On the Reality of Economic Illusion

Abstract

Economists have long taken the reasonable position that a consumer’s satisfaction cannot be evaluated correctly by counting his tangible possessions; rather, his welfare must in some way reflect the utility he derives from different quantities and combinations of such possessions, given that person’s psychological make-up. Yet this way of looking at choice and welfare has not kept us from what can be considered an analogous fallacy in which consumer’s preferences are taken to be free from ‘irrationalities’ and illusions, terms whose connotations will become clearer as we proceed. On this basis, at least some economists have advocated measures which are widely disliked, presumably upon the grounds that, despite their unpopularity, they really serve the public’s true welfare. An example is the view that income tax is to be preferred to an excise, both because the latter is generally more regressive and because it may lead to a poorer allocation of resources (though lately the literature on the ‘second best’ has cast serious doubt on this second contention). I will suggest that the contrary is likely to be true: that even considering its distributive effects the excise is often likely to be, shall we say, nearly Pareto preferable: it may well leave nearly everyone better off.