Tuesday, September 29, 2009

Equity and valuation

This subject came up in class today and was raised previously by Derek here on the blog:

When we measure value we use "willingness and ability to pay" as our metric. We can take issue with this definition of value because it is "unfair" to those who do not have as much ability to pay. Using this measure, a resource will appear more valuable to someone who has more money (and is willing to spend it). As unfair as it seems, we need a solid measure of value. Without this particular definition, we really have no way of measuring what something is worth.

How do we deal with the unfairness? Can we make adjustments in our measures of value that account for unequal income distributions?

Yes, using something called "equity weights" in cost-benefit analysis. This basically means adjusting value estimates upwards for individuals/nations with lower incomes. The level of adjustment can be based on tax rates (higher tax rate, lower weight) or some other measure.

The following passage discusses the issue nicely:

A key issue that has not been satisfactorily resolved in welfare economics (the branch of economics on which cost-benefit analysis is largely based) is Jeremy Bentham’s utilitarianist principle that actions should be evaluated on the basis of whether they generate the greatest amount of overall happiness for society. Aggregation of individual ‘happiness’ or utility is problematic because of the lack of a common numeraire for the fairly nebulous concept of utility. Utility is not measurable or comparable.

In practice, standard cost-benefit analysis tends to assume that a given change in costs or benefits (for example, $100) arising from a policy or project is valued equally by rich people and poor people and that individuals’ benefits and costs can therefore be aggregated to give an overall measure of net benefit to society. (In technical language, the marginal utility of money is assumed to be constant.) This approach (see, for example, Sugden & Williams 1978: ch. 16) implicitly accepts that the analyst’s role is principally that of an adviser on the efficiency aspects of a policy or project, and that value judgements about equity considerations should be the province of the political decision-maker.

Nevertheless, economists do sometimes advocate the use of income or other equity weights in cost-benefit analysis where it would be helpful to explore adjustments for poorer groups. But such calls are invariably tempered by a strict reminder that a non-weighted analysis should also be provided, to allow the decision-maker to easily determine the effect of including ‘equity’ weights.

Pearce & Nash (1981: 10–11), however, point out that even standard cost-benefit analyses make a value judgement by not using weights because they accept implicitly that the existing distribution of income is an equitable one. While this is true, the standard, unweighted approach is still generally preferable because the current distribution of income in a democratic society reflects (albeit imperfectly) existing social preferences. To introduce any other set of weights risks the adoption of a paternalistic or authoritarian approach by the individual analyst or decision-maker. And where weights are used, transparency requires that the same analysis be presented to the decision-maker without weights so the effect of weighting is clearly discernible.

If the distribution of income across society is considered to be inequitable, the correct solution is to rectify it directly through progressive taxation or other policies, not by distorting the analysis of highly specific projects that may in any case affect only a small section of the community.

In more recent times, the issue of effect on different socio-economic groups has also been addressed more directly by disaggregating the results of cost-benefit analysis to show the potential incidence of the costs and benefits of a government program on various sections of society. This approach is more transparent and allows the decision-maker to weigh equity and political considerations against the overall social benefit achieved.

Excerpted from "Multicriteria Analysis: 'Good Enough' for Government Work?"
by Leo Dobes and Jeff Bennett, Crawford School of Economics and Government at The Australian National University.


Emily Rossi said...

Is this really just saying that though someone vales something say at 1 million dollars and would pay it if they could, but they can't, that we must ignore them economically, because without willingness AND ability to pay there is no real way to measure a resources worth?

Anonymous said...

If that person doesn't have a million dollars to spend on something is it really still worth one million? Assume you were buying something and someone was willing to accept any amount of money. You are willing to pay 100 dollars for this item but only have 50, so you pay 50. How much is that item worth? ( what is it's value?) Is it worth 100 dollars, or is its economic value 50 dollars? I would say 50 dollars. In that sense, yes people who have a lesser ability to pay are "ignored." - Ryan D

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