2nd January 2012
Some further thoughts on cost benefit analysis
Continuing from the previous blog post, the following is an extract from the current draft of Discovery of Freedom. Its language will be significantly improved in the coming year (I'm not finding the time – and health – I need to finish this book quickly), but in its current form and shape, this extract provides supporting context to the previous discussion:
I pointed out in the first chapter that the entire discipline of economics is based, basically on four simple assumptions about human nature. These mathematically expressed assumptions generate the standard utility function which is then amenable to mathematical deduction. Using this model, economists test behaviour through utility maximisation equations subject to a relevant budget constraint. This method leads to many extremely useful conclusions.So what is the relationship between maximising our freedoms – subject to accountability – and maximising utility subject to a budget constraint? I believe these two are closely related so long as all key externalities are taken into account. We use our freedom to maximise what (we believe) is good for us, and to minimise what we believe is evil or vile (using Hobbes’s three-fold terminology). Only free people can choose among the full range of options available to maximise utility. In other words, utility maximisation can't work properly without freedom.The utility maximising model must ensure that we internalise the costs of the damage we cause, for the theory of freedom (and justice) insists on accountability. The concept of freedom is a far higher principle. The utility maximising model can accommodate accountabilities through, for instance, markets for pollution or court imposed penalties for harm. The standard economic theory can therefore be used for the most part, but with caution in the few matters discussed below.In the first instance we should note that utility maximisation works for individuals, not aggregates. Aggregation of utility across the society, the basic bread and butter of ‘welfare economics’, doesn't work very well. But it is theoretically impossible to aggregate the preferences of all individuals, or to compare utilities. This approach is therefore fundamentally flawed.According to Bentham, ‘it is the greatest happiness of the greatest number that is the measure of right and wrong’. Thus, a ‘utilitarian’ aims to maximise the total utility of a society. By assuming that everyone has the same utility function, a ‘social welfare function’ – which merges everyone’s identity – can be mathematically created. The utility maximising model can accommodate a host of political theories, including the Rawlsian collectivist maximin (i.e. difference) principle, by making appropriate assumptions. We must guard against its misuse; the mathematics must be rigorously controlled by philosophy.This idea, of lumping all individuals together, can destroy individual freedom if we do not exercise great caution. Attempts to maximise ‘social’ utility seem to invariably lead to arguments for redistribution of wealth. However, a government must only facilitate the maximisation of our freedom subject to accountability. Everything else, including whether we are happy or not, is something we determine, independently. Benthamite paternalism is all pervasive but the typical start of the slippery slope towards statism.For instance, Claude-Adrien Helvétius (1715-1771), the founder of utilitarianism (Bentham was its most prominent proponent) believed that the policy maker should educate people so they are better equipped to increase their happiness and reduce pain. The laws would then provide incentives to people to do the ‘right’ thing. This is an unnecessarily statist and paternalistic approach, and suggests that policy makers are ‘smart’ and people are stupid. We hear strong echoes of in modern behavioural economics, for instance that the default option for a (public) financial saving scheme should be conservative. Such conception can easily infringe on our liberty and this approach must be closely interrogated.Utilitarian approaches can also end up denying freedom when they become ‘inconsistent even with Pareto optimality – perhaps the mildest utility-based condition and the most widely used welfare criterion in economics.’ We must therefore consider trade-offs between strict utilitarianism and freedom. Freedom must receive unambiguous precedence.The technique of social cost-benefit analysis (CBA) suffers from the defect of aggregation. When economists compare costs and benefits (say, of regulation) across an entire society, they are generally often indifferent about the individuals on whom these costs are imposed, so long as net benefits are positive. In some cases those who cause harm do pay up, but in others regulations become a channel for re-distribution and destroy the liberal social contract (for coercive redistribution by the state is theft).Some utilitarians have sought to conduct a cost-benefit analysis of freedom itself. Such analysis ‘can lead one to argue against slavery on the grounds that the advantages to the slaveholders do not counterbalance the disadvantages to the slave and to society at large’. Even the thought of such a possibility is totally abhorrent. Freedom is beyond CBA – a higher, non-negotiable value. Utilitarian CBA must necessarily be subordinated to the overarching demands of life and liberty. Having said this, CBA does act as a check on drastically bad policy by forcing the disclosure of the policy maker’s assumptions, and by (at least notionally) treating everyone equally in the calculations.
 Bentham, Jeremy, A Fragment on Government, 1776. London: T. Payne. [http://socserv2.mcmaster.ca/~econ/ugcm/3ll3/bentham/government.html] This approach was first explored by Bergson (1938) and Samuelson (1947). Details in Mas-Colell, Andreu, Michael D. Whinston, and Jerry R. Green, Microeconomic Theory, New York: Oxford, 1995, p.825-838. Sen, Amartya, and Bernard Williams, ‘Introduction’, in Sen and Williams, eds., Utilitarianism and Beyond, Cambridge: Cambridge University Press, 1982, p.7). Rawls.