Efficiency, Fairness and The Markets

How do we achieve both efficiency and fairness as India takes a leap ahead? Through policies that have their hearts in the right place, but also the awareness of how powerful incentives are.

Imagine a hot afternoon in May, in Rajasthan. the sun a fiery ball in the sky. Babloo, owner of a small shack in the middle of the desert, idles away, waiting for a customer to come by. At this hour of the day, travelers want a bottle of water or a dose of tobacco. And being the only shop in miles, Babloo often charges any amount that comes to his head for that bottle or that pack. Years of experience have also taught him to read a customer’s wallet from his face.

Ah, here they come! A car and a bike stop in front of his shop. From the car emerges a young man called Amit. On the bike is Dilip. They both ask for two-three bottles of water each. Babloo checks his stock; he has just two of them left. Typically a bottle would go for Rs.20. But Amit seems loaded. 100 bucks a bottle, announces Babloo, I just have two left.

Dilip is shocked. “100 bucks? What rubbish!” he says. “I just have Rs 50 on me.” Amit takes out a 500-rupeee note, gives it to Babloo and says, “Keep the change”. He starts walking back to his car, both bottles in hand. Dilip is livid. He knows very well that for 50 miles in either direction, there is no place where he can get water, and his throat is parched. He believes he deserves some share of the water and pleads with Babloo and Amit. Soon, things get heated up and they decide to approach an economist who happens to live nearby. (OK, this is just a story to initiate an analysis of fairness and efficiency in the light of economics and game theory, so don’t ask why there’s an economist living close by and no one to sell water in a 50-mile radius. Thank you.)

Anand, the economist, is impressed by their arguments. All three of them have a solid case. Babloo, being a shop owner, has every right to decide how and whom to sell the bottles to. If he decides to give them away for free, it’s his choice. If he decides to earn as much money from the customers as possible, that too is fair. If he decides to charge as high a price as possible, while restricting every customer to just one bottle, that’s again purely a choice of his own. Understandably, there is nothing much to criticize him about.

And then there is Amit, desperate for water. He wants to drink as much water as possible. Or maybe he wants to drink one bottle and he needs another to pour on his car engine that has heated up. Whatever the reason, he needs two bottles and he isn’t willing to settle for less. How can one possibly find a fault with that?

But how can one blame Dilip either? He has been riding through the heat, and he wants a bottle of water for which he is willing to pay. It’s just that he can’t pay as much as Amit.

Anand listens to everyone intently. And finally says, “I’m really sorry, my friends. I have to disappoint you. From my heart, I feel that they both should get a bottle each. But honestly, you came to me to hear me as an economist, and not Anand, the person. And as an economist, I am afraid, I don’t have one very good answer.”

Why is Anand not of any help to these three people? What’s the use of studying economics if a simple dilemma like this can’t be answered satisfactorily? After all, this is a simple problem where almost every person whose heart is in the right place would want Amit and Dilip to take a bottle each even if that means that Babloo makes a bit less money. Sure, there will be some radical libertarians who would prefer Amit taking both the bottles. But let’s leave them aside for a moment. If we, possibly broadly, agree that Amit and Dilip should take a bottle each, then why should it be so difficult for an economist to say so?

The answer to that is fairness is a rather tough nut. It’s an incredibly complex, contextual and vague a notion to formalize and develop normative guidelines for it. However, efficiency, as economists see it, is a rather simple and obvious concept that one can interpret in a normative manner.

The word “efficient” in economics typically means what is known as Pareto Efficiency. In simple terms, it means that an allocation of resources is efficient if we cannot redistribute those resources in such a way so that everyone is at least as well off as they were before and at least someone is strictly better off. That is, it is impossible to allocate resources in in a way that makes any one individual better off without making at least one individual worse off.

For example, given that both Amit and Dilip would like as much water as possible, Amit getting both the bottles and Dilip getting none is efficient because any other redistribution makes Amit strictly worse off. If we include Babloo and look at this ‘three-person’ system, the allocation is still efficient. The catch is, suppose Anand, the economist, gave a verdict that Amit and Dilip should get a bottle each, knowing that this would reduce Babloo’s profits, then, even that allocation is efficient! That, in many ways, is really the limitation of what economics can offer to a very practical problem such as the one we saw.

This is not to say that something is deeply deficient in the way economics is studied. The problem lies in the fact that formalizing fairness is a very difficult concept. Suppose, for a moment, that we decide that economists should combine efficiency with fairness to give out their verdict. But what is fairness? Suppose instead of two people (Amit and Dilip), three people were fighting over two bottles of water. But each of them wanted at most one bottle. Now, what should we do? Any allocation is going to result in one person not getting any bottle of water. Do we call the outcome unfair?

Where does efficiency come about in all this? Since fairness is quite hard to define precisely and address it head on, we take a step back and do something different. If we set the bar to achieving an efficient allocation, then all we are really saying is that no matter how we allocate resources, we should not waste something. This is the sense in which many people call these kind of policies ‘making the pie larger’. By going after allocations of these kinds, we are ensuring that what we achieve is the largest size of the pie.

For example, we have a pool of land that a farmer owns and the government discovers that there is a tremendous amount of oil underneath it. A businessman wishes to buy the land off from the farmer and for as little price as possible. The farmer, say, is going to make Rs 30 lakh in terms of present discounted value from the land and the oil field is going to fetch the businessman Rs1 crore for one year and zero thereafter. The efficient thing to do is for the farmer to sell the land to the businessman. But at what price?

That, as an economist, I would be agnostic about. This is because the farmer, if he is wise, could charge the businessman just a little under Rs 1 crore and the businessman would still agree to the deal. This is so because the businessman was anyways making zero without the land, but now he would make something positive. On the other hand, if the farmer charges just above Rs 30 lakh, even that is alright as the farmer is still strictly better off. What we don’t want, under any circumstances though, is the trade not happening. This is the idea behind striving for efficient allocations. A person who values a certain object the most should get it. This is the driving force behind all auctions. And how do we achieve a fair outcome through this? Now that we know that no trade between the businessman and the farmer is worse for everyone, we, as government, then force the farmer to sell the land to the businessman and we fix the price arbitrarily at Rs 50 lakh and make both the parties better off.

This is where two key theorems, called simply the First and Second Fundamental Theorems in Welfare Economics come into the picture. The first theorem, whose most general proof was given by Kenneth Arrow and Gerard Debreu in the 50s, is taken as a proof of Adam Smith’s ‘Invisible Hand’. The first theorem says that when people exchange objects (say money and goods) at some prices in the economy, where the price is a result of their interaction, the outcome is efficient. We now know the precise sense in which it is efficient. Therefore, the size of the pie in the economy is as much as it could have been in any other allocation.

The second fundamental theorem is much more powerful and maybe even beautiful. It says that amongst the set of all the efficient allocations, one could achieve any outcome that one likes through a market economy after redistributing wealth and then letting the market take over. This is really the driving force behind nearly all the arguments that we see supporting a market takeover! This, along with some other stuff written around that time, in many ways showed why capitalism can work and work well. Observe that in our fictitious story, if some government could give Dilip some money from Amit and let them compete, the outcome would be each of them getting one bottle each.

Take a moment to think about why these two theorems are beautiful, elegant and very powerful. This gave a remarkably strong foundation to letting markets take over. Then came Milton Friedman and the likes who pushed the agenda further. At the height of the Cold War, a strongly analytical and foundational proof of why competitive economies work did wonders for all the supporters. The movement, as it happens in any intellectual discipline, was checked partly due to American economist Akerlof’s seminal work called The Market for Lemons, where he showed that, if there is some bit of ‘asymmetric information’, that is, suppose buyers aren’t sure of the quality of the items the sellers are selling, then under certain conditions the market can completely break down.

This is exactly what happened during the 2008 credit crunch when credit froze as both sides of the market were unsure about each other. The point Akerlof proved (he won the Nobel Prize for Economics in 2001 for his work) was that not all is hunky-dory with the market and there is at least a case for government intervention when there are informational asymmetries. But then, that got us back to a famous critique by Freidrich Hayek from his extraordinary essay called The Use of Knowledge. Hayek argued that no government can do better than the market as prices convey information and the government, if it is to do better, would need the information.

How do we then reconcile Akerlof and Hayek? What I believe, and there is every chance that I have understood my Hayek and/or Akerlof wrong, is that the way to think about all this is what is known as ‘constrained efficiency’ where the question asked is: If the government had the same instruments as the agents in the economy, then can it do better? If the answer is yes, then we definitely have a very strong case for a government intervention.

Coming back to the point of relating all this to fairness, if we know that any efficient allocation can be obtained by redistributing resources in some way, then we peg back the question of choosing a ‘fair allocation’ to the planner himself. Since it is mostly a question of taste, an economist would probably not want to build a theory around it. Instead, economists are telling the planner to start with some lump-sum transfer to the people and then they can interact in the market and give an allocation that the planner intended them to. This is really the philosophical base with which people push for market-based economies. In most practical problems, the government could do this wealth transfer later through taxes and redistributive policies. But, as in the farmer-businessman case, if there is no market, there is no trade and everyone is worse off.

As nice as it sounds, obviously there are very many caveats. Since all the argument in favour of the market rests on a planner’s ability to implement wealth transfers if he wants a particular outcome, what if they are not available? This is absolutely not far-fetched; we can think of many such situations. In all those, if a government cares about fairness and has some objective criterion for doing so, how can it possibly achieve an outcome that it desires without transfers? And if it cannot, then would it not rather have a more fair outcome than an efficient but a highly unfair one?

In India, these are very exciting times. We have, in all likelihood, broken from the past of crony-capitalism in the name of socialism or caring for the poor. There is a strong push from Modi supporters to implement market based policies. But Modi has traveled through the length and breadth of India. He has seen poverty. He would know too well that it is extremely difficult for the government to reach out to all the poor and implement transfers so that post-transfers, the market delivers. Unfortunately, in scenarios like these, economic theory doesn’t have a lot to offer.

When people say that a certain policy is a bad policy because it’s not efficient while market is, they tend to forget the almost mandatory concerns of fairness—however hazy and imprecise–that any government needs to have. For any government, if it’s crippled with the inability to transfer wealth to people, then it is far from obvious that it should choose efficient policies. Even if one doesn’t care for the poor, (yes such people can exist too), one must remember that there are significant links between propensity to commit crimes, violence and burglary once your income drops. Isn’t it somewhat obvious that one who has too little to lose will probably commit all kinds of crimes? For a person who has barely any food to eat, an act of burglary, if not caught, can yield substantial returns. If caught, he will end up in a jail which also is probably not all that worse than his current status. A planner needs to be aware, sensitive and pragmatic about this.

At the same time, an aspect of economics which makes it probably as powerful as what it is, and an aspect that is completely absent in this post, is incentives. Everyone needs an incentive to work. Yes, even the bleeding hearts have their fancy handbags and perfumes, their conferences in Delhi’s plush India Habitat Centre with cocktail dinners, the FabIndia saris and what not, that act as incentives on a discussion on poverty.

If the government gives free food to the poor, how do we know that they would still go and work in the field? And if they don’t, who produces food? A planner needs to be aware of this. Most right-wingers, who call for market-oriented approaches, are largely focused on these issues. So even if they, for a moment, miss the point about fairness, this concern is well-founded. What we need therefore, are people whose heart is in the right place in terms of caring for the poor but who have enough experience to know how powerful incentives are. It is the people with these sensitivities and pragmatism who will help us solve the problem of efficient and fair policies as India takes a jump ahead. For now, we can safely laugh at those who mock the right-wingers as lacking concern for the poor. Many right-wingers have their hearts pretty much in the right place. Not widely understood is the role of the welfare theorems in pushing for market-based economies and fair outcomes, though. Coupled with that though, they will do a splendid job.

As I said, these are exciting times and I am quite optimistic.