Efficiency and Total Value Maximization in Evaluating Institutions

"Tools" lecture. Concepts will be used a lot in the course.

Efficiency: An arrangement is efficient if and only if there exists no alternative in the feasible set -- that is, which can be obtained with given endowments and technology -- that is at least as good for everyone and makes at least one individual better off.

We often talk about allocative or productive efficiency.

We can also apply the term to evaluate economic institutions. An organizational or institutional structure is efficient if it is not possible to make someone better off without making someone worse off, allowing for compensation.

Consider a simple firm in which there is an owner, who supplies capital and receives profits, and several workers who have different jobs for which they are compensated.

Start from a given situation.

Suppose you could rearrange things -- match individuals to different jobs (perhaps because they like the new tasks better) in a way that increases each individual's utility and raises the owner's profits.

Was the original situation -- organizational structure -- efficient? No.

Suppose instead that when you rearranged the workers, there was no way of matching them all to jobs they preferred. Does this mean the original organizational form was efficient?

No. It might be possible for the owners or other workers who were better off from the new matching to compensate those who were made worse off in a way that, in the end, left everyone better off than they were in the original situation. If so, then the original arrangement was inefficient.

Efficiency as a Norm

Efficiency is a good candidate for evaluating/comparing organizations. What are the problems associated with efficiency as a norm? [example of multiple efficient arrangements] But with these caveats we will proceed, and consider efficiency a goal.

Incentives and Efficiency

Under certain conditions, efficiency tends to win out over inefficiency. For this to be the case, individuals need to be able to bargain and enforce their decisions at low cost.

Suppose an institution is inefficient.

Then someone always has an incentive to propose an efficient arrangement, and there will always be a way to do so in a way that makes everyone at least as well off as they were before.

This argument is often used to explain corporate takeovers.

In the simple firm example above, if it were known by someone -- either inside or outside of the firm -- that there was a mismatching between workers and jobs, they would buy the firm, then make the efficient changes (or propose the efficient arrangement in a way which everyone would accept).

Problems: One example is in trade policy. Tariff reductions may increase efficiency. But how to pay off those you make worse off is a problem. (A side issue is "should you pay them off at all," but that is not the point here.) And how do you know how much you have to pay off certain groups when they have an incentive to overstate damages?

Efficient institutional arrangements are stable in the sense that no individual or coalition with the ability to change the arrangement would actually do so. Ability means the authority to propose changes.

Total Value Maximization

It is very difficult to check whether an institution is efficient, because it requires that you know the preferences of each individual, and see if accounting for changes in each thing that they care about (not just wealth), they are better off.

Enter TVM.

Theorem: If there are no wealth effects (with respect to individuals' preferences), an arrangement is efficient only if it maximizes total value with respect to these individuals.

This is useful because checking to see whether total value is maximized is easier than evaluating how each individuals' utility changes.

But what does "no wealth effects" mean?

It means that consumers' preferences between any goods or bundles of goods do not change with their wealth.

In effect, it means that we can separate wealth from all other goods in the utility function: U(x, y1, ... yn)=f(x)+g(y1,...yn). 

What must hold under the "no wealth effects" assumption? What does this mean? For example, some people would be unwilling to take certain jobs for any amount of compensation. Suppose part of the wealth maximizing arrangement were for me to work at USC tutoring offensive linemen. But there was no amount of money available for me to accept such a heinous task. Then the wealth maximizing arrangement will always leave me worse off than the present non-wealth-maximizing arrangement, and hence cannot be ranked higher on efficiency grounds.  Here there are multiple efficient arrangements, and at least one does not maximize wealth. (An a more prosaic level, morality concerns may play a role. Orthodox Jews working on the Sabbath.) If individuals do not have the wealth to compensate others when they move from a worse to the wealth maximizing arrangment, non-wealth-maximizing arrangment may be efficient (cannot move to the wealth maximizing arrangement without making someone worse off). It may be efficient to make Steve Lavin financially responsible for reductions in alumni donations resulting from poor basketball teams. But this would run into wealth constraints. Lavin could not pay off in bad states of the world.

Ticket allocation example:

Consider Harold's preferences for seats at Dodgers' games. Harold's preferences exhibit wealth effects. Why?

Suppose x represents Harold's initial wealth, B indicates "box seat," and U indicates "upper deck." Then we can represent Harold's preferences as: If NWE holds, then subtracting $10 from Harold's wealth in the second should not make him prefer the box to the upper deck. But it does, since doing so yields U(U,x)>U(B,x-10), which contradicts the first relationship.

Harold valuation sitting in the UD relative to the box depends on his income. He prefers the upper deck when he has high income, and the box when he has low income.(Interpretation might be: When you're rich, you don't need status symbols to make you feel wealthy?) 

Under no wealth effects....

The extra utility I get from having a box seat rather than the upper deck does not depend on my wealth. Reasonable? Suppose I have a ticket for a box and you have one for the upper deck. Then the amount you would have to pay me to change seats would not differ between when I was a grad student and once I became a professor.

But we still use this assumption. Why?