Welfare Economics

Ideal Money:

Welfare Economics

A related topic, which we can’t fully consider in a single lecture, is that of the considerations to be given by society and national state to “social equity” and the general “economic welfare”. Here the key viewpoint is methodological, as we see it. HOW should society and the state authorities seek to improve economic welfare generally and what should be done at times of abnormal economic difficulties or “depression” ?

We can’t go into it all, but we feel that actions which are clearly understandable as designed for the purpose of achieving a “social welfare” result are best. And in particular, programs of unemployment compensation seem to be comparatively well structured so that they can operate in proportion to the need.


Paul Anthony Samuelson (May 15, 1915 – December 13, 2009) was an American economist, and the first American to win the Nobel Memorial Prize in Economic Sciences. The Swedish Royal Academies stated, when awarding the prize, that he “has done more than any other contemporary economist to raise the level of scientific analysis in economic theory”.[1] Economic historian Randall E. Parker calls him the “Father of Modern Economics”,[2] and The New York Times considered him to be the “foremost academic economist of the 20th century”.[3]

He was author of the largest-selling economics textbook of all time: Economics: An Introductory Analysis, first published in 1948.[citation needed] It was the second American textbook to explain the principles of Keynesian economics and how to think about economics, and the first one to be successful,[4] and is now in its 19th edition, having sold nearly 4 million copies in 40 languages. James Poterba, former head of MIT‘s Department of Economics, noted that by his book, Samuelson “leaves an immense legacy, as a researcher and a teacher, as one of the giants on whose shoulders every contemporary economist stands”.[1] In 1996, when he was awarded the National Medal of Science, considered America’s top science honor, President Bill Clinton commended Samuelson for his “fundamental contributions to economic science” for over 60 years.[1]

He entered the University of Chicago at age 16, during the depths of the Great Depression, and received his PhD in economics from Harvard. After graduating, he became an assistant professor of economics at Massachusetts Institute of Technology (MIT) when he was 25 years of age and a full professor at age 32. In 1966, he was named Institute Professor, MIT’s highest faculty honor.[1] He spent his career at MIT where he was instrumental in turning its Department of Economics into a world-renowned institution by attracting other noted economists to join the faculty, including Robert M. Solow, Franco Modigliani, Robert C. Merton, Joseph E. Stiglitz, and Paul Krugman, all of whom went on to win Nobel Prizes.

He served as an advisor to Presidents John F. Kennedy and Lyndon B. Johnson, and was a consultant to the United States Treasury, the Bureau of the Budget and the President’s Council of Economic Advisers. Samuelson wrote a weekly column for Newsweek magazine along with Chicago School economist Milton Friedman, where they represented opposing sides: Samuelson took the Keynesian perspective, and Friedman represented the Monetarist perspective.[5] Samuelson died on December 13, 2009, at the age of 94.

Samuelson is considered to be one of the founders of neo-Keynesian economics and a seminal figure in the development of neoclassical economics. In awarding him the Nobel Memorial Prize in Economic Sciences the committee stated:

More than any other contemporary economist, Samuelson has helped to raise the general analytical and methodological level in economic science. He has simply rewritten considerable parts of economic theory. He has also shown the fundamental unity of both the problems and analytical techniques in economics, partly by a systematic application of the methodology of maximization for a broad set of problems. This means that Samuelson’s contributions range over a large number of different fields.

He was also essential in creating the Neoclassical synthesis, which incorporated Keynesian and neoclassical principles and still dominates current mainstream economics. In 2003, Samuelson was one of the ten Nobel Prize–winning economists signing the Economists’ statement opposing the Bush tax cuts.[10]


Samuelson is also author (and since 1985 co-author) of an influential principles textbook, Economics, first published in 1948, now in its 19th edition. The book has been translated into forty-one languages and sold over four million copies; it is considered the best-selling economics textbook in history. Written in the shadow of the Great Depression and the Second World War, it helped to popularize the insights of John Maynard Keynes. A main focus was how to avoid, or at least mitigate, the recurring slumps in economic activity.

Samuelson wrote: “It is not too much to say that the widespread creation of dictatorships and the resulting World War II stemmed in no small measure from the world’s failure to meet this basic economic problem [the Great Depression] adequately.”[12] This reflected the concern of Keynes himself with the economic causes of war and the importance of economic policy in promoting peace.[13]

Samuelson’s influential textbook has been criticized for including comparative growth rates between the United States and the Soviet Union that were inconsistent with historical GNP differences.[14] The 1967 edition extrapolates the possibility of Soviet/US real GNP parity between 1977 and 1995. Each subsequent edition extrapolated a date range further in the future until those graphs were dropped from the 1985 edition.[15]

Samuelson concluded the economic description of the Soviet Union and marxism in 1989: “Contrary to what many skeptics had earlier believed, the Soviet economy is proof that… a socialist command economy can function and even thrive.”[16] The Revolutions of 1989 happened during the same year, and the Soviet Union broke up two years later.

Growth definition by Samuelson

Samuelson’s famous growth definition states, “Economics is the study of how men and society choose, with or without the use of money, to employ scarce productive resource which could have alternative uses, to produce various commodities over time and distribute them for consumption, now and in the future among various people and groups of society.”

Welfare economics, in which he popularised the Lindahl–Bowen–Samuelson conditions (criteria for deciding whether an action will improve welfare) and demonstrated in 1950 the insufficiency of a national-income index to reveal which of two social options was uniformly outside the other’s (feasible) possibility function (Collected Scientific Papers, v. 2, ch. 77; Fischer, 1987, p. 236).

For many years, Samuelson wrote a column for Newsweek. One article included Samuelson’s most quoted remark and a favorite economics joke:

To prove that Wall Street is an early omen of movements still to come in GNP, commentators quote economic studies alleging that market downturns predicted four out of the last five recessions. That is an understatement. Wall Street indexes predicted nine out of the last five recessions! And its mistakes were beauties.[18]


Welfare economics is a branch of economics that uses microeconomic techniques to evaluate well-being (welfare) at the aggregate (economy-wide) level.[1] A typical methodology begins with the derivation (or assumption) of a social welfare function, which can then be used to rank economically feasible allocations of resources in terms of the social welfare they entail. Such functions typically include measures of economic efficiency and equity, though more recent attempts to quantify social welfare have included a broader range of measures including economic freedom (as in the capability approach).

The field of welfare economics is associated with two fundamental theorems. The first states that given certain assumptions, competitive markets produce (Pareto) efficient outcomes;[2] it captures the logic of Adam Smith’s invisible hand.[3] The second states that given further restrictions, any Pareto efficient outcome can be supported as a competitive market equilibrium.[2] Thus a social planner could use a social welfare function to pick the most equitable efficient outcome, then use lump sum transfers followed by competitive trade to bring it about.[2][4] Because of welfare economics’ close ties to social choice theory, Arrow’s impossibility theorem is sometimes listed as a third fundamental theorem.[5]

Attempting to apply the principles of welfare economics gives rise to the field of public economics, the study of how government might intervene to improve social welfare. Welfare economics also provides the theoretical foundations for particular instruments of public economics, including cost-benefit analysis, while the combination of welfare economics and insights from behavioural economics has led to the creation of a new subfield, behavioural welfare economics.[6]


Situations are considered to have distributive efficiency when goods are distributed to the people who can gain the most utility from them.

Many economists use Pareto efficiency as their efficiency goal. According to this measure of social welfare, a situation is optimal only if no individuals can be made better off without making someone else worse off.

This ideal state of affairs can only come about if four criteria are met:

  • The marginal rates of substitution in consumption are identical for all consumers. This occurs when no consumer can be made better off without making others worse off.
  • The marginal rate of transformation in production is identical for all products. This occurs when it is impossible to increase the production of any good without reducing the production of other goods.
  • The marginal resource cost is equal to the marginal revenue product for all production processes. This takes place when marginal physical product of a factor must be the same for all firms producing a good.
  • The marginal rates of substitution in consumption are equal to the marginal rates of transformation in production, such as where production processes must match consumer wants.

There are a number of conditions that, most economists agree, may lead to inefficiency. They include:

Fundamental theorems

The field of welfare economics is associated with two fundamental theorems. The first states that given certain assumptions, competitive markets (price equilibria with transfers, e.g. Walrasian equilibria[3]) produce Pareto efficient outcomes.[2] The assumptions required are generally characterised as “very weak”.[7] More specifically, the existence of competitive equilibrium implies both price-taking behaviour and complete markets, but the only additional assumption is the local non-satiation of agents’ preferences – that consumers would like, at the margin, to have slightly more of any given good.[3] The first fundamental theorem is said to capture the logic of Adam Smith’s invisible hand, though in general there is no reason to suppose that the “best” Pareto efficient point (of which there are a set) will be selected by the market without intervention, only that some such point will be.[3]

The second fundamental theorem states that given further restrictions, any Pareto efficient outcome can be supported as a competitive market equilibrium.[2] These restrictions are stronger than for the first fundamental theorem, with convexity of preferences and production functions a sufficient but not necessary condition.[4][8] A direct consequence of the second theorem is that a benevolent social planner could use a system of lump sum transfers to ensure that the “best” Pareto efficient allocation was supported as a competitive equilibrium for some set of prices.[2][4] More generally, it suggests that redistribution should, if possible, be achieved without affecting prices (which should continue to reflect relative scarcity), thus ensuring that the final (post-trade) result is efficient.[9] Put into practice, such a policy might resemble predistribution.

Because of welfare economics’ close ties to social choice theory, Arrow’s impossibility theorem is sometimes listed as a third fundamental theorem.[10]


Some, such as economists in the tradition of the Austrian School, doubt whether a cardinal utility function, or cardinal social welfare function, is of any value. The reason given is that it is difficult to aggregate the utilities of various people that have differing marginal utility of money, such as the wealthy and the poor.

Also, the economists of the Austrian School question the relevance of pareto optimal allocation considering situations where the framework of means and ends is not perfectly known, since neoclassical theory always assumes that the ends-means framework is perfectly defined.

Some even question the value of ordinal utility functions. They have proposed other means of measuring well-being as an alternative to price indices, “willingness to pay” functions, and other price oriented measures.[citation needed] These price based measures are seen as promoting consumerism and productivism by many.[citation needed] It should be noted that it is possible to do welfare economics without the use of prices, however this is not always done.[citation needed]

Value assumptions explicit in the social welfare function used and implicit in the efficiency criterion chosen tend to make welfare economics a normative and perhaps subjective field. This can make it controversial.

However, perhaps most significant of all are concerns about the limits of a utilitarian approach to welfare economics. According to this line of argument utility is not the only thing that matters and so a comprehensive approach to welfare economics should include other factors. The capabilities approach to welfare is an attempt to construct a more comprehensive approach to welfare economics, one in which functionings, happiness and capabilities are the three key aspects of welfare outcomes that people should seek to promote and foster.


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