Welfare economics I: Definition and main economists

 

Summary

Welfare economics analyses different states in which markets or the economy can be. Its main objective is to find an indicator or measure in order to guarantee that markets are behaving optimally, thus also guaranteeing that consumer welfare is as high as possible. In this Learning Path, we learn about the basics of welfare economics.

Welfare economics are a part of normative economics which objective is to evaluate different situations of a given economic system, in order to choose the best one.

Its study can be traced back to Adam Smith, who related an increase of welfare with an increase on production, and to Jeremy Bentham, whose utilitarian views made him think that welfare was equal to the sum of individuals utilities or, in other words, to a “social” utility.

Traditional welfare economics is based on the work of three neoclassical economists. Alfred Marshall stated that consumer’s welfare was the consumer’s surplus, and therefore was measurable in monetary units. Vilfredo Pareto would criticize this cardinal view, and would be the economist who built a true theory of welfare economics in his book “Manual of Political Economy”, 1906: based on the principles of unanimity and individualism, he designed what nowadays is known as the Pareto Optimality, which would become the core of welfare economics. Later, Pigou wrote “The Economics of Welfare”, 1920, stating that a definition of social welfare must include both efficiency and equity.

During the XXth century, welfare economics developed quickly. Nicholas Kaldor and John Hicks’ compensation criteria, and its following critics by Scitovsky, Little and Paul Samuelson, which aim was to find some way of classification of different optima. Also Bergson’s social welfare function, and Kenneth Arrow’s impossibility theorem, proving the former could not be identified. The theory of second best, developed by Lipsey and Lancaster, aimed at finding an optimum when Pareto optimality could not be found. Finally, the increasing use of cost-benefit analysis marks the validity of welfare economics nowadays.

Arthur C. Pigou

Pigou was a British economist (1877-1959), disciple of Alfred Marshall, whom he succeeded as a professor at Cambridge. Pigou is remembered above all as a precursor of welfare economics, for his books “Wealth and Welfare”, 1912, and “The Economics of Welfare”, 1920, in which he used measures of national income and its distribution in order to understand how wealth and welfare are related. He is also remembered for making a distinction between different degrees of price discrimination.

Being part of the Cambridge school, Pigou used common tools derived from neoclassical economics, such as marginalism, amongst others.

Vilfredo Pareto

Pareto was an economist and sociologist of Italian origin, born in Paris (1848-1923), who taught at the University of Lausanne, as well as previously did his mentor, Léon Walras. They both were part of the Lausanne School, which is considered, along with the Austrian School, as the birthplace of marginalism and neoclassical economics.

His chief works were “Course of Political Economy”, 1896-97, and “Manual of Political Economy”, 1906. Among Pareto’s contributions, we can highlight the graphical development of Edgeworth box, as well as an improvement on the way indifference curves are drawn, and studies on the personal distribution of income.

In his studies of the late nineteenth century, Pareto found some regularity in the personal distribution of income in different countries. From that regularity, he determined a series of economic and sociological conclusions, which became known afterwards as Pareto’s Laws. He also studied some regularities in businesses, where concentration was the explanation for the fact that many companies get 80% of their revenue from only 20% of its products.

Nowadays, however, he is mostly known for the Pareto optimal, a notion widely used in game theory and welfare economics.

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