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Richard S. Markovits is the holder of the John B. Connally Chair in Law at The University of Texas Law School. He teaches and writes in the areas of antitrust, law and economics, constitutional law, and jurisprudence.

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Truth or Economics

Yale University Press

Contents

Acknowledgments.................................................................................................................................................ixIntroduction....................................................................................................................................................1Part One The Definition of Economic Efficiency..................................................................................................................191 The Correct Definition of the Impact of a Choice on Economic (Allocative) Efficiency..........................................................................212 A Critique of the Definitions of and Tests for Economic Efficiency That Economists and Law and Economics Scholars Use.........................................48Conclusion to Part I............................................................................................................................................63Part Two The Assessment of Economic Efficiency..................................................................................................................733 The Distortion-Analysis Approach to Economic-Efficiency Assessment............................................................................................794 Some Second-Best-Theory Critiques of Canonical Allocative-Efficiency Analyses and of the Standard Justifications for Ignoring Second Best.....................271Part Three The Relevance of Allocative-Efficiency Conclusions...................................................................................................3435 The Prescriptive-Moral and Legal Relevance of Allocative-Efficiency Conclusions...............................................................................3776 A Critique of Various Relevance Arguments Made by Economists and Law and Economics Scholars...................................................................402Conclusion......................................................................................................................................................421Notes...........................................................................................................................................................437Glossary of Frequently Used Symbols and the Concepts for Which They Stand.......................................................................................491Index...........................................................................................................................................................499

Chapter One

Chapter 1 has four sections. The first articulates the monetized definition of the impact of a choice on economic efficiency that I think is correct, explores its critical features, and explains why it is correct. The second elaborates on this definition by analyzing whether those equivalent-dollar effects of a choice that reflect the external or bad preferences of the individual who experiences them should be ignored when calculating the choice's allocative efficiency. The third points out that my argument for the correctness of my monetized definition of the impact of a choice on allocative efficiency defeats the claim that there is no non-arbitrary way to resolve the offer/asking problem. And the fourth considers various additional moral issues that the definition or operationalization of economic efficiency implicates.

SECTION 1. THE CORRECT DEFINITION OF THE ECONOMIC EFFICIENCY OF A CHOICE

As the Introduction to this book indicates, I believe that, correctly defined, the impact of a choice on economic efficiency equals the difference between the equivalent-dollar gains the choice confers on its beneficiaries (the winners) and the equivalent-dollar losses it imposes on its victims (the losers). Although most economists would not find this definition controversial, many would find my operationalizations of the winners' equivalent-dollar gains and losers' equivalent-dollar losses problematic. I argue that a winner's equivalent-dollar gain should be defined to equal the number of dollars that would have to be transferred to him to leave him as well off as the choice would leave him if

1. he did not agree to the transfer;

2. he either was intrinsically indifferent to the substitution of the transfer for the policy in question or was unaware of the linkage between the transfer and the policy's rejection;

3. his distributive attitude toward such transfers, non-parochial distributive preferences, or normative distributive commitments gave him no reason to prefer the transfer to the choice or vice versa; and

4. the transfer would not benefit or harm him indirectly by changing the conduct of others by altering their incomes and/or wealth.

Similarly, I argue that a loser's equivalent-dollar loss should be defined to equal the number of dollars that would have to be withdrawn from him to leave him as poorly off as the choice would leave him under the four assumptions just delineated.

The preceding operationalizations measure the relevant dollar gains and losses by the equivalent variations in the relevant winners' and losers' wealths and then elaborate on the definitions of the equivalent variations in question. This section explains why the relevant equivalent variations differ from the compensating variations that I think are incorrect operationalizations of the dollar effects of an event, public policy, or private choice on its individual beneficiaries and victims. It also discusses the reasons why the equivalent variations should be calculated on the assumptions the preceding two sentences specified and referenced.

I have already explained why the dollar impacts that are components of the impact of an event, public policy, or private choice on monetized economic efficiency should be measured by the equivalent rather than by the compensating variations in the relevant winners' and losers' wealths: the equivalent variation captures both the professional and popular (intuitive) understanding of the relevant dollar gains and losses-that is, correctly operationalizes the meaning of these expressions in professional and popular understanding-and, relatedly, defines these concepts in the way that maximizes their contribution to the evaluation of any private choice or public policy. I now want to explain how and why the relevant equivalent variations differ from the relevant compensating variations and what my resolution of these issues implies for the accuracy and bias of estimates of the impact of a private choice or public policy on monetized economic efficiency that are based on compensating-variation estimates of the relevant dollar gains and losses.

Equivalent variations differ from compensating variations for two reasons. The first is that money has diminishing marginal value, regardless of whether the individual in question values money for the utility it enables him to secure or for some other reason. The diminishing marginal value of money causes the number of dollars that a choice's winners would have to be given to be left as well off as the choice would leave them (the total of the equivalent variations in their respective wealths) to exceed the number of dollars that would have to be withdrawn from them to leave them as poorly off as the choice would leave them (the compensating variations in their wealths). Assume, for example, that (1) a relevant winner values both money and the policy for the utility they will give him, (2) the relevant winner possesses $50,000 in the initial position, and (3) the policy will give him 300 units of utility (utils) regardless of whether his wealth is increased or decreased over the relevant range prior to the policy's implementation, (4) the average utility-value of the dollars that would raise his wealth from $50,000 to $50,300 is one util, and (5) the average utility-value of the dollars that would raise his wealth from $49,750 to $50,000 (or lower his wealth from $50,000 to $49,750) is 1.2 utils (where the utility-value of each dollar above $49,750-indeed, above $1-is lower than the utility-value of its predecessor). On these facts, the variation in the relevant winner's wealth that would be equivalent to the policy would be $300 (since 300[1 util] = 300 utils), while the compensating variation to the policy would be $250 (since 250[1.2 utils] = 300 utils). Hence, if money has diminishing marginal value, a policy's compensating variation will tend to be lower than its equivalent variation on that account, and any analysis of a policy's economic efficiency that incorporates a compensating-variation definition of the dollar gains it generates will tend on that account to underestimate the policy's economic efficiency.

The diminishing marginal value of money will also cause the number of dollars that would have to be withdrawn from a policy's losers to leave them as poorly off as the policy would leave them (the equivalent variations in their wealths) to be lower than the number of dollars that would have to be transferred to them to perfectly offset the policy's impact on them (the compensating variations in their wealths). Once again, if we assume that the utility cost of the policy to its victims will not be affected by relevant variations in their wealths, this conclusion that the equivalent variations in the losers' wealths will be lower than the compensating variations in their wealths will reflect the fact that-since the average marginal utility of any given number of dollars transferred to them will be lower than the average marginal utility of that number of dollars when withdrawn from them-the number of dollars that would have to be given to them to offset a given utility loss will exceed the number of dollars that would have to be taken from them to reduce their utility by the same amount that the policy would reduce their utility. Therefore, since the diminishing marginal value of money will cause the compensating variation in the wealth of each of a policy's losers to be higher than the equivalent variations in his wealth, (1) any analysis of the dollar losses that a policy would impose on its victims that measures those losses by the total of the compensating variations in the wealth of each loser will tend on that account to overestimate those losses, and (2) any operationalization of a policy's economic efficiency that measures the losses it generates by the total of the compensating variations in the wealth of each of its victims will tend on that account to underestimate its allocative efficiency to the extent that the marginal value of money diminishes.

In short, if money has diminishing marginal value, any analysis of a private choice's or public policy's economic efficiency that incorporates the compensating-variation definitions of its winners' equivalent-dollar gains and losers' equivalent-dollar losses will tend on that account to underestimate those gains and overestimate those losses. Clearly, these conclusions imply that the diminishing marginal value of money will render any operationalization of economic efficiency that incorporates compensating-variation definitions of the dollar gains of a policy's winners and the dollar losses of a policy's losers not only inaccurate but also biased against its economic efficiency. If I am right in assuming that money virtually always has diminishing marginal value for a given possessor, this conclusion will virtually always be applicable, regardless of the way in which the choice or policy being analyzed affects its winners and losers.

Although the second reason equivalent variations may differ from compensating variations will also apply when the marginal value of money is not declining, it has a far more limited domain of applicability than the first reason (that is, the diminishing marginal value of money). Specifically, this second reason applies only when the private choice or public policy affects the beneficiary or victim by lowering or raising the price he must pay for a good. The second reason is the non-zero wealth-elasticity of the demand for goods. To the extent that the demand that a policy victim or policy beneficiary has for a good whose price the policy will change is wealth-elastic, the compensating variation will differ from the equivalent variation because the relevant compensating and equivalent variations are calculated respectively on a counterfactual and accurate assumption about the wealth the relevant individual will possess when the policy is adopted. In particular, the compensating variation in the wealth of a policy's beneficiary equals the positive dollar value the policy would have for the beneficiary if (counterfactually) his wealth were reduced by the compensating variation before the policy's adoption, and the compensating variation in the wealth of a policy's victim equals the negative dollar value the policy would have for the victim if (counterfactually) his wealth were increased by the compensating variation prior to the policy's adoption.

I will now discuss some examples that illustrate the difference between the compensating and equivalent variations to policies that change the price some of their beneficiaries or victims must pay for some good. Assume that the policy is an antitrust-exemption policy or a pollution tax that would harm a particular victim by increasing the price of some good he purchased-the good whose producers the policy would exempt from antitrust regulation or the good whose production would be subjected to a pollution tax. If the relevant victim's demand for the good is positively wealth-elastic (that is, if, given the price of the good, the number of units this individual will purchase will increase with his wealth), as is typically the case, then the dollar cost of the policy to him (the sum of [the product of the number of units of the good that he will continue to buy at the higher price the policy causes to be charged and the price increase the policy would generate] and [the buyer surplus he originally realized by purchasing the units at the lower, pre-policy price that he did not buy at the higher, post-policy price]) will be higher if his wealth is increased prior to the policy's adoption by the amount that would constitute the compensating variation to the policy's adoption (since in this case the number of units he will purchase at the higher, post-policy price [and at the lower, prepolicy price]-the number of units for which the policy would cause him to pay a higher per-unit price-will be higher). Hence, when the relevant victim's demand for the good in question is positively wealth-elastic, the compensating-variation measure of the dollar loss the policy will inflict on him will be higher than the equivalent variation-that is, will overestimate the loss the policy will inflict on the victim in question-and hence any approach to economic-efficiency assessment that incorporates a compensating-variation measure of the dollar losses in question will tend on that account to underestimate the allocative efficiency of the policy in question. On the other hand, if the relevant victim's demand for the good is negatively wealth-elastic (if, given the price of the good, the number of units this individual will purchase will decrease as his wealth increases), as is sometimes the case, then for analogous reasons the dollar cost of the policy to him will be lower if his wealth is increased prior to the policy's adoption by the amount that will constitute the compensating variation to the policy's adoption. In this case, the compensating variation will be lower than the equivalent variation-will underestimate the loss the policy will inflict on the victim-and hence any approach to economic-efficiency assessment that incorporates a compensating-variation measure of the dollar losses will tend on that account to overestimate the allocative efficiency of the policy.

Obviously, analogous arguments would establish analogous conclusions in cases in which the relevant policies were pro-price-competition policies or policies that remove pollution taxes. The compensating-variation measure of the gains that such policies confer on those of their beneficiaries who purchase the goods whose prices they reduce will overestimate the dollar gains such policies confer on those buyers whose demands for the goods in question are negatively wealth-elastic and would underestimate the dollar gains they confer on those buyers whose demands for the goods are positively wealth-elastic. It is worth noting that the preceding results imply that any approach to allocative-efficiency assessment that adopts the compensating-variation measure of the dollar gains and losses a choice or policy generates will underestimate its allocative efficiency in what I take to be the typical case in which the relevant wealth-elasticities of demand are positive.

Of course, precisely the opposite conclusions will be warranted when the relevant winners' and losers' demands for the products whose prices the policies will affect are negatively wealth-elastic. In such cases, the compensating-variation measures of the relevant losers' dollar losses and relevant winners' dollar gains will tend to underestimate those dollar losses and overestimate those dollar gains, and any approach to allocative-efficiency assessment that incorporates compensating-variation measures of the dollar gains and losses in question will tend to overestimate the economic efficiency of the policy in question on that account.

Admittedly, the fact that the compensating-variation measure of the equivalent-dollar losses and gains a policy generates may be wrong for two reasons does not guarantee that allocative-efficiency assessments that are based on this measure of those gains and losses will always be inaccurate on that account. Conceivably, in some cases, the non-zero wealth-elasticity of demand-related error of the compensating-variation measure approach to dollar gain and loss assessment will perfectly offset the diminishing marginal value of money-related error it makes. Since the latter error will always tend to cause approaches to allocative-efficiency assessment that incorporate the compensating-variation measure of the dollar gains and losses the policy generates to underestimate its allocative efficiency, this outcome will be conceivable only when the policy in question

1. A. harms some victims by increasing the price of one or more goods they purchase and

B. the relevant victims' demands for those goods are negatively wealth-elastic or

2. A. benefits some winners by reducing the price of goods they purchase and

B. the relevant winners' demands for those goods are negatively wealth-elastic.

However, even in what I take to be the unusual circumstances in which the relevant demands are negatively wealth-elastic, the error associated with the non-zero wealth-elasticity of demand will perfectly offset the error associated with the diminishing marginal value of money only rarely and fortuitously. In any event, because I believe that the relevant wealth-elasticities of demand are usually positive, I suspect that, in most cases, the former error will usually compound the tendency of the latter error to cause any allocative-efficiency analysis that adopts the compensating-variation measures of the dollar gains and losses a policy generates to underestimate its allocative efficiency.

(Continues...)

Excerpted from Truth or Economicsby Richard S. Markovits Copyright © 2008 by Richard Spencer Markovits. Excerpted by permission.
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