The theory of the second-best

One of the few provable useful results in economics is the one about markets producing an optimal outcome.

If all goods and services in an economy are traded via perfectly competitive free markets, the resulting outcome is efficient (i.e. Pareto-efficient), i.e. there is no other possible arrangement of available resources in which some would be better off and no one would be worse off.

By contrast, an “inefficient” outcome is one where the position of some can be improved without making anyone else’s position worse, e.g. where the benefits of exchange have not been fully exploited.

This is potentially a very useful result, because if we want to ensure that things are as good as they could be (ignoring redistribution issues) we need not first calculate everyone’s happiness under various different conditions. All we need do is set up perfectly competitive (PC) markets and let people trade amongst themselves. This is just as well, since it is impossible in practice to know what people’s happiness level is under different conditions, or to find out all possible preferences between different outcomes for every individual. We may not even need to do anything as active as “setting up markets” since they tend to develop spontaneously.

If we currently don’t have conditions of PC markets, the way to get to efficiency is simple, in theory: do whatever it takes to get to precisely those conditions.

The problem is that, in practice — for various reasons, e.g. political — we may not be able to get to PC conditions. We may therefore have to choose between other, suboptimal alternatives, and try to decide which of those is preferable from the point of view of efficiency.

What does economics have to tell us about how to optimise efficiency, if we cannot achieve perfect competition)? There are two ways of dealing with the "problem of the second best" for policy purposes. The first favours government intervention, the second does not.

1) If we had information about the preferences of every individual in the economy, we could calculate what the range of possible optimal states are, given the constraints we have to work with. (Call these states “second-best solutions".) In that case, it might turn out that, if the economy departs from PC in one specific area but is PC elsewhere, we will only be able to get to a second-best solution by departing from PC in other areas as well. In fact, it can be shown that for very simple scenarios, that is the case — i.e. it is better to deviate from perfect competition in all areas rather than just in some.

This is sometimes taken to prove that in certain cases government intervention is better than laissez-faire as a way of generating the best possible outcome, given the constraints. But note that this conclusion depends on knowing everybody’s preferences, which in practice is impossible. The great benefit of the strict-PC model — of being certain that the outcome will be efficient, without having to know anything about people’s preferences — does not apply here.

2) The other way of treating the problem of the second best is to advocate agnosticism. If we do not have perfect PC conditions and cannot get to them, and we do not know everyone’s preferences, then we can’t know whether any particular policy change will move things in the direction of greater efficiency. Even if a policy change appears to be moving things in the direction of PC conditions, it might easily result in less overall efficiency.

Now there are two ways to interpret treatment (2), either of which might be appropriate depending on the circumstances.

(2a) One is to be conservative, in the sense of being cautious about doing anything, especially major changes. They might do harm on balance, rather than good. This generates the opposite conclusion to that of (1), in the sense that you should avoid tinkering further with an already imperfect system in case you make it worse.

(2b) The other way to react is to adopt a muddle-through approach, for which there is no strict justification, but which might be the best one can do, on a sort of hopeful common-sense basis. This could be taken to mean, we should try to aim at the nearest thing to PC in all markets, being careful to ensure that no major areas are omitted.

The one thing second-best theory can definitely tell us is the following: one should be wary of policy changes which involve partial marketisation of a given area. E.g. if the intergenerational market for private capital (= inheritance) is heavily distorted by estate duties, it is not necessarily a good idea to marketise (i.e. remove subsidies from) cultural institutions such as universities or opera houses.

Also — though one does not really need second-best theory for this — it may well be misguided to impose artificial marketisation, e.g. by making academics or medical professionals try to prove they are generating “value for money”. There is no hard support from economic theory for the idea that anything other than a genuine market (where the genuine end users are able to vote with their wallets) will generate any benefit whatsoever.

The standard textbook interpretation of the point about second-best (originally made by Richard Lipsey and Kelvin Lancaster *) is (1) above, i.e. the version which appears to favour government intervention. This interpretation is at best biased, and at worst simply false, but is very common. Dani Rodrik, for example, uses it when he says that

the First Fundamental Theorem of Welfare Economics is proof, in view of its long list of prerequisites, that market outcome can be improved by well-designed interventions.

This is not exactly false, but does seem to exaggerate the case in favour of intervention. The best that could be said is:

The First Fundamental Theorem of Welfare Economics is proof, in view of its long list of prerequisites, that interventions may not necessarily make things worse.

In March I made this point on the Talk page of the Wikipedia article, where the same misinterpretation was being used.

This entry is incomplete as it stands, and in a way which generates a political bias i.e. in favour of state intervention.

Another way of looking at the Lipsey/Lancaster point is as follows. If you are not at a Pareto-optimal point for the economy, you don't know whether any change that doesn't actually take you onto an optimal point is going to improve efficiency (i.e. make everyone better off). Even when you move in what appears to be the direction of greater efficiency, e.g. by changing all controllable parameters to an average of where you are now and where a Pareto optimum is, you might be making things less efficient i.e. making everyone worse off.

So another moral (apart from the one given) is that, when you have a market that is already regulated or otherwise distorted, it is not necessarily a good idea to move in the direction of less distortion. You can be sure that if you can get to a Pareto optimum, that is a good thing (at least in terms of efficiency); apart from that, you can't be certain of the effects of different policy changes. This is a consequence of the severely restricted conclusions of Pareto theory.

In fact, the moral given in the entry is questionable as stated. It isn't really the case that intervention to move things in a direction different from the pro-market one is sometimes a good idea. It's just that such a move might be a good thing, only neither the government nor anyone else can ever know if it would or not.

In a paper published in June, Professor Lipsey himself came out in favour of the second interpretation.

The upshot is that in practical situations, as opposed to theoretical models, we do not know the necessary and sufficient conditions for achieving an economy-wide, first-best allocation of resources. Achieving an economy-wide second best optimum allocation looks even more difficult than achieving the first best. Without a model of the economy’s general equilibrium that contains most let alone all of the above sources, we cannot specify the existing situation formally and so cannot calculate the second best optimum setting for any one source that is subject to policy change. This is an important point since much of the literature that is critical of second best theory assumes that economists know a distortion when they see one and know that the ideal policy is to remove the distortion directly, something that is necessarily welfare improving only in the imaginary one-distortion world.

* R. Lipsey and K. Lancaster (1956), 'The General Theory of Second Best', Review of Economic Studies 24, 11-32.

(originally published on the mediocracy blog)

Such a thing as society

Is there such a thing as 'society', over and above a collection of individuals? Curiously, the question is now associated in many people’s minds with Margaret Thatcher, who said:

I think we have gone through a period when too many children and people have been given to understand "I have a problem, it is the Government's job to cope with it!" or "I have a problem, I will go and get a grant to cope with it!", "I am homeless, the Government must house me!", and so they are casting their problems on society and who is society? There is no such thing! There are individual men and women and there are families and no government can do anything except through people and people look to themselves first.

The argument may of course originally have been mentioned to her by one or more of her intellectual supporters. It has also been pointed out that it was made in a fairly informal context, i.e. an interview with Woman’s Own (in 1987).

There are several ways of interpreting the question. Unfortunately, attention tends to be focused on the least interesting one. The trivial answer is, “yes, of course there is”. The word is useful in the same way that the concept of ‘global warming’ is useful — it is a shorthand for describing complex phenomena by means of aggregating and averaging.

Probably one can go further, and say that there are social phenomena which, while ultimately reducible to individual behaviour, only become observable at the aggregate level. They are, in other words, a kind of (weakly) emergent behaviour. For example, to say that "Italy advanced technologically in the sixteenth century" is theoretically reducible to the behaviour of individual Italians, but it would be difficult to do so, and the aggregate phenomenon is not readily predictable simply from information about the individuals.

However, to say that patterns emerge at an aggregate level which are not conveniently reducible to descriptions of individual behaviour is not the same as saying that a different kind of entity emerges at that level. There is clearly a sense in which methodological individualism — the claim that the whole is ultimately nothing but the sum of its parts — is trivially true, and anything more ambitious than weak emergence — e.g. social holism — is 'obviously' false.

The arguments that individuals are influenced by their social environment (situationism), or even that they are largely a function of that environment (constructionism), are really concerned with a different issue from the one raised by Thatcher's assertion. Even if the actions of individuals are always traceable to societal influences, those actions are still the basic components of social behaviour, and the latter must ultimately admit explanation in terms of the former.

However, all the above points are somewhat incidental to the issue typically at stake when the Thatcher quote is discussed. Reactions to it are more often concerned with a different matter altogether: that of whether ontological or moral priority should be given to the individual over the social group. In other words, the argument is really about the conflict between political individualism and communitarianism.

Consensus and dissent

Ipsos MORI reports that 56% of British adults agree with the statement "Many leading experts still question if human activity is contributing to climate change", and suggests that people have been "influenced by counter-arguments". Al Gore, who helped to organise last week's Live Earth event, remarked that "those people think, wrongly, that the scientific debate is still raging." The Royal Society's vice-president commented: "People should not be misled by those that exploit the complexity of the issue, seeking to distort the science and deny the seriousness of the potential consequences of climate change. "

The global warming controversy raises issues about (a) what is meant by "scientific consensus" and (b) the extent to which politicians and voters ought to accept what scientists agree is fact or highly probable. There is also the question of whether views which depart from the consensus should be suppressed because they are likely to be false, or promoted because they maintain a healthy debate and prevent thinking from becoming stale and dogmatic.

It seems clear that a majority of scientists support the idea that it is "very likely" that the gradual increase in temperature over the last century is "predominantly" due to human activity. But should we be interested in the views of those working in areas other than climate change? For example, the views of the Australian Medical Association in effect form part of the "consensus", but are they relevant? It is interesting that the most recent statement by the American Meteorological Association sounds more guarded than similar statements by other groups of scientists. Climatology is a highly complex subject: modelling conditions even a few weeks into the future generates results that are notoriously unreliable.

Many believe there is a high risk that CO₂ emissions over the next few decades, unless actively restricted, will create significant and damaging climate change, and think additional environmental policies are therefore urgently needed. And for many of these people, persuading the voting public to agree to such policies is seen as a crucial obstacle. For them, climate change sceptics are simply holding up the necessary shift in public perceptions.

While there does seem to exist a consensus of sorts, we need to bear two things in mind. The first is that what is relevant is not whether there exists a consensus among the highly educated, or among scientists or academics in general, but whether those who are expert in the field in question are in agreement, and whether that agreement is unanimous or merely in the majority. Second, we know from past experience that consensus in itself does not conclusively demonstrate correctness, especially if the issue in question has political implications.

Assuming for the sake of argument that there is a consensus among climate scientists, and that the consensus should be given due weight, there is still an argument that opposing viewpoints should actively be given publicity, both from a utilitarian and a libertarian viewpoint. Consequentialism in science does not seem like a good idea.

Other articles
Dizzy on the politicisation of science
Acton Institute blog on Live Earth
Stumbling & Mumbling on climate moralising
BBC's The Investigation on the Stern Review
Crooked Timber endorses the Stern Review
Crooked Timber blames Exxon for scepticism
Carl Wunsch on "The Great Global Warming Swindle"
Nigel Lawson on climate change
Bjorn Lomborg on being vilified
Tim Worstall on IPCC forecasts

No smoking

Smoking is now illegal in the UK in all indoor locations that are open to the public. Controversially, this includes private establishments where the counter-argument exists that a non-smoker could frequent another establishment if they minded enough.

The logic for tolerating the smoking ban seems to proceed as follows.

1) Most people now believe that smoking cigarettes is equivalent to taking a regular dose of poison: it is basically extremely harmful to health, probably more so (addiction aside) than any of the major illegal drugs.

2) Therefore the right to behave how you like, provided it does not harm others, is not important in this case, and hence does not need to be defended.

3) Many smokers are themselves in favour of the ban, because they believe it will help them to give up.

There has therefore been relatively little objection to the ban encroaching on areas where no non-smoker is being harmed. But is it possible that an important principle is being lost sight of? J.S. Mill argued that “the only purpose for which power can be rightfully exercised over any member of a civilized community, against his will, is to prevent harm to others. His own good, either physical or moral, is not sufficient warrant.”

Once a major piece of legislation breaks clearly with this moral restriction, and without significant opposition, are we likely to find other areas in which it will be applied? “Slippery slope” arguments of this kind are regarded as dubious by many philosophers. Bernard Williams, for example, considered them illogical because they appear to assume “that there is no point at which one can non-arbitrarily get off the slope once one has got onto it”.

Nevertheless, there does seem to be something in the idea of slippery slopes, in politics at least. The argument “we allow A, therefore it is inconsistent not to allow B", or “we already ban X, so why do we allow Y?”, is frequently used. Even if not sound, it is a line of argument which the general public seems prepared to regard as reasonable. On that basis, it may not be long before other legislation is proposed to prevent unhealthy individual behaviour. It has already been suggested that it should be a crime for a parent to allow their child to overeat. On that basis it is not impossible that it will, in the not too distant future, become illegal to sell or consume certain foods, e.g. snacks with more than a permitted maximum level of sugar or fat.

Other articles
David Hockney against the smoking ban
Daily Referendum on the smoking ban
Reuters on the smoking ban
Pub tries to avoid ban by becoming an embassy
Stumbling & Mumbling on the smoking ban
Nourishing Obscurity on the smoking ban
Julian Baggini on slippery slopes
Fallacy Files on slippery slopes

Localism

An issue closely related to transparency is that of democratic participation. It has often been argued that voters need to become more involved in deciding issues which matter to them. This philosophy is behind the recent trend for more consultations.

There is also a movement to make democracy more devolved, and allow for more voting about local issues at a local level, which is currently receiving exposure in the Daily Telegraph. As with transparency, however, is it necessarily helpful to the effectiveness of democracy to have more participation? Or is there a risk that, by trying to make people be more involved, the effect is to favour the interests of more politically-minded voters?

This comment from US citizen Ron Craig may give food for thought:

"The idea of public referenda doesn’t actually work in practice. Take the experience here in California. With each and every election we are bombarded with countless ‘propositions’ to vote on. What on the face of it looks like the ultimate democratic action ends up being taken over by vested interests and their apologists, who fill the airwaves with, dare I say it, lies to support their ‘for’ and ‘against’ cases. The end result is that the average voter probably makes their decision based on which commercials they watch."

Other articles
Ben Fenton on freedom of information
Adam Smith Institute on direct democracy
Zac Goldsmith on local referenda
Tim Worstall on Zac Goldsmith
Antony Jay on localisation
Bruno Kaufmann on direct democracy in Switzerland
Stumbling & Mumbling on demand-revealing referenda

Transparency

Gordon Brown will shortly become Britain's unelected premier. He has promised to introduce more "transparency" into government. Concepts such as transparency and opennness were also popular with the current incumbent Tony Blair. The present administration introduced the Freedom of Information Act, intended to make information about government activities more accessible to ordinary people. The results of the Act have had mixed reviews, with some claiming they represent a genuine contribution to transparency, and others arguing they are a sham.

But is "transparency" an important goal? Do voters need to know about what goes on behind the scenes? Or is there a risk that transparency becomes a substitute for more important issues, such as whether new legislation is a good thing? Which is better: a good deal of unconsidered legislation, with voters being able to see everything about the processes involved; or legislation of higher quality and lower quantity, shielded by a certain degree of secrecy?

Can the concept of "transparency" be used against voters, by encouraging legislation which allows information about private citizens to be made more accessible, or by encouraging whistleblowing? Does a culture of information accessibility make the sharing of information about individuals between different government agencies more likely, and is this desirable?

Other articles
Stumbling & Mumbling on freedom of information
Ben Fenton on freedom of information
Bel is Thinking on MPs opting out of FOIA
UK Liberty on MPs opting out out FOIA
ARCH Blog on information sharing
The Times on freedom of the press
Not Saussure on whistleblowers
Onora O'Neill on trust and accountability
Shuggy on grassing

Genes and opportunity

Most people would agree that one of the key political issues is this:
How can talented children from poor backgrounds have the same opportunity as those from wealthier backgrounds?

To assess where we are in terms of this goal, we can look at data on social mobility. The problem is, the data can only be interpreted in conjunction with data about heritability of talent.

Say, for the sake of argument, that “ability” is 100% inherited and has no environmental component. Then, in a society that was perfect in terms of the above goal, so that social position was perfectly correlated with ability, would we not find that people never moved from the class they were born into?

Therefore, does it not follow that you cannot assess whether we have the “correct” level of mobility without taking into account heritability? In which case, are not the arguments of both left¹ and right², to the effect that there is “clearly a problem” because so few from the lower classes rise up the hierarchy, entirely specious?

1. Alan Johnson: "There is still a long way to go. A child who is not on free school meals is twice as likely to get five good GCSEs as one who is."
2. David Willetts: "Just 2% of children at grammar schools are on free school meals when those low income children make up 12% of the school population in their areas."

Other articles
Not Saussure on mobility
Stumbling & Mumbling on talent
Conservative Party Reptile on grammar schools
Daily Telegraph on the distribution of ability
The Spectator on David Willetts
Stumbling & Mumbling on nature vs nurture
Peter Hitchens on grammar schools