The Reality of Pareto Optimality

Earlier this week I discussed this question of the Kaldor-Hicks criterion versus Pareto optimality: two standards we use for government intervention from the welfare economics perspective. I argued that unless we constrain our assumptions about the world, a completely Pareto optimal government intervention is impossible to reach. After having thought about the issue some more, I realized that this is really a question about open versus closed systems. In a closed system, we can have a Pareto Optimal solution. A broad long-lasting insurance pool benefits everyone who is a part of that pool, but may raise costs for those outside of it. Foundation grants that fund projects in a single city may benefit everyone who lives in that jurisdiction, but it raises the opportunity costs of those living elsewhere.

Theodore Lowi approaches this idea of policy benefits and burdens from a political science perspective. If you remember from our reading on explaining policy choices, Lowi is associated with the idea that policy shapes politics. He argued that there were four types of policies: distributive, re-distributive, regulatory, and constituent (although his earlier work only acknowledged the first three of these categories) . Key to his argument is the idea that each of these types of policies have their own arenas of power, in other words, each of these types of policies produce different relationships between interest groups, elected officials, and agencies.

For this post, I will focus on distributive policies. The current form of distributive policy would be those earmarks and pork-barrel politics that we discussed during the first week of class. They distribute large benefits to a small group of people, but the burdens they place on others (mostly due to taxes and opportunity costs) are small and diffuse. While these may meet the Kaldor-Hicks criterion, they are certainly not Pareto Optimal. The original use of the term "distributive policy" was to describe 18th and 19th century American land policies. During that time, land in America was considered an almost unlimited resource. The American government was basically giving away land to anyone willing to travel west. From the perspective of 18th and 19th century Americans, I would argue that distributive policies, as defined in this way, were Pareto Optimal. There was enough land to go around, those willing to make the trip to the west could have it, freeing up space and resources for those remaining on the East Coast. Everyone had to travel to the west to benefit, so the opportunity costs were more or less the same for everyone.

I hope that by now you have all recognized the flaws in this argument. This assumes a very closed system. The definition of "American" in this example does not include those who were already living on the land in the West (some of whom had already been displaced from the East Coast), and who were brutalized, killed, and occupied so that American citizens could all benefit from free western land. (Of course, I am talking here about Native Americans/American Indians). Once we extend our system to include Native American/American Indian peoples, we no longer have a Pareto Optimal solution. These policies would not qualify as distributive policies in the modern sense of the term "concentrated benefits with small diffuse burdens", and they would fail the Kaldor-Hicks criterion, as well. The short-term and long-term harms  they imposed (most notably genocide, relocation, and rape) likely outweigh the benefits. This would be true for the colonialist actions of other nations, as well.

The interest in these two criteria for government action in class has allowed me to engage in a thought experiment about what they could look like in real-life. While grounded in economic and policy theory, these arguments are not based on research and should only be taken as thought experiments. I think one lesson here is that policy-makers and analysts need to be weary of solutions that seem to be Pareto Optimal. When burdens of any action seem nonexistent or even small and diffuse, we may be guilty of closed-systems thinking. We,  as responsible members of a global society, need to at least consider the harms and burdens that our actions will cause to those we consider outside our reference group, our society, and our nation. There may still be a good argument for action, but if we don't at least consider these possibilities we risk history's harsh judgement.

The Affordable Care Act and the Kaldor-Hicks Criterion

On Tuesday, I gave a lecture in class about different theories and models for examining the design of public policy, the policy process, and the effects of policy on society. I spent a lot of time on economic models of public policy, as this tends to be the dominant paradigm that policy scholars use to study all three aspects of policy. I discussed welfare economics in-depth including the two major justifications that we use for government action to maximize social utility: Pareto optimality and the Kaldor-Hicks criterion. As a reminder, the standard of Pareto optimality posits that government should intervene in the market if it can make at least one person better off without making anyone worse off. In the global, systemic world in which we live, this is basically an impossible task for public policy to achieve. As I will discuss here on Friday, we can think of some examples of Pareto optimal policies when we constrain our models of society in certain ways, but I have yet to come up with a public policy that does not harm a single person once opportunity costs and relative harms are taken into account. I invite you to help me brainstorm to come up with such a policy. In contrast, the Kaldor-Hicks criterion is easier to meet and is usually what we rely on as our standard for policy-making. The Kaldor-Hicks criterion states that if we can make at least one-person better off through government policy and the benefit to that person or group of people exceeds the harm imposed on others, thus creating an overall net-gain of utility for society, then government should act. Further, the person who is made better-off can, in theory, reimburse the person or people who are harmed, creating a theoretically Pareto optimal solution. Of course, this criterion may lead to extreme inequality even while it creates an overall net gain for society if the same people are always made better off and there is no requirement to compensate those made worse-off.

There was a request from one of my students to apply the Kaldor-Hicks criterion to healthcare reform, specifically the Patient Protection and Affordable Care Act, often referred to as the Affordable Care Act (ACA). In order to do that, we need to take a step back to talk about the concept of insurance in general. Why do we have insurance for some things (car insurance, unemployment insurance, home-owners insurance, social security insurance etc.) and not others? For the basic answer to that question, turn back to my blog post on why we have health insurance, here. In general, insurance is a solution to the problem of imperfect information about our future health that allows us to pool risk across many different people. At a single point in time, we essentially have a classic Kaldor-Hicks situation. The healthy in our (hopefully large) risk pool pay a little more in premiums than they would on medical care for themselves, while the sick pay much less and are not left bankrupt after the sudden on-set of a serious illness. However, rarely is anyone healthy over the entire course of their lifetime. Given enough time in an insurance pool, those who paid in extra when they were healthy will be compensated or reimbursed by paying less than they otherwise would when they are sick. 

So how do people decide whether or not to purchase insurance? Those who are unhealthy, who believe that they will spend less in premiums than they will for their own care will of course purchase insurance, if they can. What about the healthy? They are choosing between spending their money on insurance premiums and other goods and services. Remember, we are talking about rationally self-interested utility-maximizers here so they will each have their own individual utility curves that map this trade-off. This curve is a function of their disposable income, their knowledge about their current and past health, their knowledge about family health history, their degree of risk aversion, and the price of health insurance. Those people who are healthy, young, and risk-neutral or risk-seeking likely will choose to spend their money on other goods and services. Those people with very little disposable income may be forced to spend their money on other goods and services. Those people with an extremely high amount of disposable income who are risk-neutral may decide that they have enough money to cover their individual health costs regardless of what happens to them and avoid purchasing insurance. 

Like any good public policy from the economics perspective, the ACA adjusts this utility curve. The provision that young people under 26 can be added to their parent's health insurance plan reduces the cost of insurance for that young person (who is more likely to be healthy and less risk-averse then the general population). This should incentivize young people (or their parents) to pay for health insurance. By creating state health insurance exchanges, there is greater risk pooling which should lower the costs of health insurance relative to the individual market, incentivizing more healthy uninsured people to purchase insurance. By providing tax-credits for the purchase of health insurance to low- and moderate- income individuals the act increases the income available to spend on health insurance and increases the opportunity cost of purchasing other goods and services, incentivizing more people who would not have otherwise been able to afford insurance to purchase it. Similarly, by imposing a tax penalty on those who do not purchase insurance, the individual mandate changes the opportunity costs of not buying insurance (for those making enough to afford insurance, see more about this here). All of these changes should increase the pool of healthy people who purchase insurance, making those already in the pool better off, but possibly penalizing those who decide not to purchase insurance. 

Once again, this is not the end of the story. We also have provisions that will increase the short-term burden on the healthy individuals in the pool. Health insurers can no longer exclude the sick from health care in the same way that they previously could. They also cannot rescind coverage from individuals when they become sick. The influx of expensive to treat patients into insurance coverage may mean that premiums increase and the Kaldor-Hicks criterion is violated in the short-run. However, in the long-run when these healthy people themselves become sick, these regulations ensure that they will then benefit and be compensated for their previous over-payments. In some ways we can think of an insurance system with a large risk pool as Pareto optimal for those inside the pool. As I will mention on Friday, those  outside the pool will likely still be harmed, making the solution technically non-pareto optimal. Now, when we attach insurance to employment and the labor-market shifts from long-term employment in a single firm to high turn-over positions, how does that affect the ability to remain in an insurance pool long-term? How does that affect our Kaldor-Hicks criterion? Of course there's a lot more depth we can go into here, but I will save that for another time.

Semester Wrap-Up Fall 2011

As we finish up the semester, I wanted to do a quick summary of what I hope you will take away from this course. It has been a pleasure reading your reflection papers and reading your comments about public policy issues. This is the first time I have taught this course online, and I certainly learned a lot; I hope you did, too.

Many people come into this class hoping to find out the "right" answer for how government can solve a problem, be it undocumented or illegal immigration, inequality in the education system, or housing the homeless. I hope that  this course has taught you that the world of public policy is never so simple that a single "right" answer is easy to find. The United States, in particular, has a very complex system of government with three branches at the national level, states with at least two branches, and local governments all working alone and in concert to solve problems. Not to mention that nonprofit and for-profit organizations also play an important role in creating, advocating for, and implementing public policies. While the dream of "three-page" bills would certainly increase transparency, it seems as though our system of government is too complex to make such a goal a reality. Next time a politician suggests a simple answer to a complex problem, I hope that you will view such a suggestion skeptically.

I hope that our discussions of  substantive policy issues peaked your interest, as well. Although our department does not currently have the capacity to offer classes in each of these substantive areas, there are classes in departments like sustainability, criminology, sociology, social work, and economics where you can explore these substantive areas in more depth. Further, for those of you who are planning to pursue the public service and public policy major, I hope that this gave you some ideas in terms of where you might want to do your internship and possible topics for your capstone. The CQ researcher briefs are all accessible online through the library and they provide a good starting point for understanding the "players" and major debates in each policy area. Peters' book provides a more straightforward look at the background of each of these larger policy areas. I hope you will refer back to these resources as you continue your studies of public policy.

In comparison to some of the other courses you may take in this department, this course attempts to instill more of a critical perspective in each of you. While some may see this perspective as oppositional to the more "scientific" and "objective" courses in cost-benefit, statistical, and economic analysis; I believe that both perspectives are essential to the evaluation of public policy proposals. Without this perspective, you may miss some of the underlying assumptions or as Stone would say "counting as" used in these analyses that can fundamentally alter the results of an analysis. You may also miss assumptions that can alienate or confuse policy targets. Ultimately, I hope that those of you who pursue a career in policy, administration, or politics will take your skills in economics, statistics, and critical thinking and combine them to approach each policy skeptically and then choose the policy alternative that fares the best on all three criteria.

Most of all, I hope that you take away the idea that although we may disagree with each other on these issues we can still have a civil discussion about each of them, and generally find at least some point of common ground. It seems as though our policy discourse will only become more fractured and hostile as the 2012 election approaches, and it's important to keep in mind that those who support a different candidate or take a different  perspective on an issue are not our enemy. We can learn a lot more about ourselves and our opinions when we take the time to listen to and understand the other side of arguments, and why others may disagree with our own perspectives.

Thank you all for a great class and I hope you enjoy your winter break!

P.S. Don't forget to turn in your policy memos on the 11th. Make sure you refer back to the rubric from policy memo 1, as we will be using that same rubric to grade your second memos.

The National Debt

I scheduled our discussion of the national debt for this week in the hopes that we would have a deal from the "supercommittee" (officially known as the Joint Select Committee on Deficit Reduction) to discuss. Unfortunately, they were unable to come to any agreement. Instead, I'll talk a little about the readings and then discuss the implications of the lack of a deal.

This week's reading on the national debt is one of the most up to date that we've read so far. Although the chapter was written before the "debt ceiling crisis" of the summer, it asks many of the same questions that the supercommittee has tried to reconcile over the past few months. Most notably, how can we work to reduce our large deficit without stalling or preventing an economic recovery. Of course, the supercommittee is also concerned with the political ramifications of their actions. We have had two bipartisan committees tasked with reducing the national debt, the Bowles-Simpson National Commission on Fiscal Responsibility and Reform and the Rivlin-Domenici Debt Reduction Task Force. Both of these committees were bipartisan and offered recommendations for reducing the debt as models from which the supercommittee could work (even though the Bowles-Simpson commission failed to reach the supermajority among commission members necessary to fully endorse their plan). Even with these blueprints, the committee was unable to make a recommendation for action. As the chapter points out, Americans want to balance the budget while cutting taxes and increasing spending, an impossible task. Any cuts or tax-increases would run the risk of being politically unpopular less than a year before a major national election.

When the Supercommittee was formed as part of the debt ceiling deal this summer, a system of sequestration or automatic cuts to defense, Medicare (providers only), and Social Security was created as a consequence of the supercommittee failing to pass an additional $1.5 trillion in cuts. The good news is that these cuts will not occur until FY2013, so there is still time for Congress to reach an agreement. Policymakers on both sides are already attempting to over-ride sequestration for their preferred programs, but the Obama administration has vowed to veto any such attempts. It seems as though we have reached an impasse.

So, now that the supercommittee has failed, what can we expect? The Obama administration is hoping that the full Congress can pass extensions on the payroll tax cut and extended unemployment benefits before recessing in December. The Republicans are hoping to avoid raising taxes and to make the Bush tax cuts permanent while further cutting domestic spending and fundamentally altering entitlement programs (Medicaid, Medicare, Social Security). Democratic members of the legislature are hoping to preserve Medicare, Medicaid, and Social Security while letting the Bush tax cuts on the wealthiest members of society expire. Regardless of what happens, as we saw with the debt-ceiling debate, the appearance of a "do-nothing Congress" may be the most damaging aspect of these negotiations to the economy, our democracy, and the faith-and-credit of the US government.

My Thoughts on Peters Ch. 17 - Cost-Benefit and Ethical Analysis

So here we are in the final week and back to Peters for his final chapter. In this edition, Peters combines cost-benefit and ethical analysis into a single chapter. While I generally prefer to discuss these two issues separately, I think the combined chapter works for the purposes of this class. This chapter helps serve as a teaser for two 400-level courses we offer (or will be offering) as part of the Public Service and Public Policy major. PAF 471: Public Policy Analysis will be a required course for the public policy concentration and will likely focus on economic models of policy analysis, specifically cost-benefit analysis and quantitative analysis. PAF 460: Public Service Ethics is our required ethics course and will help you navigate current ethical issues in public policy, public administration, and the non-profit sectors. I hope that this chapter sparked your excitement for these courses.

There are other reasons why it may make sense to combine these two chapters. In some ways, cost-benefit analysis can be thought of as a specific type of consequentialist ethics. Consequentialism is just a fancy way of saying "the ends justify the means". Of course, this form of ethics can lead to many actions that we would consider unethical, but it is often used in public policy creation. Basically, cost-benefit analysis is attempting to reach a Pareto Optimal outcome, where no one is made worse off but at least one person is made better off, or a Kaldor-Hicks outcome where society experiences a net-gain. In this case, the ends and the means are quantified so that the ends justify the means if the outcome is a net monetary benefit. Of course, opportunity costs, consumer surpluses, unintended consequences, and net values need to be considered in the calculation you use to determine the costs and benefits. I think Peters does a good job of walking you through these concepts using a basic example of cost-benefit analysis. It is important to note that although we rarely use Pareto Optimality as a goal in policy analysis (because it is usually an impossible standard to meet) it likely works much better as a criterion for ethical analysis. Certainly, ensuring that no one is made worse off by government action is a stronger ethical stance than assuming that the individuals who benefit from government action will somehow compensate those who are burdened by government action.

As Peters points out there are many problems associated with the use of cost-benefit analysis. It requires a lot of assumptions about risk and future circumstances. Small changes in those assumptions can drastically change the predicted net benefit of a program. In a policy world where solutions are often looking for problems, interest groups have substantial power, policymakers are politically motivated, and competition for funds is the primary rule of the game the temptation to make favorable assumptions about the future of one's preferred project is overwhelming. I believe the perception that cost-benefit analysis is preferable to other forms of analysis because it is straightforward is really an incorrect perception. Cost-benefit analysis can be just as subjective as ethical analysis.

Further, while cost-benefit analysis can help us choose projects out of a list, it offers very little normative advice. It cannot answer the question "what should government do?" We have to draw on our cultural and social values for that. Peters' discussion of "ethical analysis" is really about these value questions. After Stone, his recommendations likely seem a little quaint but they are as follows: the preservation of life, the preservation of individual autonomy, truthfulness, fairness, and deservedness. In many ways these parallel with Stone's values of security, liberty, and equity with truthfulness added for good measure. Of course as we saw with Stone, actually defining what these values mean and whose definition we should use is the difficult part.

I agree with Peters assessment that we as policy analysts are over-reliant on cost-benefit analysis because of its apparent objectivity in comparison to ethical analysis. Policymakers are a different story. Some policymakers have become little more than rubber stamps for programs with positive cost-benefit analysis, but currently values seem to be the prominent metric determining whether or not policies proceed through the policy process we discussed during the first few weeks of class. Many of the policies Congress is considering are policies that invoke those tough ethical questions such as Don't Ask, Don't Tell; defunding Planned Parenthood, immigration policies, and even the debate over the deficit. Cost-benefit analyses have played very little role in these debates. This leads me to two questions: Would we be better off if policymakers used the cost-benefit analyses provided by policy analysts rather than relying on their own definitions of values, and what is the state of the policy analyst profession if their primary means of analysis is often ignored by policymakers?

Policy Paradox and Homelessness

This week we aren't discussing any new theoretical topics, instead we are reviewing some of what we learned from Stone and seeing how you would use Stone's point of view to analyze policy debates. This is a transition into the week after Thanksgiving when we will briefly cover Cost Benefit and Ethical Analysis. Policy analysis is the topic for PAF 471, which will be offered next semester so if you enjoy these topics and want to learn more, I would recommend registering for the course.

In Policy Paradox in Action, Deborah Stone analyzes the history and discourse surrounding Affirmative Action using the framework she presents in this book. She illustrates how you can use the critiques she provides to critically examine policy evidence and argument. She points out where she is using each critique in her analysis. You'll notice that we didn't cover all of the goals, problems, and solutions she discusses. I hope that if you are interested in learning more about what we had to skip that you will at least go back and skim the relevant chapters.

In some ways, this may seem like another substantive chapter about Affirmative Action. While I'm happy that this is an opportunity to learn a little more about the topic, that's not what I want you to take away from this reading. I want you to see that you can combine discussions of goals, problem definition, and policy tools to think critically about public policies, legislation, and implementation. As we'll discuss in two weeks, this does not mean that statistical and cost benefit analysis do not provide valuable insight into our public policy choices. All that I ask (and that I believe Stone asks) is that you approach these analyses skeptically, engage with their methods, and question the possible agenda of those who are conducting them. After thinking critically about them, you can decide for yourself how valuable each analysis is and how close it comes to representing "the truth".

As I mentioned on Twitter, one of the challenges for this week is to read the Housing the Homeless chapter and watch the Street Vets documentary using Stone's critical lens. This chapter was chosen for this week because so many of the issues we are debating in homelessness policy have to do with the questions Stone's book challenges us to think about. Most importantly, the question of numbers and defining who to count as homeless is a major one giving the changing face of "housing insecurity" in the current recession. The chapter also raises the question of using veterans as a synecdoche for the problem of homelessness, given the changing nature of the problem. We have stories about inadvertent (PTSD), accidental (temporary job loss), and mechanical (recessionary effects, lack of mental health and substance abuse treatment) causes. We also have a variety of policy solutions that make very different assumptions about their target populations.  Were you able to read this chapter without being influenced by Stone's critical viewpoint? How do you think the debates presented in the chapter held up to Stone's scrutiny? Did you see other elements associated with the polis in the chapter?

My Thoughts on Inducements and Policy Paradox in Action

The fourth section in Stone's book deals with solutions to policy problems. Stone lists five possible solutions: inducements, rules, facts, rights, and powers. Sometimes we refer to these solutions as policy instruments or policy tools. They serve as the mechanisms through which government or the community exerts its power on individuals to change their behavior. I chose to assign chapter 11 on inducements rather than one of the other chapters because inducements tend to be our preferred tool in American public policy.

Inducements are the common strategy of rewarding preferred behaviors and penalizing undesired actions. Sanctions and incentives are two-sides of the same coin. They allow the individual to choose his or her behavior but seek to alter the anticipated rewards or penalties for carrying out that behavior. The removal a sanction for good behavior or an incentive for bad behavior illustrates the inter-related nature of sanctions and incentives. This is especially true when we consider research in behavioral economics. Studies have shown that we feel a loss much more sharply than we feel a lack of gain. In other words, you would feel worse about a salary reduction of $300 a month than you would feel about not getting a raise of $300 a month even though they are numerically equivalent.

Inducements are based on the understanding of human behavior characteristic of economics. It assumes that individuals are rational, that they know what will make them happy, and that they act to maximize their happiness. In order for inducements to work individuals must have control over their behavior, they must know about the possible penalty or reward, and they must be able to change their course of action. When inducements are used to act on a group or another collective entity, these assumptions usually fail. At the vary least, it makes the rational decision-making process more difficult. Inducements must be designed differently in these cases to account for the processes of group decision-making in a particular context.

Inducements are also affected by time. It is rare for an incentive or sanction to be delivered immediately after a good or bad action occurs. Even when we can deliver such an inducement, it always occurs after the act. Individuals or groups must be able to anticipate such inducements before they carry out a behavior. Many of our financial incentives and sanctions are delivered through the tax code. This creates a gap in time of up to a year from when the behavior occurs to when the inducement is delivered. If individuals or groups do not believe they will personally have to deal with long-term penalties or receive long-term benefits, then the inducement will be ineffective.

Inducements tend to imply purposeful action. They may try to alter actions with either intentional or inadvertent causes, but they do little to alter mechanical or accidental causes over which individuals have no control. This is why causal stories can be very important. If you want to benefit or burden a group using inducements you have to be able to tell a story about purposeful actions. Although not assigned for this class, the documentary and book, Freakonomics tells a story about the use of monetary inducements to encourage students in a high school to improve their grades. The program seems to work for some students but does not for most of them. This is a common story in public policy. Any time we use a policy tool, particularly inducements to alter behavior we have three groups. We have a group who will always do the desired behavior, a group that will never do the desired behavior, and a group that will change its behavior in response to the right inducement. This group is called the marginal group. Designing a good inducement is difficult because we have to decide the correct value of the inducement and target it to the changeable group. This can bring up a tension between efficiency and equity. It would be more equitable to ensure that everyone who performs a good behavior is rewarded with an incentive, but it is not efficient to reward the group who would perform a good behavior without an incentive.

Although positive and negative inducements are two-sides of the same coin, they can have different effects in the polis. Positive inducements help communities to build trust, goodwill, and cooperation while negative inducements can create conflicts and divisions. Rewards build upon a shared sacrifice. The giver gives up the reward and the receiver gives up his or her desired behavior. Sanctions result in one or both parties experiencing a cost or loss. Of course, we must remember that whether rewards or sanctions are offered, they are both based on an unequal power relationship where one group or individual is able to change the behavior of another.

The design of inducements in the polis is an art. Large positive incentives can lead to excessive competition and even cheating. Large negative sanctions can lead to a reluctance to enforce them. Sanctions or rewards that require a lot of effort on behalf of the giver are often not carried out. Incentives and sanctions can easily become guarantees when the giver is perceived as having little will or power to remove them. When the giver and receiver are very different, there may be a misunderstanding about what type of incentive or sanction will change behavior. Symbolic understandings of need come into play because behaviors that are tied to identity are often impossible to change.

Of course, no inducement operates in isolation. Individuals and groups are motivated by their own desires, but also by inducements imposed by government, business, friends, family, colleagues etc. Even if we accept the assumption that humans are calculating and weigh costs and benefits before they act, an inducement instituted through the policy process is only one small influence on behavior. This is especially true when individuals can adapt their behavior to strategically avoid the consequences of a sanction or reap the rewards of an incentive when it is not really deserved. Going back to the Freakonomics example, if we targeted our incentive only to those students who were able to bring their grades up from a D or F to an A or B, we may see a group of formerly A or B students whose grades drop significantly so they can later receive the incentive for bringing their grades back up to A's or B's. We often refer to this as a perverse incentive, but it is really a consequence of individual rational choice and adaptability.