Welfare Economics - Central Web Server 2


Welfare Economics


Summer 2006

Prof. Cunningham


What is it?

A branch of economics concerned with discovering the principles for maximizing social welfare.


Heyday of Welfare Theories:



Vilfredo Pareto (1848-1923)

Founder of modern welfare economics

Based on Walrasian General Equilibrium


1906, Manual of Political Economy

Most famous contribution:

“Pareto Optimality”

Maximum welfare = no change could make anyone better off without making someone worse off.


Pareto (2)


Optimal income/output distribution

Optimal technical efficiency

Optimal technical allocation of resources

Optimal output (Maximal output)

Occurs when:

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


Pareto (3)


Does not really address distributive justice.

Analysis is static.


Arthur Cecil Pigou


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


Makes case for income distribution

Theory of externalities


Pigou (2)

Saving is critical. Do not encourage people to consume.

Do not tax saving, property, or bequests.

Avoid progressive income tax.

Tax consumption (sales tax)

Macroeconomics of Keynes

Pigou effect (real balance effect)


John Atkinson Hobson



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.


Ludwig Von Mises



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


Von Mises (2)

Argues against socialism.


Oscar Lange



1937, On the Economic Theory of


Advocates “market socialism”

Shows that theoretically socialism can work

Von Hayek argues that the informational assumptions are prohibitive.


Lange (2)

Market socialism is characterized by:

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)


Lange (3)

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.


Lange (4)

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:

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.


Kenneth Arrow

(1921- )

Graduated from Columbia, moved to Stanford.

Known for his ability in symbolic logic, mathematics, and statistics.

Dissertation, Social Choice and Individual


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.


Arrow (2)

Four criteria for voting:

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.


James Buchanan

(1919- )

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.


Buchanan (2)

Public Choice

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.


Buchanan (3)

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.


Buchanan (4)

Critique of conventional welfare economics:

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.”


Buchanan (5)

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.