Thoughts on economics and liberty

Tag: Cost-benefit analysis

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’[1]. 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[2] – 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.’[3] 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’[4]. 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.

[1] Bentham, Jeremy, A Fragment on Government, 1776. London: T. Payne. [http://socserv2.mcmaster.ca/~econ/ugcm/3ll3/bentham/government.html]

[2] 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.

[3] Sen, Amartya, and Bernard Williams, ‘Introduction’, in Sen and Williams, eds., Utilitarianism and Beyond, Cambridge: Cambridge University Press, 1982, p.7).

[4] Rawls.

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Want good policy? Do a cost-benefit test first, then test for freedom

In BFN I've cautioned against the blind use of economic (or cost benefit) analysis, thus:

While endorsing most of the standard literature of economics and economic reforms, I would like to suggest a few words of caution: 

  • Our future is too important to be left to economists. We must never let economists monopolize the thinking that we need to put in as concerned citizens. The literature of economics should be used to supplement our holistic thinking; not as a primary source of policy ideas. 
  • Economists are driven primarily by the goal of economic efficiency. They do not base their advice purely on the principles of freedom. They are therefore likely to propose interventions by governments on grounds of market failure, information failure, information asymmetry, ‘equity’ and so on. We should soundly reject such advice. We need to back off from any intervention by the government unless it is proven without doubt that such intervention will improve our freedoms including our accountability. Let us follow the imperatives of freedom and we won’t go wrong.
And in the Online notes to BFN (these will, I hope, one day be re-combined with the main book, according to the original design):
If conclusive evidence cannot be adduced to prove beyond doubt that the government can, on balance, deliver better outcomes than citizens acting on their own behalf, then that activity will revert back to the citizens. It is preferable that citizens solve a Problem imperfectly in complete freedom, than for them to pay a government to do it equally or more imperfectly at much greater cost.
Basically, efficiency is about a cost-benefit test. I have not denied the value of a cost-benefit test in BFN, but cautioned against giving it more value than it deserves.
 

The freedom test

Without first qualifying the hurdle of a cost-benefit test, however, we can't even come close to assessing the second (and key question) does this policy pass the test of freedom? There are areas of government policy that must be off-limits REGARDLESS OF COSTS AND BENEFITS. That is what I've written about in BFN through the three-tier classification of the roles for government: 
FIRST ORDER: A good government needs to deliver high quality outputs in at least three ‘first-order’ core areas, of defence, police and justice. These functions must be carried out outstandingly well and, if necessary, to the detriment of all other functions. If funds run short, a government can always provide incentives to citizens to take up relatively secondary things like infrastructure through a range of innovative ways by transferring property rights over roads, airports, or railways. 
SECOND ORDER: After performing these first-order core functions outstandingly well, a government must focus on providing infrastructure and equality of opportunity. Appropriate funds need to be deployed to deliver second-order core functions well. Given space constraints, I do not discuss infrastructure provision here. All I note is that where goods are excludable, i.e. wherever boundaries can be drawn around an infrastructure and therefore user-pays ticketing is feasible, such infrastructure will be sold in a systematic manner to the private sector. Where partial ownership or property can be given to the private sector, such as through toll-based highways or other public–private partnerships, that option will be explored. Finally, where it is not feasible to privatize infrastructure because of non-excludability, the government will directly provide the service wherever possible, outsourcing it and acting as an auditor rather than manager.
 
THIRD ORDER: There are some non-core functions that a government can also perform, if funds so permit. (I only gave the example of environmental sustainability in BFN, but a few others, e.g. support for the preservation of "heritage" might come in this category). 
The Freedom Team of India has, after nearly three years of debate, adapted this approach to categorisation of public policy (I encourage you to consider FTI's draft approach, which is quite good).

The diagram below summarises this:

This is revolutionary stuff!

But note that this way of thinking is quite revolutionary! For instance, in India, NO policy is ever determined through a cost benefit test (leave alone a test of freedom). I'll leave you here with an extract from a recent conversation on FB with Harsh Vora:

Harsh Vora: Legalizing drugs is indeed a delicate issue. Here, Friedman makes fairly strong points in its support by explaining the 'negative' effects of banning drugs. I guess the question is whether the costs outweigh the benefits!  {Reference: this youtube video}

Sanjeev Sabhlok: The idea that cost/benefit analysis should be undertaken for public policy is totally revolutionary. Most moralists will not accept it. It is also difficult (in a moral sense) to quantify the value of the loss of innocents' lives. Moralists don't see both sides of the picture: only one (i.e. that taking drugs is wrong). I suspect on a pure economic cost benefit test, legalisation of drugs (with good regulatory frameworks) will significantly overwhelm the policy of prohibition.

Cost-benefit analysis is a utilitarian (a branch of classical liberalism) concept that gives all costs and all benefits equal weight, which is a weakness in its design (for after all, the rich man cares less for a loss of Rs.100 than a poor man). It also does not factor in the loss of freedom. However, in the absence of other techniques, it is the best available method, and if used carefully, can get us towards good policy. I think I briefly wrote about it in BFN. In India there is NO concept of cost-benefit analysis but only whims of policy makers (or moralistic preachers who claim to tell us what we should do).

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Michael Sandel’s lectures on justice

Came across this excellent set of 12 lectures by Harvard academic Sandel. I've listened quickly to two of these (#2, on cost-benefit analysis, and #8 on Rawls). On cost-benefit analysis, Sandel's views are consistent with mine (as expressed in DOF). On the latter, I think he lets off Rawls too easily. In DOF I've got a detailed critique of Rawls.

Regardless of whether one agrees or disagrees with these lectures I'd encourage you to watch as many as possible. 

Justice with Michael Sandel

 
 
 
 
 
 
 
 
 
 
 
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