Welfare Economics
Kaushik Basu
Is the study of decision making with the aim of enhancing social welfare, in contrast to an individual’s happiness or a firm’s profit. It is there fore a subject which should be of value to government, since government is meant to be an agency for promoting social welfare. It should, however, also be of interest to an individual who is not committed solely to enhancing his or her own happiness, or even to the ‘‘enlightened’’ firm or business corporation that seeks not only to increase its profit but also has some commitment to the general well being of society.
Suppose in choosing between two projects, A and B, all the relevant facts are known. It is known how much and who will gain from each project, how much damage each project will do to the environment, and so on. This is in itself of course not enough to choose between the pro jects. The choice depends on what it is that one is seeking to achieve. If a certain firm is evaluating these projects in order to maximize its profits, the facts may point to the choice of A. If the aim is to maximize social welfare, then the same facts point to B. However, the second decision problem is in some fundamental ways more complicated than the first one because unlike ‘‘profits,’’ what constitutes ‘‘social welfare’’ may itself be controversial.
It follows that welfare economics has two main concerns. The first is the abstract problem of deciding what constitutes social welfare, given that individuals in a society have widely diver gent and often conflicting objectives. The second concern is the more mundane one of deciding how to choose between projects, taxation schemes, industrial regulation, environ mental policy and so on, given some agreed upon notion of social welfare. The former concern relates welfare economics to moral philosophy and ethics, a boundary with considerable intellectual trespassing (Sen, 1987). The latter explains the overlap of welfare economics with issues of cost benefit analysis and public policy (Atkinson, 1983; Ng, 1979).
Regarding the constitution of social welfare, one of the earliest and, in economics, arguably the most influential position has been a utilitarian one. With roots a respectable two centuries ago and in the works of Jeremy Bentham (1748– 1832) and the two Mills (James, 1773–1836 and John Stuart, 1806–73), utilitarianism is an ethical doctrine that requires us to maximize the sum total of everybody’s utility or happiness. Hence, a welfare economics wedded to utilitarianism would simply sum the total benefit that results from each project or action, giving equal weight to all human beings, and then recommend the project that yields the larger aggregate welfare.
Though the utilitarian method has been and still is widely used in assessing the goodness of alternative government policies or projects, like tax schemes or new airports, it came under severe attack in the first half of this century. One set of criticisms pertained to the fact that utilitarianism requires us to sum everybody’s utility. It is easier to agree that social welfare should depend on every individual’s utility, but not necessarily be their sum. We may, for in stance, argue that if a project impoverishes a rich man by two dollars (assuming for simplicity that dollars measure individual utility) and enriches a poor person by one dollar, this may be a desirable project even though the sum total of utility in society is lowered. The Bergson–Samuelson social welfare function (see Samuelson, 1947; Graaff, 1957) allows for such flexibility which is not there in the utilitarian system.
The second criticism of utilitarianism, and one that also applies to the Bergson–Samuelson method, is that it entails interpersonal comparisons between different people’s utility. But can we really compare one person’s happiness with another’s? (See Basu, 1995, for discussion.) How do we know whether a dollar would make Guildenstern or Rosencrantz happier? So if we have only one dollar to give away and we want to maximize social welfare, whom do we give it to?
A method that tries to circumvent this problem and has been immensely influential in modern welfare economics is the method of Vilfredo Pareto (1848–1923) (see pareto optimality). Welfare economics defines a Pareto improvement for a society as any change that leaves no one worse off and at least one person better off. A Pareto optimal state is then defined as a situation from where no further Pareto improvements are made.
One reason why the idea of Pareto optimality shot into prominence in economics was the discovery of a major theorem, the so called Fundamental Theorem of Welfare Economics. The Fundamental Theorem is essentially a formalization of conjectures which date at least as far back as the writings of Adam Smith (1723–90). It states that, given some condition, perfect com petition in an economy ensures that the economy will attain Pareto optimality. The importance of this theorem stems from the fact that it has been used – perhaps somewhat cavalierly – to justify a variety of government policies, for example, the enactment of antitrust legislation in order to encourage competition among firms, and, also, at times, to justify unbridled laissez faire.
An advance which gave welfare economics a big boost was the discovery of a theorem of gigantic proportions – Kenneth Arrow’s (1951) general impossibility theorem. An Arrovian social welfare function – ‘‘SWF’’ – is a rule by which individuals’ rankings over a set of alternatives (e.g., candidates in an election) are con verted into a social ranking. Instead of fixing a particular SWF, Arrow developed some reason able axioms that we would want any SWF to satisfy. The impossibility theorem demonstrates that no SWF can satisfy these axioms. The theorem was remarkable because it was so unexpected; its proof relied on no standard mathematics but just careful chains of deduction. A large literature emerged to ‘‘solve’’ the problem (see Sen, 1970). The literature has grown so as to straddle the formal algebra of voting theory on the one hand and the conceptual world of moral philosophy on the other.
Instead of being a separate field of study, welfare economics is increasingly a method of analysis that underlies diverse branches of eco nomics. With one foot in the groves of academe and the other in the practitioner’s workplace, welfare economics is here to stay as an essential part of the economist’s repertoire.
Bibliography
Arrow, K. J. (1951). Social Choice and Individual Values. New York: Wiley.
Atkinson, A. B. (1983). Social Justice and Public Policy. Brighton: Wheatsheaf; and Cambridge, MA: MIT Press.
Basu, K. (1995). On interpersonal comparison and the concept of equality. In W. Eichhorn (ed.), Models and Measurement of Welfare and Inequality. Berlin: Springer-Verlag, 491 510.
Graaff, J. de V. (1957). Theoretical Welfare Economics. Cambridge: Cambridge University Press.
Ng, Y.-K. (1979). Welfare Economics. London: Macmillan.
Samuelson, P. A. (1947). Foundations of Economic Analysis. Cambridge, MA: Harvard University Press.
Sen, A. K. (1970). Collective Choice and Social Welfare. San Francisco: Holden-Day.
Sen, A. K. (1987). On Ethics and Economics. Oxford: Blackwell.
Tags