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A reformulation of the foundations of welfare economics

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Abstract

Neoclassical welfare economics takes an outcome-oriented approach that uses Pareto optimality as its benchmark for welfare maximization. When one looks at the remarkable improvements in economic welfare that have characterized market economies, most of those improvements in welfare have been due to economic progress that has introduced new and improved goods and services into the economy, and innovations in production methods that have brought costs down, leading to higher real incomes. Pareto optimality is only peripherally related to actual economic welfare, and no economist would argue that people are materially better off today than a century ago because the economy is closer to Pareto optimality. After analyzing the actual factors that lead to improvements in welfare, this paper suggests a reformulation of the foundations of welfare economics to replace the almost irrelevant outcome-oriented concept of Pareto optimality as the benchmark for evaluating welfare with a process-oriented benchmark based on factors that generate economic progress. The paper then explores some implications of this reformulation.

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Notes

  1. It may be possible to further increase social welfare if redistribution would lower the utility of those from whom resources were transferred less than it would add to the utility of the recipients of those resources, following Samuelson (1956).

  2. Second-hand smoke can be considered an external cost, of course, but can be limited by clearly defined property rights to determine where someone can smoke, and at any rate is more limited than the health care costs described in the next sentence. The externality of second-hand smoke can spread throughout an entire room. The externality generated by publicly funded health care can spread throughout an entire nation. And, if transaction costs within a room are low, then following Coase (1960) bargaining among individuals can internalize the externality of second-hand smoke.

  3. This is the idea behind revealed preference, and the idea behind what Rothbard (1956) calls demonstrated preference. Rothbard (1956) should be acknowledged because the title of this paper is similar to his title. While there is some similarity in the ideas also, criticisms of Rothbard by Cordato (1992), Prychitko (1993), and Caplan (1999) are well-taken.

  4. Kirzner (1973) would clearly separate the function of the entrepreneur from that of the investor, but Rothbard (2004: 64) indicates that entrepreneurship consists not only of the entrepreneur spotting a profit opportunity, but also acting on it so that he has “invested accordingly.”

  5. For a critique of this theory, see Holcombe (2008).

  6. In the taxonomy given by the Journal of Economic Literature classification system, welfare economics is classification D6, under the heading of Microeconomics. Growth theory is classification O4, under the heading of Economic Development, Technological Change, and Growth.

  7. Within a general equilibrium framework, if the economy is in equilibrium and then a Schumpeterian entrepreneur disturbs that equilibrium, producing creative destruction, the economy moves from a Pareto optimum away to a situation that is not Pareto optimal, which generates economic progress and is welfare-enhancing. The caveat here is that the economy may not be resting at a Pareto optimum, so one cannot know whether the change moves away from Pareto optimality. Because Pareto optimality is non-observable, one can never, in fact, say that an actual economy is moving closer, or further from, a Pareto optimum.

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Authors and Affiliations

  1. Department of Economics, Florida State University, Tallahassee, FL, 32306, USA

    Randall G. Holcombe

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  1. Randall G. Holcombe
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Correspondence to Randall G. Holcombe.

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The author gratefully acknowledges helpful comments from an anonymous reviewer of this journal.

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Holcombe, R.G. A reformulation of the foundations of welfare economics. Rev Austrian Econ 22, 209–224 (2009). https://doi.org/10.1007/s11138-009-0089-1

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