The wreck of welfare economics

I just re-read Will Baumol’s Welfare Economics and the Theory of the State, first published in 1952, based on his doctoral dissertation, with a 2nd edition in 1965. I started mulling over welfare economics while writing my latest book, Markets, State and People: Economics for Public Policy (OUT THIS WEEK – TA-DAH!).

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This is the area of economics concerned with the question of what it means for society to be better off. As a branch of theory, welfare economics is highly abstract and mathematical, covering the existence of a general equilibrium, its optimality properties (and the extent to which these are delivered by the market economy), and the various impossibility theorems about aggregating individual utlities into social welfare. As a matter of practice, some hazy sense of all of this theory lies behind policies such as the use of cost-benefit analysis. In writing the book, I became increasingly and uncomfortably aware of the theory-practice gap.

Better economists than me were on to this earlier. In 2001 the late, great Tony Atkinson wrote a powerful article noting the ‘strange disappearance of welfare economics’, largely ignored since the 1970s – it was published in a journal (Kyklos) unknown to many economists unfortunately. As it turns out, Baumol skewered the basic problem in this book. “Mathematical manipulation can yield no more than is contained in the premises which are being examined. Walras [in his work on general equilibrium], by assuming that every indivudal independently sought his own ends, obtained mathematical statements which amounted to the not excessively surprising assertion that every individual did as well for himself as possible under the circumstances.”

In other words, if you assume individuals are wholly independent, you conclude that the optimal economic organisation simply requires individual decision-making. But as Baumol points out in the final chapter, titled The Wreck of Welfare Economics, any brush with empirical reality underlines the interdependence of both production and consumption decisions. His conclusion: if economics is to say anything of practical use about economic progress, we need to start filling – with both theory and empirics – the currently empty boxes with labels like ‘externalities’ and ‘increasing returns’.

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Social limits to growth

In preparing for an event tomorrow celebrating the 40th anniversary of the publication of Fred Hirsch’s The Social Limits to Growth, I’ve naturally been re-reading the book. It’s full of comments that leap out from the page, such as this: “The extent of interdependence of many forms of consumption in advanced, urbanized societies has brought increasing recognition that to give effect to public choice among the available economic alternatives represents a still unresolved intellectual and administrative problem, rather than requiring merely the sweeping away of impediments to the working of the market mechanism.” And, “To see total economic advance as individual advance writ large is to set up expectations that cannot be fulfilled, ever.”

These comments reminded me very much of Will Baumol’s long overlooked book (his PhD thesis!), Welfare Economics and the Theory of the State, which I read quite recently. Part of his argument is that interdependence is far more extensive than in textbook world. The changes in the character of the economy since 1977 have made this ever more true. Hirsch is of course famous for the concept of positional goods, where there are negative consumption externalities – I am worse off if you have the status symbol and I don’t. Some of this has been absorbed in modern signalling models. However, positive consumption externalities – network effects, direct and indirect – are now becoming widespread too.

The conventional matrix of goods (according to whether they are easy or hard to exclude and rivalrous in consumption or not) needs extending:

—————————-Easy to exclude                        Hard to exclude

Rivalrous+neg externality      Positional                           Commons good

Rivalrous                               Private good                      Commons good

Non-rivalrous                         Club good                         Public good

Non-rival+pos externality       Network club                     Network commons

In only one of these boxes does the standard ‘free market’ presumption apply.

 

 

 

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The prescience of Will Baumol

The sad news about Will Baumol’s death sent me looking at his publications, and I’ve been reading the (1950) book of his PhD thesis, Welfare Economics and the Theory of the State.

The book begins by noting that laissez faire is certainly not no-government anarchism, but the list of things the government ‘ought’ to do (defence, justice, street lights, roads….) can vary between laissez faire writers and is rather arbitrary. Can there be a set of criteria based on first principles? What about asking, “Which, if any, are the circumstances in which the people composing an economy will find that a particular extension of the authority of the government is requisite for the most efficient pursuit of their own economic interests.” The thesis seeks to answer this question by an extension of the notion of external economies in consumption and production, and concluded that this approach can yield a consistent list of government activities (and moreover one that has governments do more than is often the case, rather than less).

The book then essentially destroys some of the standard convenient assumptions of welfare economics, in amazingly prescient ways. Baumol for example argues that individual preferences are not fixed, but rather influenced by other people, that monopoly and monopolistic competition are the norm, and that there is imperfect knowledge, prefiguring behavioural economics and information economics by some decades. The book ends with an Epilogue: “The Wreck of Welfare Economics.” He writes: “The simplifying premise that these types of interdependence [ie of production costs or preferences] are negligible or non-existent is misleading. Such an assumption is not neutral; it leads inexorably to the acceptance of laissez faire.” He concludes that until economics can say more about external economies and diseconomies, in terms of empirical investigation, there is no point in applying welfare theory.

 

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