There are times when the efficiency criteria breaks down as a useful guide to economic policymaking. These times occur most frequently in situations when property ownership conveys major differences in wealth – which leads to disparities in willingness-to-pay versus willingness-to-accept measures of value. An illustration will help.
If you asked me how much I would be willing to pay to obtain a handheld stapler, I might say $5.00. If you asked me right now how much you would have to pay me to accept having this very stapler being taken from me, I would probably answer something closer to $5.00. In other words, there is little difference between what I would be willing to pay to obtain property that is not yet mine and what I would be willing to accept to part with property that is already mine. There are several reasons for this in this case, but most important is that ownership of a stapler is not likely to have a very large impact on my overall wealth and well-being.
The same is not likely to be true in the desert. I would pay you every dollar in my pocket for the privilege of drinking 1 gallon of water when I am near death. If I already had the water, there is probably no monetary amount I would accept to give up the water. How can this be? Isn’t a gallon of water worth what a gallon of water is worth? In this case no, since ownership of the gallon of water has a dramatic impact on my overall wealth. I am as big a believer in the efficiency criteria as anyone, but in these kinds of cases I believe we need to supplement it with other normative criteria to make reasonable judgments about the “proper” allocation of water (I am leaving lots out here for brevity’s sake).
Now consider the status quo of government schooling. 90% of American schoolchildren go to government schools. I do not like this. Presumably the many hundreds of thousands of inner city families that are forced into dangerous and failing schools do not like this either. How would the efficiency criteria guide us with respect to changing the status quo? Suppose I wish to promote an ending of public schools. We have a problem. You see, there is already an enormous constituency benefiting from the existence of government schools – either from a current job, or via subsidies for their children or retirement benefits or from supplying the schools or for training future teachers in those schools, etc. In other words the status quo matters here – the existence of government schools makes those constituents much wealthier than they might be under an alternative scenario. So if we asked them how much they “value” government schools, we are very likely to get a different answer today than if the status quo were reversed. How can we proceed? I suggest we need to move beyond the efficiency criteria, which you might think would universally recommend maintaining the status quo (maybe not – we could simply ask current constituents how much they’d be willing to pay to maintain the status quo and compare it to what I’d be willing to pay to change it). But in both of our cases the wealth effects are quite large and render a simple cost-benefit accounting difficult. This is one reason why folks like me push harder on the moral case against government schooling than I would against, say, the existence of the EPA. But that is for another discussion.
One of my friends wrote a good piece on the endowment effect: http://mises.org/daily/5839. Having gone through some govenrment and private school, I think the few years I had at the government school were probably some of the most destructive in my life; I had stopped reading because it wasn't enjoyable anymore.