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Welfare Economics
ECON 205W
Summer 2006
Prof. Cunningham
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What is it?
A branch of economics concerned
with discovering the principles for
maximizing social welfare.
 Issues
 Heyday of Welfare Theories:
1900-1955.
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Vilfredo Pareto (1848-1923)
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Founder of modern welfare economics
Based on Walrasian General Equilibrium
Background
1906, Manual of Political Economy
Most famous contribution:
“Pareto Optimality”
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Maximum welfare = no change could make
anyone better off without making someone
worse off.
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Pareto (2)
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Implications:
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Optimal
Optimal
Optimal
Optimal
income/output distribution
technical efficiency
technical allocation of resources
output (Maximal output)
Occurs when:
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All agents have identical marginal rates of substitution
between pairs of goods
Firms optimize
Marginal rates of technical substitution between factors
are equal
Marginal rates of substitution between each pair of
goods = marginal rates of transformation
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Pareto (3)
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Problems:
Does not really address distributive
justice.
 Analysis is static.
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Arthur Cecil Pigou (1877-1959)
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Marshall’s successor, master of
neoclassical economics.
Chair of political economy at Cambridge
from 1908 to 1943.
Takes a softer view toward a larger role
government
1920, The Economics of Welfare
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Method
Makes case for income distribution
Theory of externalities
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Pigou (2)
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Saving is critical. Do not encourage
people to consume.
Do not tax saving, property, or
bequests.
 Avoid progressive income tax.
 Tax consumption (sales tax)
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Macroeconomics of Keynes
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Pigou effect (real balance effect)
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John Atkinson Hobson
(1858-1940)
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Background
Most mainstream economists, including
Keynes, thought his work was mostly
flawed and confused.
Strong supporter of government
intervention.
Argued that excessive saving, deficient
demand, might result in macroeconomic
recessions.
Solution is income redistribution.
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Ludwig Von Mises (1881-1973)
Background
 1912, Theory of Money and Credit
 1949, Human Action
 1922, Socialism
 1956, Theory and History
 Distinguished Fellow of the AEA
 Von Mises Institute at Auburn
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Von Mises (2)
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Argues against socialism.
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Oscar Lange (1904-1965)
Background.
 1937, On the Economic Theory of
Socialism
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Advocates “market socialism”
 Shows that theoretically socialism can
work
 Von Hayek argues that the
informational assumptions are
prohibitive.
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Lange (2)
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Market socialism is characterized by:
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Private ownership of consumer goods and free choice
of consumption from available goods (cons. choice)
Free choice of occupation
State ownership of the means of production
Markets for goods, services, and labor, but not for
capital and intermediate goods
A central planning board sets the prices of capital
goods by changing prices to eliminate shortages and
surpluses.
Workers are paid a market wage plus a share of the
social dividend (yield on capital and natural
resources)
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Lange (3)
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The central planning board instructs
the managers of the state
enterprises to act as if prices are
constant, and follow two rules:
Combine resources so as to minimize
the average cost of production by
setting the MRTS equal.
 Set MC=P to set output level.
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Lange (4)
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Friedrich von Hayek and other neo-Austrians
argued against Lange’s model in the face of the
collapse of socialist economies around the world.
Their arguments were:
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It has proved difficult to achieve efficiency in large
economies through central planning. Achieving this
requires much more information than is available to
planners.
Lange’s Socialism does not give participants sufficient
incentive to allocate resources efficiently or pursue
opportunity.
The market economy handles these problems easily.
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Kenneth Arrow (1921- )
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Graduated from Columbia, moved to Stanford.
Known for his ability in symbolic logic,
mathematics, and statistics.
Dissertation, Social Choice and Individual
Values.
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Evaluates various criteria of social welfare.
Arrow’s Impossibility Theorem: No majority
voting scheme simultaneously respects the
personal preferences of the voters, ensures
maximum welfare, and does not depend upon
the order that the issues are voted upon.
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Arrow (2)
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Four criteria for voting:
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Social choices must accurately reflect the
preferences of the individual voters;
Social choices must be transitive;
The group choice must not be dictated by
anyone inside or outside the community;
A social preference made between two
alternatives must depend only on
preferences toward the two alternatives,
and not on people’s opinions of other
options.
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James Buchanan (1919- )
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Founder of public choice theory and
constitutional economics (the economics of
rules).
Middle Tennessee State and Chicago. Studied
under Frank Knight.
Moved to University of Virginia, later to Virginia
Tech, and then to George Mason University.
Coauthered The Calculus of Consent: Logical
Foundations of Constitutional Democracy with
Gordon Tullock, 1962. Thought it was pretty
obvious stuff.
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Buchanan (2)
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Public Choice
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The pursuit of self-interest leads to spontaneous
order through exchange.
Question: If individuals seek self-interest in the
market, why would we expect them to seek social
interest in or through government?
Human nature is human nature. People seek out selfinterest no matter what the organization or arena.
The public sector is also driven by self-interest;
moving a problem to the public sector does not avoid
competition or self-interest. It simply changes the
way self-interest is expressed or is manifested.
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Buchanan (3)
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Some results of this:
Helps explain the collapse of
communism.
 Explains the deficit bias in industrial
nations.
 Explains logrolling—the exchange of
votes among politicians.
 Explains rent-seeking behavior.
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Buchanan (4)
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Critique of conventional welfare
economics:
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Government officials are sometimes viewed as
pursuing a social welfare function.
• Individual preferences are known only to individuals.
No one can discern a collective or social welfare
function.
• Even if the social welfare function were known, the
public sector could not be relied upon to pursue it.
The people in the public sector would be pursuing
their own interests.
• There is “government failure” as well as “market
failure.”
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Buchanan (5)
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Constitutional Economics
We need government to establish and
enforce property rights rules, contracts,
etc.
 There is also a need for constitutional
rules to constrain the state.
 Supermajority rules, etc.
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