Pareto's Republic and the New Science of Peace

by Filip Palda

  While such regimes may sometimes produce remarkable accomplishments in architecture, military prowess, and education, their leaders can use extreme means to achieve their ends. They have ignored the 100 percent approval characteristic of Pareto efficiency. This characteristic, the second pillar of Pareto efficiency, is a fail-safe mechanism that limits the adverse effects of decisions about how to use physical and human resources. The second pillar arises from the fact that Pareto efficiency does not admit that the well-being of one person should be sacrificed for that of another.

  The third pillar of Pareto efficiency is that it provides a flexible system of social accounting that does not require that everyone get an equal benefit out of an exchange. All that Pareto efficiency requires is that, at the very least, one person profit and none is harmed. This is perhaps the most remarkable and subtle aspect of Pareto efficiency. To see why, we need once again to look at an opposite case. In small groups living in stable communities, Pareto efficiency is of little interest or importance. Their members live in fixed relation to each other, which allows them to go beyond efficiency to attain fairness. More specifically, the community’s intimate nature allows it to identify and correct imbalances caused by those who are considered too greedy or too lucky in their affairs. Community members may depend upon each other to such a degree in order to survive that the idea of an explicit exchange of goods may not even arise. Such is the case in an Israeli kibbutz, a Mennonite community, or among the Bushmen of the Kalahari. The main challenges in their lives are collective. Collective challenges inculcate an egalitarian mindset.

  These societies usually rely on some idea of reciprocity. Scholars call such notions of reciprocity Golden Rules. Those rules aim for everyone to contribute fairly to communal work. The problem with Golden Rules is that as a community grows and people become distant from one another, it becomes difficult to enforce a uniform notion of fairness in exchange. When a society grows into a collection of fast-moving, anonymous individuals, a more flexible and quantifiable version of the Golden Rule is necessary. That version is Pareto efficiency. It does not require that the fruits of an exchange be equally divided between both parties. An exchange is efficient if it makes at least one party better off and none worse off. The balance may not be perfect as it might seem to be in Golden Rule communities, but it is sufficiently satisfactory, even for perfect strangers. These types of exchanges need to be facilitated so that a society can continue to grow.

  A sense of community, stability, and a certain flexibility in the exchanges we can make with others sound fine, but how does any of this lead to prosperity? To answer this we need to know what prosperity is. The concept has a static and a dynamic aspect. Imagine you inherit a farm with rich land, equipment, and livestock. That is prosperity of a static sort. Finding new ways to use your land to maximize its value can lead to prosperity of a dynamic sort. Paul Romer, possibly the leading expert in the study of economic growth, illustrated this point by noting that

  In most coffee shops, you can now use the same size lid for small, medium, and large cups of coffee. That was not true as recently as 1995. That small change in the geometry of the cups means that a coffee shop can serve customers at lower cost. Store owners need to manage the inventory for only one type of lid. Employees can replenish supplies more quickly throughout the day. Customers can get their coffee just a bit faster. Although big discoveries such as the transistor, antibiotics, and the electric motor attract most of the attention, it takes millions of little discoveries like the new design for the cup and lid to double a nation’s average income.

  The search to enhance the use of resources is not exclusive to societies geared towards Pareto efficiency, yet such societies are particularly successful in this search because of the way they allow people to express talent. Pareto-efficient societies encourage the use of talents that can benefit their owners and others, but harm no one else. Societies that allow deviations from Pareto efficiency allow darker talents to be expressed, such as a knack for preying on the riches of others or simply indulging in a taste for mayhem. Economists Kevin Murphy, Andrei Shleifer, and Robert Vishny expanded on the differences between Pareto-efficient and predatory societies in a 1991 article by observing that which activities the most talented people choose can have significant effects on the allocation of resources.

  When talented people become entrepreneurs, they improve the technology in the line of business they pursue, and as a result, productivity and income grow. In contrast, when they become rent seekers, most of their private returns come from redistribution of wealth from others and not from wealth creation. As a result, talented people do not improve technological opportunities, and the economy stagnates. (page 505)

  As examples of rent-seeking—the act of cutting up society’s resources rather than finding better ways to exploit them—they point to Mandarin China, medieval Europe, and African countries in this century where “government service, with the attendant ability to solicit bribes and dispose of tax revenue for the benefit of one’s family and friends, was the principal career for the ablest people in the society.”

  Pareto efficiency as a dynamic concept

  Pareto efficiency is a broad principle upon which to organize society, but it is not a complete principle. It is mainly useful as a guide to organizing society once resources have been divided up. Before such a division, Pareto efficiency is no guide to using resources. This may seem an extremely unlikely nuance to worry about, but it does arise during rare instances of social upheaval and it has some importance in discussions about fairness, as we shall see in the next chapter.

  The challenge of coming up with an initial allocation of resources is remote to Western minds, but it was the sort of problem East Bloc countries faced starting in 1989 when they moved from state to private ownership. Pareto efficiency was of little help as a guide to allocating these resources. Think of a society in which the only product one can consume is apples and that government has control over all of them, but wishes to allocate them to its subjects. It can split the apples evenly among citizens, it can give all to one individual and none to others, or it can devise many other splits or “allocations.” Any one of these possible allocations is Pareto-efficient! That is because once the split is made, there is no way to intervene and split up the apples again without harming at least one person. Clearly, in a case such as this, Pareto efficiency is no guide for government action.

  Some other principle, such as fairness, or even fear, is needed to decide the initial split of resources. In the East Bloc fear was the main motivation for a too quick division of communist property. Journalists have called this restitution “the theft of the century,” but East Bloc economists such as Vaclav Klaus and Yegor Gaidar pushed their governments to privatize quickly out of a concern that communism might return should the state be allowed to keep its assets. In addition to seeking to thwart a return to communism, economists sought a restitution of property—fair or not—in part because they believed in something called the “second fundamental theorem of welfare economics.”

  The second welfare theorem states that if you can distribute to people initial allocations of resources in the form of “lump-sum transfers,” that is, without any strings attached, this allocation will, through free trade, lead to a specific Pareto-efficient final distribution of resources. What this means is that if a person is not completely satisfied with the fresh-start package received from government, he or she can seek out other people who have their own packages and trade with them if a mutually agreeable exchange is possible. As Robert Blaug notes, Starr’s 1997 explanation of the importance of the second welfare theorem deserves to be cited. Starr writes that the second theorem

  is the basis of the common prescription on public finance that any attainable distribution of welfare can be achieved using the market mechanism and lump-sum taxes (corresponding to the redistribution of endowments). On this basis, public authority intervention in the market through direct provision of servi
ces (housing, education, medical care, child care, etc.) is an unnecessary escape from market allocation mechanisms with their efficiency properties. Public authority redistribution of income should be sufficient to achieve the desired reallocation of welfare while retaining the market discipline for efficient resource allocation. (page 198)

  One might think of the second welfare theorem as an adult way of describing what happened to the lunches our parents sent with us to school. There was perhaps nothing fair about who got what in the first round, and if the principal had forced some children to trade their lunches with others, there would have been no guarantee that no child would have been disappointed. Yet somehow, in the schoolyard, pastries, sausages, curries, and even vegetables changed hands until children had undone whatever nutritional or devotional scheme their parents had devised, and the happiness of all had been enhanced. The continued trading that starts to take place after the initial allocation, whether in the schoolyard or the boardroom, leads to a dynamic form of Pareto efficiency, which as we shall now see, is a powerful principle on which to order society.

  Property rights and Pareto efficiency

  Pareto efficiency does not come about by itself. It needs some sort of medium through which to work. There are two candidates for the job. One is an all-knowing government that resolves differences over the use of resources by drawing up detailed plans for the economy. The other candidate is the individual, empowered to make personal decisions on the use of resources within his or her control. This sphere of control is called private property. Let us start by looking at this second means of attaining Pareto efficiency.

  Before we understand how Pareto efficiency and property are linked, we need to ask what is property. This is a question that has been debated before courts over hundreds of years. The lesson from this debate is that there is little practical meaning in simply saying that property belongs to someone. Think of a time-share condominium in Florida. In what sense does a person “own” this property? He or she can perhaps stay there two weeks in the year, and may not modify the interior or allow pets inside. The time-share example illustrates that one should not think simply about owning property, but rather about owning varied claims on resources. The fundamental, but not exhaustive list of claims on resources are the right to use and enjoy the resource, the right to its fruits (such as revenues from the sale of minerals or agricultural output), and the right to modify, sell, or dispose of it as he or she sees fit. The set of these claims are usually called property rights.

  Talking of property rights as varying claims to the fruits, use, and disposal of resources may seem contrived, but the degree to which we can understand and appreciate the peace of Pareto depends on how well we can separate the physical image of property from its abstract representation in law. Imagine you own a run-down property from which a non-functioning telephone cable runs into the neighbour’s garden, under his house, and out into the street where it connects with the city telephone network. You want to tear the cable out because it is an unsightly coil. Your lawyer sees something different. To him it represents a right-of-way, which would allow you to pass updated telecommunications cables across the property of potentially hostile owners so that you might profitably hook your house up to the city infrastructure. What you see as the physical essence of the wire your lawyer sees as a legal concept.

  In a system of property rights Pareto efficiency comes about by trade. If you farm apples and someone else farms oranges, both of you can profit by exchanging some of your product because no one wants to eat only apples or only oranges. Of course some other farmer who produces apples but who adores oranges far more than you may outbid you. His or her greater bid will be the final step towards Pareto efficiency if no one else is willing to offer the orange farmer a similar or even greater bid. In such a case, no one’s well-being can be improved without diminishing the well-being of someone else.

  Economists call this Pareto efficiency in consumption. If you have inherited a rental property but have no idea of how to run it, you might go bankrupt. You could avoid that fate by selling the property to someone who knows the rental trade. The exchange makes you richer and allows someone with greater expertise to provide others with an enhanced rental service. Then if a major real-estate management firm with even greater skills comes along, it may offer the person who bought your property even more money for it. When property rights end up in the hands of the most efficient manager, economists say that Pareto efficiency in production has been achieved. In the case of both farmers and property managers, Pareto efficiency comes about by exchanging property until it is either in the hands of the ablest managers, or is being consumed by those who are willing to pay the most for it.

  The most common objection to this view of Pareto efficiency is that it is incomplete because it does not take into account the manner in which price changes can hurt people. If I run a laundry business, I will not appreciate the arrival of immigrants who are willing to work longer than I am, or have greater skills that allow them to undercut my prices. If I live in a sleepy town and have been considering the purchase of a house, I will not be pleased to see property prices being bid up by rich newcomers from the big city.

  By upsetting the market value of property rights, do not these price changes violate Pareto efficiency? Could not the solution to this problem be to create a fourth dimension to property rights? As we’ve seen, the first three dimensions are the right to enjoy, enhance, and transfer property. How about the right to a guaranteed price for one’s property?

  This suggestion is by no means far-fetched. Almost every country has some products for which the government tries to fix or set some limit to the price. In developed countries farmers have successfully lobbied governments for “supply management” systems that stop new competitors from entering the industry and driving down the price of agricultural products. In developing countries that balance of power tilts towards city dwellers who manage through government to extract from farmers food at prices below what they would get if they were allowed to sell the good freely.

  In some cases this “price-security property right” is formally entrenched in law. Broadcast licenses for cable TV are legally recognized property rights that block entry into the market of other cable companies. The same is true of taxi licenses, milk production quotas, and in a more obscure but no less effective way various trade protection societies such as those run by physicians, chiropractors, plumbers, and lawyers who have organized into official bodies with the legal right to limit entry into their professions by competitors who would drive down the price of their services.

  The effect of adding a fourth dimension that guarantees the value of property rights is to violate, or at least diminish, the other three dimensions. A production quota that allows only its holders to sell milk violates the right of cow-owners without a quota to transfer their product to others. Remember that transferability is one of the other three dimensions. Rent control prevents property owners from temporarily transferring their rental property to those willing to pay the most, with the collateral effect of discouraging owners from investing in the upkeep of their rental units. A fixed limit on the number of physicians to be licensed prevents potential physicians from offering their services to potential patients. In these and hundreds of other cases, “price-security property rights” clash with the function of enjoyment, enhancement, and transfer of one’s resources.

  Whether or not to add this fourth dimension in Pareto’s Republic is an extremely complex question, but one that has a clear answer: no. The question is complex because it forces us to understand the difference between initial allocations of resources and continued reallocations based on chance events.

  Following an initial allocation of resources economists have shown through the second theorem of welfare economics that there are no price changes because everyone has exploited the situation to the maximum and all profitable trades have been done. The moment resources are allocated only one final set of prices emerg
es from the haggling that follows in the market. A popular television program illustrates this to perfection. Highly irritated men and women bid for the contents of abandoned storage lockers. Here is the initial allocation. The program follows their attempts then to price, with the help of experts, some musty manuscript or creaky turntable extracted from the miscellany in the locker. This expert price is supposed to be final and in this sense represents the price at which no one is willing to further buy or sell. Once you put resources into peoples’ hands, they immediately search out the best use for them and do so Pareto-efficiently because property rights do not allow one to enter into an exchange that harms the other party.

  Then chance intervenes. Someone discovers a machine that can clean laundry at a tenth of the previous price. That means my laundry business will suffer due to the competitor who invented the machine. Yes, Pareto efficiency is violated, but it is the workings of chance that have made it so.

  To repair or exploit the new opportunities that chance presents, people then once more set about trading resources to find the new Pareto-efficient way of using them. If we were to insulate ourselves from the effects of chance by blocking new inventions then certainly some businesses would continue to survive and some jobs would be preserved, but as the years passed and new discoveries continued to accumulate, a growing pot of gold would be sitting at society’s periphery, untouched. Similarly, we could force people to sell food at a fixed low price to areas afflicted by shortages, but the effect would be to discourage the production of food. Who wants to sell anything at less than what it can profitably produce? Fixing prices creates an imbalance in social accounts that eventually leads to shortages and disaster.