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4. ETHICAL BASIS OF ECONOMIC POLICY
John Maynard Keynes:
- “economics is basically a moral science”
- ”The political problem of mankind is to combine
three things: economic efficiency, social justice
and individual liberty.”
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2.
3.
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5.
6.
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Freedom
Happiness
Efficiency
Equity
Market failure – and political failure
GDP and economic growth
Social choice theory
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1. Freedom

Classical economics, closely related to natural law theory, stressed the individual freedom
that unregulated markets were associated with,

This perspective has also been stressed by the intellectual heirs of classical theory, such as
Friedrich Hayek and Milton Friedman: the market allows decentralized economic activity by
using the price mechanism (the “’invisible hand’) ,

Hayek: the alternative to the market economy, central planning, inevitably results in a
totalitarian dictatorship; cf. ‘The Road to Serfdom’ (1944); Friedman ‘Capitalism and
Freedom’ (1962),

But what is ‘freedom’?
Sen: 1) processual freedom: market mechanism OK
2) substantive freedom: can be poor if there is not (‘positive’) freedom to achieve
commodities or states that are truly valuable to the individual
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2. Happiness
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Reasonable idea which goes back (at least) to Epicuros,
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Important to the classical economists, who wanted ‘the greatest happiness of the
greatest number’, to maximize the sum of happiness of the members of society,
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This ‘utilitarianism’ differs from ‘modern welfare economics, tough both versions focus
on happines of atomistic, utility-maximizing individuals
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Is there a conflict between utilitarianism and natural law or freedom, between
utilitarianism and liberalism? (classical economists typically were both)
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Utilitarianism is now history but Happiness has in recent years experienced something
of a comeback (the idea that the success of a society is properly evaluated on the basis
of the happiness of its citizens) and surveys of happiness are often made
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One key question: Is happiness a function of income?
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It has been widely claimed that increased income does not add to happiness (after a certain level
has been reached), this is known as the ’Easterlin paradox’, but recent research suggests
orherwise, higher income does seem to increase happiness as measured in surveys
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3. Efficiency
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’Modern welfare economics’ claims that interpersonal comparison of utility is not possible,
which would mean that utilitarianism (summing of happiness) is meaningless
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What remains then is the Pareto-criterion: alternative A is better than alternative B (a
‘Pareto-improvement’) if alternative A improves the situation of one or more individuals
without worsening the outcome for anybody; a ‘Pareto-optimum’ is a state of affairs in which
no ‘Pareto-improvements’ are possible,
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A ‘fundamental theorem’ states that any competitive market equilibrium is necessarily also a
Pareto-optimum (provided that a number of restrictive assumptions hold): interesting in
principle (the market economy fulfills certain efficiency conditions as claimed already by
Adam Smith)
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However, the practical significance of this theory is limited, because it has nothing to say
about issues of income distribution. Modern welfare economics based on the Paretocriterion is therefore of no great use when confronted with the important, difficult and
interesting problems of society, which often concern distribution.
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Utilitarianism and the Pareto-criterion compared
MUA
a
Income of A is measured from O to the right, income of B from B to the
left, marginal utility (MU) of a is aa, MU of B os b1b1. Original distribution
is at P, utilitarian optimum at E. However, if MU of B is b2b2, then
utilitarian optimum is at G.
MUB
b1
P
E
Z
G
b1
b2
a
b2
O
H
C
D
B
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4. Equity

the night-watch state would not need to be big, max 10 % of GDP, but more is needed if
there are ambitions to deal with market failures and/or equity

What does ’equity’ mean? Equality OK but equality of what?
1) equality of liberty in the sense of absence of restrictions on the individual (’negative
freedom’)? (cf. Rawls first principle)
2) equality of ability to succeed (ex ante equality of possibilities), which can be
enhanced by policies (e.g. education)
3) equality of ex post outcomes (fight against poverty and action to redistribute
income ) (cf. Rawl’s second principle, part b)

Equity’ is a highly controversial concept, ideological, becomes even more difficult if allowance
is made for the time dimension (equality as between generations) and the space dimension
(equality in a global context).
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5. Market failure – and political failure
Governments pursue activities far beyond the tasks of the night-watch state. These activities may often be
justified as ways to deal with ‘market failures’:
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lack of effective competition or cases of ‘natural’ monopolies (competition policy)
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externalities, positive or negative (subsidies, taxes, regulation)
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information problems such as asymmetric information or myopia (e.g. social insurance)
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Macroeconomic stabilization to maintain high unemployment
Many of the market failures do not necessarily raise serious issues of ethical character. To the extent that
market failures create economic distortions, and if these distortions can be corrected by government
intervention, then such intervention may constitute Pareto-improvements (it is difficult to object to Paretoimprovements whatever values one is embracing).
However, in practice it is extremely difficult to make a clean separation between considerations of efficiency
and equity, and both are often relevant for policies motivated by market failure. For instance, action to fight
unemployment can be justified as enhancing efficiency and as furthering equity.
While there are market failures, there are also ‘political failures’. . A main point of public choice theory is that
institutions (such as the constitution) should be designed so as to constrain the scope for politicians to rely on
majority positions in order to exploit minorities; ‘Leviathan” should be chained.
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6. GDP and economic growth

Probably the most common objective referred to in policy discussions by economists and politicians is the
GDP, the source of income and consumption, and employment, and of means to finance action with, for
instance, social or environmental purposes.

A powerful argument in favor of focusing on growth is that this is or may be the most realistic way to raise
the average living standard of the average citizen and also of the poor. Redistribution from the ‘rich’, an
obvious alternative, is likely to be conflictual and the means of redistribution may (arguably) cause
distortions of incentives helpful to growth. Even a small increase in the rate of economic growth will raise
the overall level of income significantly in the long run through the strong effects of compound interest.

External balance or budget deficits are obviously not to be seen as objectives in themselves but rather as
constraints that need to be taken into account for policies to be sustainable. The same may to some extent
be said of environmental objectives, though they are also associated with ethical values in themselves.

Many ‘composite indicators’ have been developed with a view to complementing or replacing GDP as a
measure of how the economy is doing. These include the Human Development Index (developed by Sen)
and the ‘General Progress Index’ (cf. Matti Pohjola, KAK)

Capitalism as a transitory (unsatisfactory) phase in a development towards a more satisfying ‘stationary
state’: John Stuart Mill was convinced that there would in the future emerge a ‘stationary state’, in which
citizens would relax and be happy. A century later (in the 1930s), John Maynard Keynes pondered
capitalist progress towards a future (utopian) society, in which the work load is light and time spent on arts
and philosophy.
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John Stuart Mill and John Maynard Keynes
on the stationary economy
John Stuart Mill: “I am inclined to believe that it would be, on the whole, a very considerable
improvement on our present conditions. I confess I am not charmed with the ideal of life held out
by those who think that the normal state of human beings is that of struggling to get on; that
trampling, crushing, elbowing, and treading on each other’s heels, which form the existing type of
social life, are the most desirable lot of human kin, or anything but the disagreeable symptoms of
one of the phases of industrial progess.”
John Maynard keynes: “When the accumulation of wealth is no longer of high social importance,
there will be great changes to the code of morals. We shall be able to rid ourselves of many of the
pseudo-moral principles which have hag-ridden us for two hundred years, by which we have
exalted some of the most distasteful of human qualities into the position of the highest virtues.
We shall be able to afford to dare to assess the money-motive at its true value. The love of money
as a possession — as distinguished from the love of money as a means to the enjoyments and
realities of life — will be recognised for what it is, a somewhat disgusting morbidity, one of those
semi-criminal, semi-pathological propensities which one hands over with a shudder to the
specialists in mental disease … But beware! The time for all this is not yet. For at least another
hundred years we must pretend to ourselves and to everyone that fair is foul and foul is fair; for
foul is useful and fair is not. Avarice and usury and precaution must be our gods for a little longer
still. For only they can lead us out of the tunnel of economic necessity into daylight.”
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7. Social choice theory
The basic question: Is it possible to derive a meaningful preference function of the society, or to rank
alternative institutional settings or policies that may be pursued by society, on the basis of the
preferences of the individuals, of which the society is composed?
Arrow (1951) demonstrated that even mild conditions of reasonableness attached to the procedure and
the preferences of individuals would make it impossible to arrive at a result in the form of a ‘reasonable’
social welfare function (the ‘Arrow paradox’).
One way to modify the analysis and achieve a well-behaved social welfare function is to assume some
similarity of individual preferences, possibly due to cultural homogeneity. However, the difficulties of
finding agreement are even then great in choices involving distribution (the sharing of a cake). Assuming
interpersonal comparability of utility is another option.
Yet, the general result is that it is difficult to find a way of generating a meaningful ranking of
alternatives for society on the basis of individual preferences. Democracy is often understood as relying
on (or even identified as) majority voting. Arrow’s paradox demonstrates that there is no inherent
optimality attached to this system; its attractiveness relates more obviously to the procedure than to its
results.
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Condorcet’s paradox
The problem that majority voting may have arbitrary outcomes was noted more than two
centuries ago by the French mathematician and philosopher Marquis de Condorcet. The problem
may be illustrated by the table below, which describes the preferences over alternatives X, Y and
A by the voters A, B and C.
Voter
A
B
C
Majority
Preferences
X > Y > Z
Y > Z > X
Z > X > Y
X > Y > Z > X
The result of voting is, for instance, that X is preferred to Y (by A and C), Y is preferred to Z (by A
and B), and yet Z is preferred to X (by B and C). This implies violation of the transitivity condition,
according to which X > Y and Y > Z should imply X > Z. This also means that the voting procedure
is unstable, ending up in any outcome depending on the sequencing of votes.
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