Allocative efficiency and the valua

Allocative efficiency and the valuation of costs and benefits
The problem of divergence in individuals’ utility functions can be resolved by applying the
normative principle of Pareto optimality. Following this principle, public interventions can be said
to demonstrate optimality, or allocative efficiency, where at least one individual is made better off
and no individual is made worse off: there are only winners. Rigorous application of this criterion
is impractical since it would be impossible to identify all winners and losers, losers would have an
incentive to overstate their losses and the scope for public intervention would be severely restricted.
Consequently, a potential Pareto optimum – the Hicks-Kaldor criterion – is generally applied by
which an intervention is considered acceptable if the amount by which some individuals gain is
greater than the amount that others lose, leading to a net-benefit, so that, in principle, winners could
compensate losers for their costs. No actual cash transfer is required. An intervention may therefore
be considered efficient even if some individuals lose, as long it generates net benefits (Boardman et
al, 1996: 29-34). In this way, the principle of allocative efficiency is underpinned by an assumption
that social welfare may be enhanced by the redistribution of resources within society, even where
this entails redistribution from the poor to the rich.
Monetary value can be used as a common denominator for the assessment of the relative merits of
public interventions, taking into account their costs and benefits to society. The benefits of public
interventions in the productive sectors, such as in agriculture and industry, can be determined with
reference to increased production and valued on the basis of market prices, where an efficient
market pricing mechanism is in place. Where government policy or local market conditions result
in price distortions – such as those arising from monopolies, taxes or administered prices –
equivalent border prices can be used. The problem lies with interventions, such as those in the
education, health and defence sectors, that generate outputs and outcomes for which there is no
corresponding market valuation. How does one, for instance, measure and then value the benefits
arising from a reduction in mortality? or the cost of environmental damage? For economists,
solutions to these problems can be found in the use of shadow prices: surrogate prices that represent
the opportunity cost of a particular good. This may entail, for instance, the valuation of loss of
human life on the basis of foregone income. Alternatively, value can be estimated based on
measures of willingness to pay, using for instance the compensating wage differentials for
employment with different levels of risk as the basis for an assessment of the value of life, or by
using values revealed in questionnaire surveys (Cullis and Jones, 1998: 137-142). Obviously, all
these methods have their shortcomings. Ultimately, the valuation of intangible costs and benefits –
such as human life, human rights or environmental diversity – rests on subjective criteria.