Economics and Ethics
ECONOMICS AND ETHICS
Economics often is regarded as the most successful of the social sciences in developing a scientific theory of social behavior. Therefore, economics is a science with manifest ethical implications.
General Equilibrium Theory
Contemporary economic theory is based on the general equilibrium model first outlined by the nineteenth-century Swiss economist Léon Walras (1834–1910) and perfected in the post–World War II era by Kenneth Arrow (b. 1921; winner of a Nobel Prize in economics in 1972) and others. The Walrasian general equilibrium model includes firms, which transform production inputs (land, labor, natural resources, capital goods such as buildings and machines, and intermediate goods produced by other firms) into outputs (including consumer goods and services) by using a technologically determined production function that summarizes the most technically efficient way to transform a specific array of inputs into a particular output or array of outputs. The only other actors in the general equilibrium model are individuals and government. Individuals supply labor to firms and own the land, natural resources, and capital, which they supply to firms, and also are consumers who use the income they derive from supplying inputs to production to purchase goods and services that they then consume. The government enforces property rights and contracts and intervenes to alter economic outcomes that are considered inefficient or inequitable.
The general equilibrium model assumes that there are many firms competing to supply each good desired by consumers. Equilibrium takes the form of a set of prices for the production inputs and outputs so that supply equals demand for each good as well as for labor, land, capital, and natural resource inputs. General equilibrium theory shows that once the equilibrium prices are known, if individuals and firms are allowed to trade in competitive markets, the equilibrium allocation of production inputs and outputs will emerge. This process often is called market clearing.
General equilibrium theory assumes that each individual has a preference function that reflects that individual's labor supply and consumption rankings, as described by rational choice theory and decision theory. The central property of preferences in the theory is that they are self-regarding; this means that individuals care only about their personal labor supply and commodity consumption. It also means that individuals are completely indifferent to the welfare of others and never willingly sacrifice on behalf of other market participants. To make this assumption more palatable, the individuals in general equilibrium theory often are described as families, thus allowing for nonmarket altruistic interactions among nuclear family members.
Consumer Sovereignty
The most important ethical judgment in general equilibrium theory is that involving consumer sovereignty: A state of affairs A is normatively better than a state of affairs B for individuals if, with everything else being equal, these individuals prefer the labor and consumption bundles they have in state A over those they have in state B. For a graphic illustration, assume that there are only two goods, Apples (a) and Nuts (n). Suppose the consumer is restricted to choosing from the Apples-Nuts bundles depicted by region S in Figure 1, bounded by OADB.
In this figure I1I1and I2I2represent indifference curves, which are sets of points along which the consumer is equally well off. These curves exhibit diminishing marginal rates of substitution; this means that the greater the ratio of nuts to apples is, the more the individual values apples over nuts, and vice versa. Note that the indifference curve I1 intersects the interior of region S, and so an agent may increase his or her consumption of both Apples and Nuts. Thus, that individual can shift out his or her indifference curve, and hence increase his or her utility, as long as that indifference curve continues to intersect region S. The consumer is thus best off with indifference curve I2, which intersects S at the single point D, at which point the indifference curve is tangent to the constraint set S. Consumer sovereignty judges consumption point D, at which the individual consumes a* units of Apples and n* units of Nuts, to be a welfare optimum for the individual.
Consumer sovereignty is a problematic ethical judgment in at least three ways. First, it ignores the distribution of economic benefits across individuals. If individual I1 is very rich and all the other individuals in the economy are very poor, it can be said that society as a whole is normatively better if I1 is made even richer as long as this is not done at the expense of the other individuals. Assuming that individuals are self-regarding, this is a plausible ethical statement, but if the poor care about equity and are hurt when their relative deprivation is exacerbated, the consumer sovereignty judgment will be flawed. In fact, it appears that individuals do care not only about their own consumption but about how it compares with that of others as well, and so improving the consumption opportunities of one group can hurt another group (Lane 1993).
A second problem with the consumer sovereignty principle lies in its failure to recognize that individuals may prefer things that are not in their own interest. For instance, it is in the nature of the addiction that a cigarette smoker prefers smoking to abstaining, but even smokers recognize that they would be better off if they abstained. Consumer sovereignty at one time was an inviolable article of faith for economists, who considered evaluating people's preferences an insulting and socially undesirable form of paternalism. Widespread phenomena such as obesity, recreational drug use, and substance addiction have convinced many economists that there is a role for government intervention to curb consumer sovereignty in such spheres. However, these sentiments are restricted to a few well-defined areas. The values promoted by economic theory are generally hostile to the notion that scientists and the educated elite (e.g., teachers, preachers, and social workers) know best what is good for everyone else.
The third problem is that consumer sovereignty implies that individuals care only about their own well-being, whereas people often care about each other. In fact, people often positively value contributing to the welfare of the less well off and to the punishment of social transgressors.
Pareto Efficiency
Consumer sovereignty leads to a very simple but powerful means of comparing the normative worth of two economic situations. One says that state A is Pareto superior to state B if at least one person is better off in state A than in state B and no one is worse off in state A than in state B, where better off and worse off are synonyms for higher up and lower down on one's preference ordering according to consumer sovereignty. It then can be said that state A is Pareto efficient if there is no other state that is Pareto superior to it. These conditions are named after the nineteenth-century Italian engineer and sociologist Vilfredo Pareto (1848–1923).
The important point here is that the Pareto efficiency condition expresses the very weak ethical judgment that society is better off when one member is better off and none worse off, and an individual is better off when he or she has more of what he or she prefers. Any maximally ethically desirable state of the economy will be Pareto efficient because otherwise, by definition, there would be a normatively superior state. Thus, one can separate the normative question "Who deserves to get what?" completely from the positive, nonethical question "What are the conditions for Pareto efficiency?"
The relationship between Pareto efficiency and the normative question of the distribution of welfare among individuals was diagramed by the English economist Francis Ysidro Edgeworth (1845–1926) in what has come to be known as the Edgeworth Box diagram (see Figure 2). One can consider a simple economy with two individuals (I1 and I2), two goods (Apples and Nuts), no labor, and no firms—the two individuals simply trade with each other. The width of the rectangle represents the total amount of Apples, and the height represents the amount of Nuts.
Suppose point C represents the initial wealth of the two individuals so that I1 has FG Apples and 1E Nuts and I2 has G2 Apples and EF Nuts. The curve represents an indifference curve for I1, a locus of points (combinations of Apples and Nuts) among which I1 is indifferent, preferring all the points to the northeast to points on the curve and preferring all points on the curve to points to the southwest of the curve. Similarly, is an indifference curve for I2. Note that point D lies on both curves, and it is easy to see that D is Pareto efficient because any move away from it will make either I1 or I2 worse off. Clearly, the initial point C makes both agents worse off than they are at D, and so it would benefit them to trade, with I1 increasing the amount of Apples in his bundle by getting them from I2 and I2 increasing the amount of Nuts in her bundle by getting them from I1.
The locus of points 1ADB2 is called the contract curve and is the set of Pareto efficient points for this economy. Note that at point 1 individual 2 gets everything, whereas at point 2 individual 1 gets everything. The points between represent different distributions of the benefits of the total supply of Apples and Nuts in the economy. Of course, I1 prefers C to most of the points on the contract curve below C and I2 prefers C to most of the points on the contract curve above C. To find out exactly which point or points each individual prefers, one can draw the indifference curves for the two agents that go through C and see where they hit the contract curve. Suppose they hit at C1 and C2 (not shown in the figure). Then the two agents will be willing to trade at any point on the contract curve between C1 and C2.
Implications for Ethics
The general equilibrium model has several important implications for ethical theory. The First Fundamental Theorem of Welfare Economics states that any equilibrium of the market economy is Pareto efficient. Note that this conclusion depends on the assumption of self-regarding preferences. If, for instance, above a certain income level people care only about their relative position in the distribution of material benefits, a market-interfering law that prohibited people from working more than a certain number of hours per week could increase the welfare of all people.
Suppose that the various production sectors have production functions that do not depend on one another and that efficient firm size is sufficiently small that there can be many firms producing each good in equilibrium. Then a Second Fundamental Theorem of Welfare Economics holds. This theorem states that if the economy satisfies the conditions stated above and a few technical conditions, any Pareto efficient allocation can be supported by a suitable initial distribution of ownership rights in land, natural resources, capital goods, and labor. This theorem successfully separates the positive (technical, scientific) issues of Pareto efficiency from the normative issue of who deserves to get what.
Perhaps the most distinctive normative characteristic of the Walrasian general equilibrium model is its strong commitment to separating considerations of technical efficiency from considerations of normative distribution. This separation is completely justified only if there is a mechanism to distribute initial ownership rights in a way that achieves an ethically desired distribution of welfare. The separation nevertheless often is defended by saying that if the economy attends to the efficiency side of the dichotomy rather than sacrificing efficiency in the name of equity, in the long run most individuals will be better off. This is doubtless a defensible position, although there are often government interventions that promote efficiency and satisfy egalitarian goals as well (Bowles and Gintis 1996).
Several aspects of the general equilibrium model render it an imperfect basis for making judgments about social policy and ethics. First, people are not entirely self-regarding. Rather, they are what may be called strong reciprocators who prefer to reward those who help them and contribute to social goals and to punish those who hurt them or act in an antisocial manner (Gintis, Bowles, Boyd, and Fehr 2003). Strong reciprocators prefer to redistribute resources to the needy if the recipients are considered worthy but not otherwise. This leads to social policies that would not be envisioned under the assumption of the general equilibrium model that people are self-regarding (Fong, Bowles, and Gintis 2004).
In addition, the idea of achieving social equity by means of an initial distribution of wealth among individuals in society followed by market exchange ignores the problem that with incomplete knowledge of the future the process of egalitarian redistribution away from the wealthy and toward the needy will have to be repeated time and time again as the economy moves away from a condition of basic equality to one of severe inequality. That type of redistribution may be infeasible because of the ensuing individual disincentives to accumulate wealth and income-earning capacity.
To see this one must remember that the general equilibrium model assumes that all goods and services are marketable and can be the subject of contracts that are enforced costlessly by a third party such as the judicial system. For instance, several behaviors that are critical to high levels of productivity—hard work, maintenance of productive equipment, entrepreneurial risk taking, and the like—are difficult to monitor and thus cannot be specified fully in any contract that is enforceable at a low cost. As a result key economic actors, namely, employees and managers, must be motivated by incomplete contracts in which monetary rewards are contingent on their performance. However, when incentive rewards are necessary to motivate behavior, egalitarian redistribution works against those who supply a high level of effort, leading to a dampening of the incentive system. Hence, it may be impossible in practice to separate efficiency from equity issues.
Another problem with periodic egalitarian redistribution is that it may violate the principles of justice that many people hold. According to the English philosopher John Locke,
every man has a property in his own person. ... The labour of his body, and the work of his hands, we may say, are properly his. Whatsoever then he removes out of the state that nature hath provided, and left it in, he hath mixed his labour with, and joined to it something that is his own, and thereby makes it his property (Second Treatise on Government (Of Property Chapter 5, Section 27).).
Such values would preclude the involuntary redistribution of wealth even if it furthered widely approved egalitarian ends.
In short, technical efficiency and normative issues concerning justice and equality cannot be separated in the manner intended in the Walrasian general equilibrium model. Moreover, because individuals are not completely self-regarding, social policies based on this model will fail to tap the genuine egalitarian motives of voters and citizens. This said, it would be folly to use these shortcomings to override completely the assumption in the Walrasian model that in the long run economic efficiency and efficiency-oriented technical change are more likely to help the less well off. Insofar as this is the case, issues of egalitarian reform should be biased as much as possible toward efficiency-enhancing redistributions such as education, training, and the financing of small business and small-scale farming.
Contracts
Another important set of issues arises when it is recognized that the neoclassical assumption that contracts can be written and enforced costlessly generally does not hold for either labor or capital. In the case of labor an employer can offer workers a legally binding wage, but a worker cannot offer the employer a legally binding amount of effort and care. This is the case because effort and care are not sufficiently measurable that a violation would hold up in a court of law. Therefore, employers generally enter into long-term agreements with their employees, using the threat of termination and the promise of promotion to elicit a high level of performance. However, this practice will motivate employees only if dismissal is costly to an employee, and this will be the case generally only if it is difficult to obtain comparable employment with another firm. That will be the case only if there is equilibrium unemployment in the economy. It can be shown that if employers follow this strategy of worker motivation, there indeed will be unemployment in equilibrium (Gintis 1976, Shapiro and Stiglitz 1984, Bowles 1985, Gintis and Ishikawa 1987, Bowles and Gintis 2000).
This situation accounts for the fact that employers generally have power over their employees in the sense that employers can use the threat of dismissal to induce employees to bend to their will, whereas the converse is not true. Although this power may be used benignly, it also may be used in an unethical manner, as occurs when employers force employees to accept unhealthy working conditions or subject them to sexual harassment and other forms of personal humiliation and discrimination.
In the case of capital the difficulty in contract enforcement arises because the borrower cannot make an easily enforced promise to repay a loan. Of course, a wealthy borrower can offer collateral in the form of valuable assets that the lender has the right to seize if the borrower defaults. Nonwealthy borrowers who lack collateral thus are frozen out of many capital markets. Special credit institutions have arisen to give non-wealthy individuals access to credit for home and automobile ownership as well as credit cards for consumer purchases. In the case of home and automobile purchases the asset itself provide collateral, and requiring the buyer to provide a sizable down payment assures the lender against sustaining a loss. In the case of credit cards the threat of a loss of one's credit rating and hence future access to consumer credit serves to protect lenders against loss (Bowles and Gintis 2000).
The absence of costlessly enforced contracts in capital markets has several important social implications. First, demand generally exceeds supply, leading to credit rationing (Stiglitz and Weiss 1981) in which wealthy agents have access to loans whereas nonwealthy agents do not. Second, banks and other lending agencies have the same sort of power over borrowers that employers have over employees by virtue of their superior "short-side" market position. This power is subject to abuse by lenders, although large borrowers have a counterbalancing power to injure lenders so that in effect it is only the small borrower who must be protected against the arbitrary actions of lenders (Bowles and Gintis 2000).
HERBERT GINTIS
SEE ALSO Consequentialism;Efficiency;Political Economy;Rational Choice Theory.
BIBLIOGRAPHY
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