Formal economics used to be almost entirely devoted to issues of the allocation of scarce resources.  A subset of inquires, usually called welfare economics, frequently explored how  different allocative schemes affected economic welfare.  Welfare, however, had a rather arcane meaning in formal economics because inter-personal comparisons were generally frowned upon in formal theory and applications.   To get around the “dryness,” of such studies, economists adopted a compensation principle where by if at least one person was made better off and none worse off, then welfare was improved.  This skirted the issue of “fairness,” or as some wrote about it, of “justice.”   What if compensation by the winners was not paid to the losers after an economic policy change?  A mere glance at today’s media tells us that issues of “fairness” rule the day, almost to the exclusion of discussions of efficiency.   Social change is often motivated by issues of fairness and politicians of every stripe place fairness at the top of their choice menu.   But, what is fair to one person, clearly could be unfair to another.  Moreover, the achievement of “fairness,” brings with it economic costs.   The latter are often ignored, but the consequences should not be.   To truly be fair, we need to evaluate the cost of achieving fairness, however it is defined.   This is the first of a series of notes that discuss aspects of the linkage between fairness and efficiency in political economy.

A scientific evaluation of the welfare consequences of legislative and executive orders that hinge on “fairness considerations” must contend with a broad economic finding:  adaptation in humans and organizations is a key element for enhancing economic welfare.   A broad application of this concept is illustrated in Feenstra (2018) in discussing the ‘gains from trade’ when tariffs are introduced.¹ It turns out that tariffs often reward the least efficient and least adaptive.  That should not surprise.  The “squeaky wheel gets the grease,” and it is an axiom of democratic politics based on marginal voter behavior.

It is well known that within an industry, broadly defined, there is a distribution of more and less efficient firms that “survive” in a monopolistically competitive structure due to the ‘apparent’ differentiation of consumer tastes.  While broadly similar, the taste for “variety” prevails, allowing “brand” to be important criterion of consumer choice. An industry with a distribution of firms that largely produce a ‘similar’ product, but with enough differentiation for a variety of firms to exhibit  ‘niches’ that allow the survival of some less efficient firms is characteristic of consumer driven economies.

Yet, some firms are more efficient than others and that efficiency will over time lead to their expansion as well as to greater than average rewards to both workers and owners of the firm during expansion.   Some may grow into exporters as well as suppliers to domestic consumers, while smaller less efficient firms continue to exist, probably leading to lower returns to both their workers and owners. Survival often comes with higher average costs and lower factor returns.  Attrition takes time and that allows persistent survival, even though there is a growing concentration in the output of the more efficient firms, enhanced no doubt by greater resources spent to advertise their products’ virtues.

Now, suppose the cries of the weaker firms or the workers within such firms draw the attention of politicians always looking to attract additional marginal voters in order to return to office?  Such repeated complaints of “unfairness” often lead both legislators and bureaucrats to try and ‘ameliorate’ this ‘obvious’ inequity of modern industrial life.  Let the cries become more shrill and attract further adherents, something will get done politically or administratively.  Who punishes whom in such a political dynamic?

The most efficient of both producers and consumers are pushed by the new tariff or tax.   Those consumers who are willing to switch ‘brands’ that are intrinsically quite similar are incented by pricing advantages while adaptive producers using new techniques to lower their production costs can offset some or all of the penalties of the “fairness tax or tariff.”

It is obvious that welfare, even in the strict economist sense of the word, is not increased by such a political move toward “fairness.” Let the process continue and on average the price of output to consumers must rise to compensate for the tariff or the tax that is introduced.  If output in the industry is reduced, because the average price received by producers is lowered (although raised for those firms who are advantaged by the tariff), consumer surplus is reduced.  Moreover, it is more than likely that the firms “hurt” by the tariff on those that on average were more efficient prior to the tariff’s introduction.

This finding has broad application.  What the politicians (or bureaucrats) have done is reward the least adaptable, the least efficient as well as the factors of production employed in such firms that have had the least ability to move out of the industry.   Dynamically, such policies inhibit productivity growth, punishing those firms and consumer who are the most adaptable.

Fortunately, innovation is ubiquitous and nothing stands still in capitalistic economy provided there is adequate free entry into markets.  If more efficient firms are more adaptable, they may respond by incurring new investment in order to lower the average costs or inventing new but related products that can be differentiated to their consumers, or by expanding production for export.  Their “squawk” becomes muffled by their own adaptation, while the cries of unfairness are seemingly mollified.  It is another application of the well-known finding that suppliers dominate changes in taxes and tariffs because the fraction of total spending by a consumer on any one product is small while the interest of the producer of that product is large.

What’s the moral of this story?  Creative encrustation, created by a democratic society trying to eradicate all traces of unfairness is impactful force of the very “creative destruction” that capitalism inspires and is the source of economic advance.  The choice for citizens is whether and when to allow political encumbrance to retard economic growth.   It is inherent in a democratic society that makes choices by shifting political margins and by appealing to softheaded arguments over “unfairness.”  It reminds us of the utter logic of the Churchill’s quote, ““Democracy is the worst form of government, except for all the others.²

1. Feenstra, Robert C. “Alternative Sources of the Gains from International Trade: Variety, Creative Destruction, and Markups,” Journal of Economic Perspectives, Vol 32, Number 2, Spring 2018,  [↩]
2.  There is some argument as to the correct attribution of this quote, but we will leave that investigation to other writers with more time on their hands. [↩]