Friday, January 30, 2009

Economics and Ethics I

Economics helps us to navigate in a world of scarcity. It helps us to make the best use of finite resources to satisfy our unlimited desires, and helps us to make intelligent decisions based on a rational evaluation of costs and benefits.

Thus economics is concerned with efficiency, satisfaction and costs. It does not obviously have anything to do with man’s ethical endeavors—especially if we take the traditional view of virtue-ethics where an ethical life is one that is lived according to certain values, like the four cardinal virtues of classical culture: temperance, wisdom, justice and prudence.

Yet when we analyse problems according to economics, it guides us quite consistently to actions and choices that could quite rightly be considered ‘virtuous’. As I hope to show in a series of articles, the rational life recommended by economic analysis overlaps significantly with the virtuous life recommended by the great ethical and religious systems of the world.

My first article will discuss the concept of utility and its implications.

Utility refers to the satisfaction, the pleasure, received by human beings. While most economists today do not think we can precisely measure utility or compare the quantities of utility received by different individuals at different times (though it was once believed that utility could be quantified objectively and rendered into units called utils), the theories and principles based on the concept of utility remain insightful and apt descriptions of human psychology and economic behavior.

First, we consider the law of diminishing marginal utility.

There can be no doubt that we derive much greater utility from the first unit of any good consumed, as compared to say, the hundredth consecutive unit consumed. The first cheeseburger may taste great and yield enormous utility, but the seventh cheeseburger eaten at the same meal may well be a torment (negative utility). Your first washing machine may well be greeted with ecstasy, but the tenth washing machine purchased would likely bring as much joy as an equivalent amount of scrap metal and plastic (assuming you cannot easily sell the machine). Thus marginal utility, the additional utility brought about by one additional unit of goods/services consumed, falls as the consumption of a particular good/service rises.

In essence, the law of diminishing marginal utility implies that the total satisfaction (the total utility) from any material good is inherently limited, since the marginal utility from consuming consecutive units of that good falls, and will turn eventually to disutility (negative utility) beyond a certain point. Economics does not tell us that money cannot buy happiness; indeed, it can, to a limited extent. But it buys happiness at an ever-decreasing rate.

Indeed, this fundamental insight is encapsulated in the principle that the marginal utility of money itself diminishes as income grows. The more money you have, the higher your total consumption of all goods and services, and the less utility you will gain from an increase in consumption made possible by an increase in income. A naked beggar in Mumbai may value a 1 rupee increase in income as much as life itself, it being a last defense against starvation and death. A 1 rupee income increase for an investment banker in Mumbai’s finance district with an annual income of 100,000 rupees may mean little to nothing. The increase in consumption to the investment banker is simply not meaningful in terms of utility, given what he is already consuming.

Greed, therefore, is not good. To pile up mountains of gold for selfish use is a highly inefficient way to gain happiness in a world of scarce resources—of scarce time, especially. It appears that the law of diminishing marginal utility counsels us to lead a life of temperance. When consuming any material good, there is a point which we should not pass if we wish to maximise our enjoyment. To enjoy in moderation is both an economical and ethical way to proceed. And once a certain amount of material wealth is secured, it is no longer efficient to continue hoarding. At some point, one should stop looking at wealth as a means of increasing personal consumption—perhaps one could derive greater happiness from giving it away. Perhaps one could undertake or promote the creation of art and beauty, the pursuit of knowledge, of justice, of God himself.

In addition, as JS Mill long ago pointed out, the diminishing utility of income is one of the strongest reasons for the redistribution of wealth. Removing $100 from Bill Gates will cause hardly a twinge of sorrow, but giving it to a beggar in downtown Seattle vastly increases utility. The sum of social utility thus increases when income is redistributed from the rich to the poor. Indeed, in an idealised case where redistribution is cost-free, and where the marginal utility function is similar for all human beings, the optimal social outcome is one in which incomes are similar for all. Of course, given the very real costs of redistribution, like the reduced incentives to work (for the rich) and the administrative costs of any redistribution program, the optimal outcome is still one of economic inequality.

But the basic implication of the diminishing utility of income remains: redistribution of wealth is one of the most important ways to increase the happiness of society as a whole. Economics thus supports, with rational justifications, the ideals of social justice recommended by most, if not all, the great religions and ethical systems of humanity.