History of Economic Thought II Module

UNIT THREE: GENERAL EQUILIBRIUM AND WELFARE ECONOMICS

3.1. Walrasian General Equilibrium
LEON WALRAS (1835-1910): Leon Walras, a French economist, was the son of Augusta
Walras, who was an economist. Walras was a professor of political economy at the University of
Lausanne, Switzerland. Walras is considered as the founder of the Lausanne school or the
mathematical school of economics. He was a born thinker and is considered as the greatest of
pure theorists. His important contributions are ‘Elements of pure Economies’, Theory of
exchange’, Theory of production’, and ‘Studies in applied Economies’. Walras developed the
concept of General equilibrium. General equilibrium theory is an analysis of the economy in
which all sectors are considered simultaneously. Thus, one considers both the direct and the
indirect effects of any shock to the system, and one considers the cross-market effects
simultaneously with the direct effects. This interrelationship of the sectors of the economy is
relatively simple to conceptualize, but it is an enormously complicated idea to put down
formally.

Walras’s contribution was to model the general equilibrium system in a formal manner. His
analysis is based on the following assumptions (i) There is free entry and competition (ii)
consumers’ tastes, technology and factors of production remain constant. Walras divided ‘the
entire economy into two markets namely, a product market and a factor market. In the product
market the sellers are business firms who produce the goods and the buyers are the households
who demand the goods. In the factor market, the business firms become the buyers while the
households who own factors of production become sellers. According to Walras, the buyers and
the sellers go to their respective markets and each is guided by the desire to maximize their
utility. When the prices at which the sellers are willing to sell equal the prices at which the
buyers are willing to buy, general equilibrium is achieved. In other words when buyers and
sellers maximize their utility, general equilibrium is attained. ‘

3.2. Approaches to welfare economics

Welfare economics is the branch of economic analysis concerned with discovering principles for
maximizing social well-being. It is not a distinct and unified system of ideas. Economics itself is
often defined as the study of how society chooses to use its limited resources to achieve
maximum satisfaction. Nearly every aspect of economics, therefore, has a welfare dimension.

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The welfare economists addressed such heterogeneous topics as rules for achieving maximum
welfare, the problem of external costs and benefits, income inequality, the potential for achieving
maximum welfare under socialism, difficulties associated with majority voting, and decision
making in the public sector. Concerns of welfare economics includes; discovering principles for
maximizing social well being (defines welfare optimality and means of achieving it), iidentifying
factors that impede the achievement of maximum well-being and means of removing the
impediments, and if the current state of welfare is W and if welfare can be made larger to W*
welfare economics tries to show whether W<W* and suggests ways of raising W to W* if
W<W*
3.1.1 Early neoclassical approach to welfare economics
Welfare economics dates back to the classical economic ideas of Smith and Bentham. Several
subsequent economists dealt with welfare considerations, including Marshall, who examined the
welfare effects of taxes and subsidies in increasing and decreasing cost industries.

Arthur Cecil Pigou( 1877 - 1939 ): Arthur Cecil Pigou was born in the family home of his
mother on November 18, 1877, at Ryde, in the Isle of Wight. He was the eldest son of Clarence
and Nora Pigou. His father came from the Huguenot line and his mother’s family came from a
line that had won fame and fortune in Irish administration. The pride and background of Pigou’s
family helped to push him along his path later in life. His abilities in academics gained him an
entrance scholarship to the school. Athletics was also one of Pigou’s strong points. His talents in
sports allowed him to be approved of by many at a time in history where athletics was looked at
as being more important than academics. He ended his stay at Harrow as head of the
school.Pigou’s work is notable in two areas: welfare economics and the theory of
unemployment. As in his major work The Economics of Welfare Pigou was strongly influenced
by his former teacher Alfred Marshall. Afterwards, he went to King’s College, Cambridge as a
history scholar. There, he came to economics though the study of philosophy and ethics under
the Moral Science Tripos. He studied economics under Alfred Marshall, and in 1908 Pigou was
elected professor of Political Economy at Cambridge, succeeded Marshall in the chair of political
economy at Cambridge University and held this position until his retirement in 1943.

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He was the leading neoclassical economist after the death of his predecessor, and like Marshall,
he expressed humanitarian impulses toward the poor, hoping that economic science would lead
to social improvement. In his own cautious way, Pigou was willing to go further than Marshall in
allowing a role for the government in ameliorating certain undesirable features of society. In his
The Economics of Welfare, written in 1920, Pigou hoped to provide the theoretical basis for
government to enact measures that promoted welfare. As an economist, he was concerned with
economic welfare, defined as “that part of social welfare that can be brought directly or
indirectly into relation with the measuring rod of money”. Unlike Pareto, who cast his theories in
terms of general economic equilibrium, Pigou continued in the “old welfare” tradition of Smith,
Bentham, and Marshall, relying mainly on partial equilibrium analysis. His contributions to
welfare economics include his observations on income redistribution and the divergence between
private and social costs. On income redistribution Pigou asserted that; greater equality of
incomes under certain conditions could increase economic welfare. According to Pigou on
divergence between private and social costs and benefits, the welfare task of government is to
equalize (1) private and social marginal costs and (2) private and social marginal benefits. It can
do this through the use of taxes, subsidies, or legal regulation like that of Marshall Views.

Pigou was of the view that the main aim of economic science is to increase social welfare. In that
case, economics would be realistic and more beneficial to the society. In his definition, Pigou
defines economics as a study of economic welfare which is that part of social welfare that can be
brought directly or indirectly into relation with the measuring rod of money”. He, therefore,
considers economics as a normative science or welfare economics. Pigou’s major work, Wealth
and Welfare (1912) and Economics of Welfare (1920), developed Alfred Marshall’s concept of
externalities, costs imposed or benefits conferred on others that are not taken into account by the
person taking the action. Pigou attributed welfare gains to the greater marginal utility a dollar of
income had for the poor compared to the rich; a transfer of income from rich to poor increased
total utility that could also be defined as increased “quality of life.”Pigou also argued that
welfare gains came from improving the quality of the work force through changes in the
distribution of income or by improved working conditions. He argued that the existence of
externalities was sufficient justification for government intervention. The reason was that if
someone was creating a negative externality, such as pollution, he would engage in too much of

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the activity that generated the externality. Someone creating a positive externality, say, by
educating himself and thus making himself more interesting to other people, would not invest
enough in his education because he would not perceive the value to himself as being as great as
the value to society.To discourage the activity that caused the negative externality, Pigou
advocated a tax on the activity. To encourage the activity that created the positive externality, he
advocated a subsidy. These are now called Pigovian (or Pigovian) taxes and subsidies.

3.1.2 New trends in welfare economics approach

Historians of economic thought, however, view Vilfredo Pareto (1848–1923) as the originator of
the “new” welfare economics, which is rooted in Walras’s principles of general equilibrium.
Pareto was an Italian engineer, sociologist, economist, and philosopher. Pareto was born in Paris
to Italian parents, studied at the University of Turin in Italy, and later accepted the chair of
economics at the University of Lausanne, Switzerland. Throughout his life Pareto was an active
critic of the Italian government’s economic policies. He published pamphlets and articles
denouncing protectionism and militarism, which he viewed as the two greatest enemies of
liberty. Although he was keenly informed on economic policy and frequently debated it, Pareto
did not study economics seriously until he was forty-two. In 1893 he succeeded his mentor, Leon
Walras, as chair of economics at the University of Lausanne. There he continued and expanded
the mathematical tradition established by his immediate predecessor, Walras. Pareto set forth his
major ideas in his Manual of Political Economy, published in 1906.

Pareto Optimality: Pareto refined Walras’s analysis of general equilibrium and set forth the
conditions for what we now call Pareto optimality, or maximum welfare. Other economists then
established the more rigorous mathematical proof that perfectly competitive product and
resource markets achieved Pareto optimality. According to Pareto, maximum welfare occurs
where there are no longer any changes that will make someone better off while making no one
worse off. This implies that society cannot rearrange the allocation of resources or the
distribution of goods and services in such a way that it aids someone without harming someone
else. The Pareto optimum thus implies (1) an optimal distribution of goods among consumers,
(2) an optimal technical allocation of resources, and (3) optimal quantities of outputs.

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Pigou’s approach came under attack from other new welfare economists Lionel Robbins and
Frank Knight. The New Welfare Economics that arose in the late 1930s dispensed with much of
Pigou’s analytical toolbox. Later, the Public Choice theorists rejected Pigou’s approach for its
naive “benevolent despot” assumption. Finally, Nobel Laureate Ronald Coase demonstrated that
efficient outcomes could be generated without government intervention when property rights are
clearly defined. Coase presents his case in the article “The Problem of Social Cost” (1960). To
explain this alternative let us continue with the paper mill example. There is a second approach
likely taken. In this line of thinking the economist considers the paper mill and others who wish
to consume or enjoy water quality as part of a competitive market where people bargain for the
use of rights to scarce property. This analysis has nothing to do with polluters’ imposing cost on
society, but everything to do with competing demands for use of an asset.If rights to the asset are
defined and assigned to members of the river-basin community, then those planning to build the
paper mill must bargain with the rightholders to determine just how much, if any, waste will
discharge into the river.If the rights are held by the mill, then the existing communities along the
river must bargain with the mill owner for rights to water quality. Again, bargaining determines
the amount of discharge to the river.

This approach relies on the work of Ronald Coase (1960). Using this framework, an economist
might recommend a meeting of the mill owners and others who have access to the river. After
organizing the parties, negotiations would ensue. If existing river users owned water-quality
rights, the mill would have to buy the rights in order to discharge specified amounts of waste. If
the mill had the right to pollute, existing river users would have to buy water quality from the
mill, paying the mill to limit its discharges.In other words, Pigouvian taxes do embody the
important principle that polluters should pay for the damages they inflict on society. But in both
law and economics, a more conservative analysis has gained popularity. Legal scholar Ronald
Coase argued that taxes and regulation might be unnecessary, since under some circumstances
polluters and those harmed by pollution could engage in private negotiation to determine the
appropriate compensation. While Pigou’s examples of externalities often involved simultaneous
harms to large numbers of people, Coase’s examples tended to be localized, individual
nuisances, where one person’s behavior disturbed the immediate neighbors. The image of
environmental externalities as localized nuisances serves to trivialize the real problems of

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widespread, collective threats to health and nature. Creative alternative readings of Coase have
been suggested at times, but the dominant interpretation of his work has provided an intellectual
basis for the retreat from regulation.

3.3. Pareto efficiency in welfare and pre conditions of Pareto efficient conditions

Pareto is best known for two concepts that are named after him. The first and most familiar is the
concept of Pareto optimality. A Pareto-optimal allocation of resources is achieved when it is not
possible to make anyone better off without making someone else worse off. The second is
Pareto’s law of income distribution. This law, which Pareto derived from British data on income,
showed a linear relationship between each income level and the number of people who received
more than that income. The most widely-used concept in theoretical welfare economics is
“Pareto optimality” (also known as “Pareto efficiency”). An allocation is Pareto-optimal if it is
impossible to make at least one person better off without making anyone else worse off; a Pareto
improvement is a change in an allocation which makes someone better off without making
anyone else worse off. Given an initial allocation of goods among a set of individuals, a change
to a different allocation that makes at least one individual better off without making any other
individual worse off is called a Pareto improvement. An allocation is defined as “Pareto
efficient” or “Pareto optimal” when no further Pareto improvements can be made. Pareto
efficient allocation is one for which each agent is as well off as possible, given the utilities of the
other agents.”“Better” and “worse” are based purely upon subjective preferences which can be
summarized in a “utility function,” or ordinal numerical index of preference satisfaction.

Pareto optimality implies an optimal distribution of goods among consumers, optimal technical
allocation of resources, and optimal quantities of outputs. Optimal distribution of goods:
Optimality conditionimplies consumers having identical marginal rates of substitution between
two goods MRSxy(A) = MRSxy(B), where A and B are individuals and x & y are goods.
Optimal technical allocation of resource: Optimality condition implies MRTS LK(X) = MRTSLK
(Y), and finally, Optimal quantities of output: Optimality condition implies MRS XY = MRTXY. If
every equilibrium point is Pareto efficient (there will be no further gain from trade) this is the
first theorem of welfare economics. When preferences are convex a Pareto efficient allocation
is equilibrium for some set of prices. This is the second theorem of welfare economics

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It is commonly accepted that outcomes that are not Pareto efficient are to be avoided, and
therefore Pareto efficiency is an important criterion for evaluating economic systems and public
policies. If economic allocation in any system is not Pareto efficient, there is potential for a
Pareto improvement—an increase in Pareto efficiency: through reallocation, improvements can
be made to at least one participant’s well-being without reducing any other participant’s well-
being. It is important to note, however, that a change from an inefficient allocation to an efficient
one is not necessarily a Pareto improvement. Thus, in practice, ensuring that nobody is
disadvantaged by a change aimed at achieving Pareto efficiency may require compensation of
one or more parties. For instance, if a change in economic policy eliminates a monopoly and that
market subsequently becomes competitive and more efficient, the monopolist will be made
worse off. However, the loss to the monopolist will be more than offset by the gain in efficiency.
This means the monopolist can be compensated for its loss while still leaving a net gain for
others in the economy, a Pareto improvement.

In real-world practice, such compensations have unintended consequences. They can lead to
incentive distortions over time as agents anticipate such compensations and change their actions
accordingly. Under certain idealized conditions, it can be shown that a system of free markets
will lead to a Pareto efficient outcome. This is called the first welfare theorem. It was first
demonstrated mathematically by economists Kenneth Arrow and Gérard Debreu. However, the
result only holds under the restrictive assumptions necessary for the proof (markets exist for all
possible goods so there are no externalities, all markets are in full equilibrium, markets are
perfectly competitive, transaction costs are negligible, and market participants have perfect
information). In the absence of perfect information or complete markets, outcomes will
generically be Pareto inefficient

While initially it might seem that every situation is necessarily Pareto optimal, this is not the
case. True, if the only good is food, and each agent wants as much food as possible, then every
distribution is Pareto optimal. But if half of the agents own food and the other half own clothes,
the distribution will not necessarily be Pareto optimal, since each agent might prefer either more
food or fewer clothes or vice versa. In the final analysis, welfare economists’ attempt to provide
a value-free or at least value-minimal justification of the state fails quite badly. Nevertheless,

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economic analysis may still inform more substantive moral theories: Pareto optimality, for
example, is a necessary but not sufficient condition for a utilitarian justification of the state.

3.4. Caldor and Hicks Criterion of Efficiency Condition

A Kaldor–Hicks improvement, named for Nicholas Kaldor and Jhon Hicks also known as
the Kaldor–Hicks criterion, is a way of judging economic re-allocations of resources among
people that captures some of the intuitive appeal of pareto efficiencies, but has less stringent
criteria and is hence applicable to more circumstances. A re-allocation is a Kaldor–Hicks
improvement if those that are made better off could hypothetically compensate those that are
made worse off and lead to a Pareto-improving outcome. The compensation does not actually
have to occur (there is no presumption in favor of status-quo) and thus, a Kaldor–Hicks
improvement can in fact leave some people worse off. A situation is said to be Kaldor–Hicks
efficient if no potential Kaldor–Hicks improvement from that situation exists.

A reallocation is said to be a Pareto improvement if at least one person is made better off and
nobody is made worse off. However in practice, it is almost impossible to take any social action,
such as a change in economic policy, without making at least one person worse off. Even
voluntary exchanges may not be Pareto improving if they make third parties worse off.

Using the criterion for Kaldor–Hicks improvement, an outcome is an improvement if those that
are made better off could in principle compensate those that are made worse off, so that a Pareto
improving outcome could (though does not have to) be achieved. For example, a voluntary
exchange that creates pollution would be a Kaldor–Hicks improvement if the buyers and sellers
are still willing to carry out the transaction even if they have to fully compensate the victims of
the pollution. Kaldor–Hicks does not require compensation actually be paid, merely that the
possibility for compensation exists, and thus need not leave each at least as well off. Under
Kaldor–Hicks efficiency, an improvement can in fact leave some people worse off. Pareto-
improvements require making every party involved better off (or at least no worse off). While
every Pareto improvement is a Kaldor–Hicks improvement, most Kaldor–Hicks improvements
are not Pareto improvements. This is because; the set of Pareto improvements is a proper subset
of Kaldor–Hicks improvement, which also reflects the greater flexibility and applicability of the
Kaldor–Hicks criterion relative to the Pareto criterion.

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