutility curve, as far as possible.
    From the graph it is evident that increasing production and consumption is
    rightly called economic growth only up to the economic limit. Beyond that point
    it becomes uneconomic growth because it increases costs by more than
    benefits, making us poorer, not richer. Unfortunately it seems that we
    perversely continue to call it economic growth! Indeed, you will not find the
    term “uneconomic growth” in any textbook in macroeconomics. Any increase
    in real GDP is called “economic growth” even if it increases costs faster than
    benefits.
    Economists will note that the logic just employed is familiar in microeconomics
    – marginal cost equal to marginal benefit defines the optimal size of a
    microeconomic unit, be it a firm or household. That logic is not usually applied
    to the macro-economy, however, because the latter is thought to be the
    Whole rather than a Part. When a Part expands into the finite Whole, it
    imposes an opportunity cost on other Parts that must shrink to make room for
    it. When the Whole itself expands, it is thought to impose no opportunity cost
    because it displaces nothing, presumably expanding into the void. But the
    macro-economy is not the Whole. It too is a Part, a part of the larger natural
    economy, the ecosphere, and its growth does inflict opportunity costs on the
    finite Whole that must be counted. Ignoring this fact leads many economists to
    believe that growth in GDP could never be uneconomic.
    Standard economists might accept this diagram as a static picture, but argue
    that in a dynamic world technology will shift the marginal benefit curve upward
    and the marginal cost curve downward, moving their intersection (economic
    limit) ever to the right, so that continual growth remains both desirable and
    possible. However, the macroeconomic curve-shifters need to remember
    three things. First, the physically growing macro-economy is still limited by its
    displacement of the finite ecosphere, and by the entropic nature of its
    maintenance throughput. Second, the timing of new technology is uncertain.
    The expected technology may not be invented or come on line until after we
    have passed the economic limit. Do we then endure uneconomic growth while
    waiting and hoping for the curves to shift? Third, let us remember that the
    curves can also shift in the wrong directions, moving the economic limit back
    to the left. Did the technological advances of tetraethyl lead and
    chlorofluorocarbons shift the cost curve down or up? How about nuclear
    power? Adopting a steady state economy allows us to avoid being shoved
    past the economic limit. We could take our time to evaluate new technology
    rather than letting it blindly push growth that may well be uneconomic. And the
    steady state gives us some insurance against the risks of ecological
    catastrophe that increase with growthism and technological impatience.

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