Short History of Welfare Economics
B.Contestabile admin@socrethics.com Last version 2009
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Table of Contents
1. Introduction 5. Decision-Theory and Social Choice 7. Conclusion
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Starting point ▪ Classical utilitarianism started with the slogan “The greatest happiness for the greatest number” ▪ Welfare economics is supposed to increase national welfare.
Type of problem Richard A.Easterlin, professor of economics at the University of Southern California found, as expected by most economists, that, within a given country, people with higher incomes are more likely to report being happy. However, in international comparisons, the average reported level of happiness does not vary much with national income per person, at least for countries with income sufficient to meet basic needs (Easterlin Paradox, Wikipedia). Does welfare economics contribute to happiness?
Result ▪ The history of welfare economics seems to confirm the following suspicion:
Whereas many branches and techniques of economics are indispensable, the mathematical models of welfare economics cannot live up to their promises.
▪ Recently economics turned back to the classical utilitarian goal to make people happier. Happiness Economics builds on empirical data about individual happiness instead of inappropriate mathematical models and bureaucratic indicators like the GDP.
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Starting point
▪ Classical utilitarianism started with the slogan “The greatest happiness for the greatest number”.
▪ Welfare economics is supposed to increase national welfare.
Type of problem
Richard A.Easterlin, professor of economics at the University of Southern California found, as expected by most economists, that, within a given country, people with higher incomes are more likely to report being happy. However, in international comparisons, the average reported level of happiness does not vary much with national income per person, at least for countries with income sufficient to meet basic needs (Easterlin Paradox, Wikipedia).
Does welfare economics contribute to happiness?
Capitalism
The historical context of classical economics was the age of enlightenment, the French Revolution (1789-1799) and the industrial revolution.
1. Classical economics is widely regarded as the first modern school of economic thought. It is the idea that free markets can regulate themselves. Its major developers include Adam Smith, David Ricardo, Thomas Malthus and John Stuart Mill (…) Adam Smith's The Wealth of Nations in 1776 is usually considered to mark the beginning of classical economics. The school was active into the mid 19th century and was followed by neoclassical economics in Britain beginning around 1870.
2. Classical economists attempted and partially succeeded to explain economic growth and development. They produced their "magnificent dynamics" during a period in which capitalism was emerging from a past feudal society and in which the industrial revolution was leading to vast changes in society. These changes also raised the question of how a society could be organized around a system in which every individual sought his or her own (monetary) gain.
3. Classical economists reoriented economics away from an analysis of the ruler's personal interests to a class-based interest. Physiocrat Francois Quesnay and Adam Smith, for example, identified the wealth of a nation with the yearly national income, instead of the king's treasury. Smith saw this income as produced by labor applied to land and capital equipment. Once land and capital equipment are appropriated by individuals, the national income is divided up between laborers, landlords, and capitalists in the form of wages, rent, and interest.
(Classical economics, Wikipedia)
Classical utilitarianism
The origins of utilitarianism are often traced as far back as the Greek philosopher Epicurus, but, as a specific school of thought, it is generally credited to Jeremy Bentham (1748-1832) (Utilitarianism, Wikipedia)
Utilitarianism retains the Epicurean view that humans naturally seek pleasure and avoid pain, but while Epicureans laud pleasure seeking and pain avoidance for their effects on the psychological state of the actor, utilitarians use it to express the consequentialist view that a good action maximizes pleasure and minimizes pain in the society (Epicurus, Science Encyclopedia)
Bentham’s utilitarianism is based on the following assumptions:
1. Each individual knows best what is good for him/her
2. Each individual should decide him/herself in private matters
3. The welfare of an individual doesn’t depend on other individual’s welfare
4. The welfare of each individual can be added in order to valuate the total welfare of the society.
5. Each individual has the same weight (rights) in collective decisions.
6. Utility is interpersonally comparable
7. The principle of competition increases welfare, if applied under the conditions of equal opportunity.
8. Economic welfare correlates with general welfare.
9. Utility can be measured by cardinal numbers and utility functions are linear.
[Kleinewefers, 37-38]
Principles of the French Revolution:
1. Freedom: assumptions 1 and 2
2. Equality: assumption 5, 7
3. Fraternity: indirect, by the common goal to increase economic welfare combined with assumption 8
Utilitarianism was originally developed as a challenge to the status quo. The demand that everyone count for one, and one only, was anathema to the elitist society of Victorian Britain (Utilitarianism, Wikipedia)
Definition
Neoclassical economics is conventionally dated from William Stanley Jevons's Theory of Political Economy (1871), Carl Menger's Principles of Economics (1871), and Leon Walras's Elements of Pure Economics (1874 – 1877). These three economists have been said to have promulgated the marginal utility revolution, or Neoclassical Revolution (…).
1. In particular, Walras was more interested in the interaction of markets than in explaining the individual psyche through a hedonistic psychology.
2. Jevons saw his economics as an application and development of Jeremy Bentham's utilitarianism and never had a fully developed general equilibrium theory.
3. Menger emphasized disequilibrium and the discrete. Menger had a philosophical objection to the use of mathematics in economics, while the other two modeled their theories after 19th century mechanics
(Neoclassical economics, Wikipedia)
Marginal utility
Instead of the price of a good or service reflecting the labor that has produced it, it (the price) reflects the marginal usefulness (utility) of the last purchase. This meant that in equilibrium, people's preferences determined prices, including, indirectly the price of labor (…).
Consumers act rationally by seeking to maximize satisfaction of all their preferences. People allocate their spending so that the last unit of a commodity bought creates no more satisfaction than a last unit bought of something else (History of economic thought, Wikipedia)
Old welfare economics
Jevons, Menger and Walras promulgated the concept of marginal utility, but didn’t invent it:
Daniel Bernoulli (1700-1782) published a formalization of marginal utility in 1738 (Expected Utility Hypothesis, Wikipedia)
Hermann Heinrich Gossen (1810-1858) was a Prussian economist who is often regarded as the first to elaborate a general theory of marginal utility (Gossen, Wikipedia)
As long as utility functions are assumed to be linear it doesn’t matter, if the welfare of the most or the least wealthy is increased. But if we assume a diminishing marginal utility of welfare, then it makes sense to increase the welfare of the least wealthy. Under the influence of Gossen’s laws a part of the welfare economists turned towards egalitarianism without being particularly compassionate. The normative force of fraternity is not required to justify redistribution, as long as Gossen’s laws are seen as a kind of “natural” laws. Under the given premises redistribution is simply a consequence of the common goal to maximize the welfare of the community.
One of the major representatives of the Gossen-type of economics was the English economist Arthur Cecil Pigou (1877-1959). According to his theory the welfare of a society can be measured by the Gross Domestic Product (GDP) and the distribution of GDP [Kleinewefers, 40-42].
Since the marginal value of income decreases, the total of utility can be increased by transferring income from the rich to the poor. Pigous ideas are still effective in the actual discussions on
1. Egalitarian utilitarianism (Pigouvian redistribution)
2. Protection of the environment (Pigovian tax for pollution etc.)
The weakness of his theory lies in the assumptions that the utility functions of all individuals are equal and that the society’s total income isn’t affected by the redistribution.
New welfare economics
The critics of old welfare economics is connected with the dispute on values in economics. Classical economics didn’t clearly distinguish between normative and descriptive statements. In the context of Popper’s critical rationalism economics attempted to be become a science, i.e. a theory that is based on logic and empirical data.
Old welfare economics used the following assumptions:
1. Utility is can be measured in terms of money and is a measure for social welfare
2. Utility is interpersonally comparable and summable.
These two assumptions were given up in new welfare economics [Clarenbach, chapt.2.6]. Pareto proved that utility is immeasurable from observations of behavior. Economists who accepted this proof (like Hicks) attempted to revise the theory of consumer behavior without the use of an immeasurable concept of utility. The analytical framework remained individualistic. All social phenomena (in particular market prices and the law of demand) had to be explained in terms of individual behavior.
Ordinal utility
Ordinal instead of cardinal utility is the major difference between old and new welfare economics [Kleinewefers, 42].
When cardinal utility is used, the magnitude of utility differences is treated as an ethically or behaviorally significant quantity. On the other hand, ordinal utility captures only ranking and not strength of preferences (…). It would e.g. be possible to say that juice is preferred to tea to water, but no more. Neoclassical economics has largely retreated from using cardinal utility functions as the basic objects of economic analysis, in favor of considering agent preferences over choice sets (Utility, Wikipedia).
The first usage of ordinal utility is attributed to Vilfredo Pareto (1848-1923).
Giving up cardinality (chapter 2, assumption 9) means giving up the cardinal hedonistic scale. Utility is now defined by a set of individual preferences and cannot be interpersonally compared (assumption 6). Without a common hedonistic scale utilities cannot be added (assumption 4). As a consequence there is no variable like “happiness” which could be maximized and distributed. Distributive justice was cancelled from the economist’s agenda.
Allocative efficiency
From now on economics concentrated on the search for allocative efficiency under the conditions of a given initial allocation and limited resources. These are the characteristics of an optimization problem.
Given a set of alternative allocations of goods or outcomes for a set of individuals, a change from one allocation to another that can make at least one individual better off without making any other individual worse off is called a "Pareto improvement". An allocation is defined as "Pareto efficient" or "Pareto optimal" when no further Pareto improvements can be made (Pareto efficiency, Wikipedia).
Unfortunately varying initial allocations lead to varying optima, and there is no criterion to compare these optima. The incomparability of optima is perplexing, if the initial allocations are already optimal.
Example:
Assume that you can distribute 1000 $ to 10 individuals and that each of them prefers to have more money. In this case all possible (initial) allocations are Pareto optimal. After the money has been distributed it is not possible to give more money to a specific individual without taking it from one of his/her competitors (Nutzen, Wikipedia).
It is not even possible to compare the optimal solution for a specific initial allocation with the non-optimal solution of a different initial allocation. The only normative goal is to realize perfect competition in a perfect market in order to reach a pareto optimum [Kleinewefers, 43-44]. Obviously the Pareto optimization cannot be applied to practical politics because political decisions normally produce winners and losers. As a consequence, economics developed new optimization criteria which could be applied to cases with winners and losers.
Using Kaldor-Hicks efficiency, an outcome is more efficient if those that are made better off could in theory compensate those that are made worse off, so that a Pareto improving outcome results. For example, a voluntary exchange that creates pollution would be a Kaldor-Hicks improvement if the buyers and sellers are still willing to carry out the transaction even if they have to fully compensate the victims of the pollution.
(Kaldor-Hicks efficiency, Wikipedia)
Using the new efficiency criteria it was possible to compare a new situation with the status quo, but it wasn’t possible to compare several alternatives and find the best one. The need to compare and rank a larger number of alternatives led to the development of welfare functions.
Welfare functions
In a 1938 article Abram Bergson introduced the social welfare function. The object was "to state in precise form the value judgments required for the derivation of the conditions of maximum economic welfare" set out by earlier writers, including Pigou, Pareto and others (Social welfare function, Wikipedia)
According to Bergson a welfare function should include all arguments which influence the members of the society in a positive or negative way.
Paul Samuelson’s welfare function aggregates individual utility functions.
Pareto efficiency could characterize one dimension of a particular social welfare function, distribution of commodities among individuals another dimension. (…). Samuelson stressed the flexibility of the social welfare function to characterize any one ethical belief, Pareto-bound or not, consistent with a complete and transitive ranking (an ethically "better", "worse", or "indifferent" ranking) of all social alternatives
(Social welfare function, Wikipedia)
Neither Bergson nor Samuelson precisely defined their welfare functions. It remains unclear how the arguments of these welfare function should be measured and how the individual utilities should be aggregated. But obviously, at this point, distributive justice was reintroduced to the economist’s agenda [Kleinewefers, 45-48].
New welfare economics is positive economics insofar, as it attempts to describe and model economic behavior. There are no value judgments; values are treated as variables or parameters. But by investigating the conditions for optimum welfare (Pareto) or maximum welfare (Bergson), new welfare economics clearly aimed at delivering input for normative economics.
With the neoclassical researchers economics started to split up into micro- and macroeconomics. Whereas Jevons concentrated on microeconomics, Walras and Menger worked on equilibrium theory which became the cornerstone of macroeconomics.
Microeconomics
▪ Classical economists (…) accounted for economic phenomena like output, consumption, value of commodities, distribution of income
▪ Neoclassical economists defined economics as a science which additionally could be capable of studying all human rational actions.
All humans can be modeled as agents who search for getting the maximal satisfaction from their actions. The marginalist neoclassicals tried to develop general economic laws, imitating the rigorous methods used in physics. Neoclassical economists were above all involved in the development of microeconomics, a science they have founded, even if the idea that all human pursued their self-interest was already mentioned in Smith, Ricardo and Mill's works (History of Economic Thought, Wikipedia).
Macroeconomics
▪ Macroeconomics examines the economy as a whole to explain broad aggregates and their interactions "top down," that is, using a simplified form of general-equilibrium theory (…)
▪ Macroeconomists study aggregated indicators such as GDP, unemployment rates, and price indices to understand how the whole economy functions. Macroeconomists develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, international trade and international finance (Macroeconomics, Wikipedia)
Integration
The Lucas Critique, named for Robert Lucas's work on macroeconomic policymaking, says that it is naïve to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data.
(Lucas critique, Wikipedia)
Particularly in the wake of the Lucas critique, much of modern macroeconomic theory has been built upon 'microfoundations' — i.e. based upon basic assumptions about micro-level behavior.
(Microeconomics, Wikipedia)
5. Decision-Theory and Social Choice
Welfare economics is closely tied to Decision Theory and Social Choice Theory:
1. Neoclassical microeconomics is nothing but the theory of individual economic decisions.
2. Kenneth Arrow realized that the aggregation of individual utilities has to be treated as a collective decision process (social choice)
Individual decisions
Economic theory assumes that an individual acts rational and attempts to maximize utility under given side constraints.
In economics, game theory, and decision theory the expected utility theorem or expected utility hypothesis predicts that the "betting preferences" of people with regard to uncertain outcomes (gambles) can be described by a mathematical relation which takes into account the size of a payout (whether in money or other goods), the probability of occurrence, risk aversion, and the different utility of the same payout to people with different assets or personal preferences. It is a more sophisticated theory than simply predicting that choices will be made based on expected value (which takes into account only the size of the payout and the probability of occurrence) (Expected Utility Hypothesis, Wikipedia)
The concept of the utility function is sufficiently flexible in order to address all relevant problems of individual rationality. It allows taking account of
1. social interdependencies
3. public goods
The problem with utility functions is not a theoretical but a practical one. There are no comparable (cardinal) estimations for the welfare of society; there is not even a complete utility function for a single individual [Kleinewefers, 277]. Approximations used so far are
1. income for the welfare of the individual
2. GDP (calculated by the income approach) for the welfare of society.
But welfare cannot be reduced to income.
Social choice
In his dissertation Social Choice and Individual Values Arrow proved that there is no democratic decision process which aggregates individual preferences into an unambiguous result [Kleinewefers, 48-52].
The difficulties are caused by the assumption that individual preferences aren’t comparable. There are basically two approaches to find a way out of this trap:
1) Individual preferences are made comparable by a normative act. They are subjected to the judgment of an impartial observer, who makes a distinction between comparable preferences (those which correspond to the Conditio Humana) and individual extravagances. The former are morally relevant and therefore considered in the aggregation, whereas the latter are neglected. The most important representative of this approach is John Harsanyi (1920-2000). Comparable preferences are called
a) fundamental preferences or human nature (Kolm)
b) basic psychological laws or extended preferences (Harsanyi).
Extended preferences are a tool to model the impartial observer.
2) Individual preferences are given up as a criterion for the valuation of social welfare and replaced by capabilities. Capabilities are defined in constitutions and laws.
The Capability Approach emphasizes functional capabilities ("substantive freedoms", such as the ability to live to old age, engage in economic transactions, or participate in political activities); these are construed in terms of the substantive freedoms people have reason to value, instead of utility (happiness, desire-fulfillment) (…) Someone could be deprived of such capabilities in many ways, e.g. by ignorance, government oppression, lack of financial resources, or false consciousness (Capability Approach, Wikipedia)
Social situations are valuated according to potentials (resources) which are offered to individuals. The usage of these potentials is then a concern of the individuals and not of society. Similar to above attempt to find morally relevant preferences, an attempt was made to find morally relevant potentials by subjecting them to the judgment of an impartial and empathic observer. The most important representative of this approach is John Rawls (1921-2002).
Approach 1 circumvents the problem by constructing a “representative” individual
Approach 2 runs across the aggregation problem on a constitutional level. Resources, goods, rights etc. aren’t measured according to the same cardinal scale and can’t be aggregated into a single value called “social welfare” [Kleinewefers, 53-54].
Approach 1 is related to microeconomics. Microeconomics stands in the liberal and democratic tradition of the 18th century and attempts to construct social welfare on the basis of individual utilities.
Approach 2 is related to the macroeconomics. It circumvents individual welfare and attempts to measure social welfare directly. This method is compatible with non-liberal and non-democratic traditions.
The idea that happiness is important to a society is not new. Thomas Jefferson put the “pursuit of happiness” on the same level as life and liberty in the United States. Jeremy Bentham believed that public policy should attempt to maximize happiness, and he even attempted to estimate a "hedonic calculus". Many other prominent economists and philosophers throughout history, including Aristotle, incorporated happiness into their work. (Happiness Economics, Wikipedia)
Definition
Happiness economics is the study of a country's well-being by combining economists' and psychologists' techniques. The goal is to determine from what source people derive their well-being (Happiness Economics, Wikipedia)
Happiness economics examines the determinants of life satisfaction by means of surveys, thereby connecting micro- and macroeconomics. The result is an average or “representative” utility function [Kleinewefers, 278] with subjective life satisfaction on one side and the statistical determinants on the other side. Determinants are those social indicators which are relevant for the life satisfaction of the majority [Kleinewefers, 58].
Happiness economists hope to change the way governments view well-being and allocate resources in the light of empirical data. They challenge conventional economic theory on two accounts:
1) They question the rational utility maximization principle of the homo oeconomicus
2) They question the definition of social indicators by bureaucratic elites and the use of untested assumptions about the determinants of happiness
[Hirata, 21]
Obviously, after a long detour, welfare economics returned to its classical target, which was the greatest happiness for the greatest number of people.
Homo oeconomicus
Following a summary of the empirical findings:
1. On the biological level people have their preferences, but on the cultural level people rather make than have their preferences.
2. Behavior systematically deviates from happiness maximization, both intentionally and erroneously. People sometimes account for moral considerations at the cost of subjective well-being; and sometimes they take decisions mindlessly. Consequently the assumption that everyone is the best judge of what will make him/her happy is by no means unchallenged. This conclusion should not come as a surprise. After all, economic decision theory is built upon psychological ad hoc assumptions which qualified primarily on formal, rather than substantive grounds. They were convenient because they warrant internal consistency and analytical versatility, making them amenable to quantitative analyses. Similarly in the context of consumption, welfare economics relies on an uncritical generalization of the casual observation of individual consumption decisions and their motivations.
The Homo Oeconomicus is an inadequate description of human behavior. Welfare economics will have to be reassessed in the light of empirical findings. All the important theories in this field (in particular the general equilibrium theory) depend on the relation between behavior and welfare through the intermediary of preferences [Hirata, 26]
Social indicators
Happiness economics maintains that social indicators are defined by bureaucratic elites and rely on untested assumptions [Kleinewefers, 277]. Indicators, once they are established, develop a normative force and influence politics. It is therefore necessary to check the relation between indicators and subjective well-being by means of surveys. The most important (and controversial) result is that the average life satisfaction of a nation probably increases with the logarithm of absolute income (and not linearly as assumed in traditional economics), see Easterlin Paradox. The logarithmic increase of life satisfaction corresponds to Gossen’s observation of the diminishing marginal utility of welfare.
Even more fundamental is the critics that social welfare shouldn’t be restricted to economic indicators. (Besides income) social indicators like
1) material security
2) political liberty
3) social justice
4) legal security
5) health care
are essential for social welfare [Kleinewefers, 56-58]. All these indicators question the List of Countries by GDP.
Following some alternatives:
1. A list which combines the indicators political liberty, legal security and social justice is the Democracy Ranking.
2. The Human Development Index published by the United Nations Development Programme combines the standard of living (as measured by the natural logarithm of gross domestic product per capita) with life expectancy, adult literacy rate and the gross enrollment ratio.
3. Traditional economic indicators (like GDP) don’t account for the exploitation of natural resources and therefore allow consumption at the cost of future generations. A recently proposed alternative for GDP is the Genuine Progress Indicator (GPI).
Above social indicators, as well as the GDP, represent objective data. But the basic idea of happiness economics consists in relating objective data to subjective happiness. Following some examples:
1) The Satisfaction with Life Index is an attempt to show the average self-reported happiness (subjective life satisfaction) in different nations. This is an example of a recent trend to use direct measures of happiness, such as surveys asking people how happy they are, as an alternative to traditional measures of policy success to GDP or GNP (…) (Happiness Economics, Wikipedia)
2) Happy Life Years, a concept brought by Dutch sociologist Ruut Veenhoven, combines self-reported happiness with life expectancy (…). Veenhoven is one of the chief critics of (…) the Human Development Index published by the United Nations Development Programme (…). Happy Life Years may be a better indicator of happiness as it relies on subjective measures of happiness (Happy Life Years, Wikipedia)
3) The Happy Planet Index combines self-reported happiness with life expectancy and ecological footprint. The HPI is based on general utilitarian principles — that most people want to live long and fulfilling lives, and the country which is doing the best is the one that allows its citizens to do so, whilst avoiding infringing on the opportunity of future people and people in other countries to do the same (Happy Planet Index, Wikipedia).
An interesting experiment is taking place in Bhutan, the only country that replaced the GDP by the Gross National Happiness.
For a philosophical criticism of happiness economics see Moral Relativism and the Search for Happiness.
▪ The history of welfare economics seems to confirm the following suspicion:
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The mathematical models of welfare economics are extremely useful as a form of employment for economists.
Author unknown
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Whereas many branches and techniques of economics are indispensable, the mathematical models of welfare economics cannot live up to their promises.
▪ Recently economics turned back to the classical utilitarian goal to make people happier. Happiness Economics builds on empirical data about individual happiness instead of inappropriate mathematical models and bureaucratic indicators like the GDP.
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1. Clarenbach Lars Albert (1999), Die Wohlfahrtstheorie auf der Grundlage kardinaler Messbarkeit und interpersonaler Vergleichbarkeit von Nutzen, Diplomarbeit, Köln 2. Frey Bruno S., Stutzer Alois (2007), Should National Happiness be Maximized? Institute for Empirical Research in Economics, University of Zurich, Working Paper Series, ISSN 1424-0459, Working Paper No. 306 3. Hirata Johannes (2004), Happiness and Economics 4. Kleinewefers Henner (2008), Einführung in die Wohlfahrtsökonomie, Verlag W. Kohlhammer, Stuttgart
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