History of Economic Thought II

Chapter Three
General Equilibrium and Welfare Economics

Introduction

The first Generation Marginalists, who led the marginalist fight against the classical economists,
applied their analysis to demand side, but the Second-generation marginalist extended this
analysis to factor markets. The Alfred Marshall developed the supply-and-demand analysis now
used in undergraduate microeconomic theory courses. This chapter considers the other way in
which the supply side and demand side integrated. In doing so, the contribution of one of the
originators of marginal analysis, Leon Walras and the leading Welfare economist’s, with special
attention to Pareto, who was founder of Modern Welfare Economics and Pique, will discussed.

3.1. Walrasian General Equilibrium

The idea of general equilibrium may be traced further back and is certainly to be found in Adam
Smith’s Wealth of Nation. Many economists identify general economic equilibrium theory with
theory tout court, compared to which any other theory can be considered a particular case. This
theory, it is said, shows that the ‘invisible hand of the market’ ensures a systematic tendency
towards equilibrium with perfect equality between supply and demand for each commodity
(market clearing), even in the presence of many commodities and many economic agents.

General equilibrium theory was formally developed by the Lausanne school, founded by Léon
Walras. Its main constitutive elements are the general interdependence among all the parts that
compose an economic system, the idea of the market as an equilibrating mechanism between
supply and demand, the view of the economic problem as a problem of optimal allocation of
scarce resources and the notion of a perfectly rational and perfectly selfish economic agent.

The idea of interrelations among the different parts that compose an economic system was
already at the center of Quesnay‘s analysis, with his tableau économique; subsequently, we have
the simple and expanded reproduction schemes developed by Marx and more recently Leontief‘s
input-output tables. None of these analytical contributions, however, included a price and
quantity adjustment mechanism based on the reactions of agents in the market to disequilibria
between supply and demand.

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Furthermore, these contributions all focused attention on interdependencies among sectors in

production, while interdependence (substitutability) in consumption choices was not considered,
or at any rate remained in the background.

The role of demand and supply in determining the price of a good was conversely at the center of
a widespread tradition of economic thinking, which in representing the working of the market
took as ideal reference points first the medieval fairs and then the stock exchanges, both
considered institutions that ensure a meeting place, in time and space, for buyers and sellers.
However, the idea of a general interrelation among the various parts of the economic system
generally remained in the background. Jevons‘s utilitarian approach focused on analysis of
individual behaviour, with comparison between disutility (labour) and utility (consumption),
while interrelations among different economic agents in the market constituted a superstructure
in many respects only outlined. Somewhat later Marshall, albeit keeping account of Walras‘s
work, indicated his preference for ‘short causal chains‘, hence the method of analysis of partial
equilibrium, as compared with general economic equilibrium analysis, considered too abstract.

The grounds to represent the classical economists as precursors of general economic equilibrium
theory are even more questionable. There are three aspects to which reference is usually made in
doing so: the notions of the invisible hand of the market, of competition and of the convergence
of market prices towards natural prices. Briefly returning to the points mentioned previously, it is
worth stressing that none of these elements implies a subjective view of value or choice of the
medieval fair (or of the stock exchange) as paradigm for representing the working of the
economy. In particular, the idea of the convergence of market prices towards natural prices did
not imply, for classical economists such as Smith or Ricardo, the idea of market prices as
theoretical variables univocally determined by an apparatus of demand and supply curves (nor
the idea that it be possible to define sufficiently precise and stable relations connecting quantities
demanded and supplied to prices nor indeed the idea that such relations can be deduced as
representing the behaviour of rational economic agents). Finally, the notion of the invisible hand
was origin-ally used by Smith in different contexts, not to uphold the idea of the optimality of a
competitive market based on the demand and supply mechanism.

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Léon Walras

The general economic equilibrium approach, insofar as it implied including the supply and
demand mechanism in a context of general interdependencies in production as in consumption,
arose with Walras, who drew particular inspiration from the field of physics, and specifically
mechanics, with its theory of static equilibrium.

Walras was born in France. The early part of his life was largely unsuccessful. He failed the
entrance exam to the Ecole Polytechnique twice, wrote a novel that went unnoticed, and founded
a bank that failed. But his father was an economist, and the younger Walras had read Cournot‘s
Mathematical Principles of the Theory of Wealth. This subject matter and approach to economics
interested him, and he turned to economics. In 1870, he was appointed professor of political
economy at Lausanne, Switzerland. He developed and advocated general equilibrium analysis,
this stood in contrast to the partial equilibrium analysis used by Jevons, Menger, and Marshall.
It was then that he resigned from his chair, wishing to concentrate on research; he favored
nomination of Pareto as his successor.

Walras’s general equilibrium theory presents a framework consisting of the basic price and
output interrelationships for the economy as a whole, including both commodities and factors of
production. Its purpose is to demonstrate mathematically that all prices and quantities produced
can adjust to mutually consistent levels. Its approach is static because it assumes that certain
basic determinants remain unchanged, such as consumer preferences, production functions,
forms of competition, and factor supply schedules.

Walras showed that prices in a market economy can be determined mathematically, taking
cognizance of the interrelatedness of all prices. The function for the quantity demanded of a good
depends on the price. That is, price is the independent variable, said Walras, and the quantity
demanded is the dependent variable. The quantity demanded of any one good, however, includes

as variables the prices of all other commodities. A consumer will not decide how much of one
good to buy without knowing the prices of all other goods.

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In fact, Walras also left a number of unsolved problems and inconsistencies, which is not strange
in view of the time he presented his ideas. Walras intended to show the existence of equilibrium,
its uniqueness and its stability. But in this he failed, perhaps he thought he had solved it but he
had not. Of course his general equilibrium paradigm had an immediate and ruling influence on
thinking in economics.

3.2 Welfare Economics

Welfare economics is the branch of economic analysis concerned with discovering principles for
maximizing social well-being. 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. Nevertheless, several important contributors to
economics have focused specifically on either or both of the following: (1) defining welfare
optimality and analyzing how maximum welfare can be achieved; (2) identifying factors that
impede the achievement of maximum wellbeing and suggesting ways that the impediments
might be removed.

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.

There are two main approaches to welfare economics. These includes the early neoclassical and
the new welfare economics.

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3.2.1 Early neoclassical approach to welfare economics

The early neoclassical economists; Edgeworth , Sigdewick, Alfred Marshall, and A.C Pigou
were contributors to the early to welfare economics. But, Professor Alfred Marshall has been
regarded as the founder of early welfare economics. According to the early neoclassical welfare
economists, utility is cardinal, Preferences are exogenously given and stable, existence of
diminishing marginal utility and interpersonal comparison of utility is possible. Here under,
Pigous’ economic ideas will be discussed for his contribution has a crucial impact in modern
economics.

Arthur Cecil Pigou (1877-1959)

Arthur Cecil Pigou succeeded Marshall in the chair of political economy at Cambridge
University in 1908 and held this position until his retirement in 1943. 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 ‘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.

Income Redistribution

Basing himself on Jevons and Marshall's principle that the marginal utility of money diminishes
as more is acquired, Pigou asserted that greater equality of incomes under certain conditions
could increase economic welfare. Pigou insisted that interpersonal comparisons of satisfaction
can properly be made when dealing with people of the same background raised in tile same
environment. In this sense he was more of a reformer than those "purely scientific" economists
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who fastidiously avoided value judgments and proclaimed the impossibility of comparing
satisfactions among different people.

Divergence between Private and Social Costs and Benefits

Pigou's most significant deviation from orthodox theory lay in his focus on the divergence
between social and private marginal costs and benefits. The idea that such a divergence could
occur was not original with Pigou. Henry Sidgwick (1838-1900), writing in 1883, discussed the
same general topic, but in a less concise way. The private marginal cost of a commodity or
service is the expense the producer incurs in making one more unit; the social marginal cost is
the expense or damage to society as the consequence of producing that unit of product. Likewise,
the private marginal benefit of a commodity is measured by the extra satisfaction it provides the
buyer; social marginal benefit is the extra satisfaction society gets from the production of the
added unit.

These distinctions are significant because the acts of production and consumption may impose
costs or benefits on parties other than the producer and consumer. These external costs and
benefits, or externalities, spillover to other parties and are sometimes referred to as "spillover
effects." For example, said Pigou, sparks from railway engines may do damage to surrounding
woods or crops without their owners being compensated for the damage. Social costs (internal
plus external), therefore, are greater than the private costs (internal) to the railway; the net
private marginal product exceeds the social net product. Similarly, an entrepreneur who builds a
factory in a residential district destroys much of the value of other people's property. The
increased sale of intoxicating beverages is profitable to the distiller and the brewer, said Pigou,
but external costs are incurred when more police and prisons become necessary.

There are opposite cases, Pigou said, in which some benefits of private actions spillover to
society's benefit, but for which the person who renders the benefit is not compensated. Thus, the
social marginal net product exceeds the private marginal net product. For example, the expansion
of one firm in an industry may give rise to external economies in the industry as a whole that will
reduce the costs of production of other firms. Private investment in planting forests will benefit
surrounding property owners. Preventing smoke from pouring out of factory chimneys will
benefit the community at large much more that it will benefit the factory owner. Scientific
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research is generally of greater value to society than to the researcher and inventor, although the
patent laws aim at creating a closer match between private and social marginal net products.

Pigou derived an important welfare implication from his analysis: Not all competitive markets
produce levels of output that maximize society's total welfare. Sidgwickian-Pigouvian analysis
of social costs and benefits, thus, challenged the widely held perspective that we can always and
everywhere rely on competitive markets to maximize society's economic welfare (produce Pareto
optimality). According to Pigou, 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. There is a greater role for government in the economy,
said Pigou, than that envisioned by advocates of laissez-faire.

Other Contributions

Several other theories presented by Pigou have had lasting relevance. His stress on the
desirability of increasing savings in the economy found favor with many economists and
government policy makers in the 1980s and 1990s.

Present Satisfaction: Pigou contended that people prefer present rather than future satisfaction
of equal magnitude because the human telescopic faculty is defective; we, therefore, see future
pleasure on a diminished scale. The bias contributes to far-reaching economic disharmony,
because people distribute their resources between the present, the near future, and the remote
future on the basis of a somewhat irrational preference. Consequently, efforts directed towards
the remote future are sacrificed for those directed to the near future, while these, in turn, are
given up to enhance present consumption. The creation of new capital is checked, and people are
encouraged to use up existing capital to such a degree that larger future advantages are sacrificed
for smaller present ones. Natural resources are consumed more quickly and wastefully because
future satisfactions are underrated.

Government Intervention: Pigou concluded that, economic welfare is diminished by

government intervention that strengthens the tendency of people to devote too much of their
resources to present use and too little to future use. Government should, thus, avoid any tax on
saving, including property taxes, death duties, and progressive income taxes if it wants to

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maximize economic welfare. Heavy taxes on consumption are preferable because they encourage
saving, but such taxes have the disadvantage of hurting low-income people disproportionately.

Price Discrimination: A final contribution of note is Pigou's discussion of price discrimination.

It was he who classified price discrimination into three types: first degree, second degree, and
third degree. First-degree price discrimination occurs when the monopolist charges each
consumer the exact amount she or he would be willing to pay rather than go without the
commodity. The monopolist, therefore, takes the consumer‘s entire surplus as revenue. Second-
degree price discrimination is a cruder form of first-degree discrimination. The seller charges one
price for each unit within an initial block of units and then charges lower prices for units within
subsequent blocks. Electrical utilities commonly used this type of quantity discounting prior to
the rate reforms of the 1970s and 1980s. Third-degree price discrimination involves separating
groups of consumers into different classes and charging different prices based on the elasticity of
demand for each group. One of many possible examples would be charging students and
professors less than the general public for business newspapers and magazines.

3.2.2 New trends in welfare economics approach

The New Welfare Economics approach is based on the work of Pareto, Hicks, and Kaldor. It
explicitly recognizes the differences between the efficiency aspect of the discipline and the
distribution aspect and treats them differently. But, Pareto laid the foundation of the modern
welfare economics by formulating the concept of social optimum which is based on the concept
of ordinal utility and is free from interpersonal comparisons of utilities and value judgements. He
aimed at formulating a value-free objective criterion designed to test whether a proposed policy
change increases social welfare or not.

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

Vilfredo Pareto (1848-1923) was a disciple of Walras and an early supporter of general
equilibrium theory. He carried through the reasoning Walras used in general equilibrium theory
and extended the analysis to consider the welfare implications of various policies. Pareto tried to
extend Walrasian economics into policy. Pareto lays claim to being one of the fathers of modern
welfare economics, the other being A. C. Pigou, who extended the welfare implications of
Marshallian economics.
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Nevertheless, Pareto addressed the issue of how to evaluate the efficiency of resource allocation
for an economy or for a particular market structure within an economy. Adam Smith had
concluded that perfectly competitive markets resulted in desirable consequences, particularly
higher long-term rates of growth for an economy. Increased interest in microeconomics, which
began in the 1870s, led to questions concerning the efficiency of resource allocation and to the
development of criteria for evaluating the merits of different economic policies that affect an
economy.

Adam Smith‘s advocacy of laissez faire was not based on a theoretically rigorous model. It
focused more on the macroeconomic consequences of markets coupled with a minimum of
government intervention. In the 1890s, Pareto began evaluating microeconomic performance
using the new marginal tools and became the father of the branch of welfare economics that
works largely in a general equilibrium framework. Pareto also represents a continental
(particularly French and Italian) approach, as opposed to the British framework based on the
partial equilibrium structure laid down by Alfred Marshall. This British line of welfare
economics began with Henry Sidgwick (1838-1900), a political philosopher who contributed to
economics.

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.

Maximum welfare, said Pareto, 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.

These pre-conditions of Pareto efficient conditions can be demonstrated by supposing the

existence of a simple economy containing two consumers (say S and G), two products (say h and
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p), and two resources (say labor and capital). The conditions for a Pareto optimum in this simple
economy are those that would exist in a realistic economy having numerous consumers, goods,
and resources.

Optimal distribution of goods: The optimal distribution of goods, that is, the distribution that
will maximize consumer welfare, occurs where S and G each have identical marginal rates of
substitution between the two goods. This can be expressed symbolically as:

MRSℎ𝑝𝑆=MRSℎ𝑝𝐺 3.1

If this condition were not satisfied, it would be possible to re-arrange the allocation as between A
and B of whatever is being produced so as to make one better-off without making the other
worse-off.

Optimal technical allocation of resources: In our two-goods, two-resources example, the

optimum allocation of resources to productive uses will occur where the marginal rates of
technical substitution between labor (l ) and capital (k) in the production of h and p are equal.
The marginal rate of technical substitution of labor for capital (MRTSlk) is the maximum
number of units of capital that could be substituted for a unit of labor without changing the level
of output. This second condition for Pareto optimality is shown symbolically as follows:

MRTSlkH = MRTSlkP 3.2

where MRTSlkH and MRTSlkP are the marginal rates of technical substitution of labor for
capital in the production of h and p.

If this condition were not satisfied, it would be possible to re-allocate inputs to production so as
to produce more of one of the commodities without producing less of the other.

Optimal quantities of output: If production and distribution meet the conditions of Pareto
optimality, then optimum levels of output will be achieved where the marginal rate of
substitution of ―h‖ for ―p‖—the rate at which each of the two consumers is willing to give up ―p‖
to get ―h‖, equals the marginal rate of transformation (MRT) of ―p‖ for ―h‖. This is the rate at
which it is technically possible to transform p into h. Symbolically,

MRShp = MRThp 3.3

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Evaluation

Pareto's welfare theory is a significant contribution to economics. He did much to help

economists better understand the conditions for, and the welfare significance of, economic
efficiency. However, the central Pareto criterion, "Does a change make someone better-off while
making no one worse-off?" is not always well suited for evaluating public policies.

Of the several criticisms of the Pareto standard, four seem particularly germane. First, some
economists argue that it fails to address the important issue of distributive justice, or the fair
distribution of income in society. Instead, it simply establishes the efficiency conditions for any
existing distribution.

Second and closely related, many public policies that increase national output and overall
welfare also redistribute income as a by-product of the policy. For example, although a policy of
free foreign trade normally boosts a nation's total output and welfare, it may also injure specific
individuals who lose their jobs because of imports. A strict interpretation of the Pareto criteria
would block the enactment of such a policy. Similarly, under most circumstances, immigration
of skilled workers increases total output in the destination nation. However, the increased supply
of labor may depress the wages received by native workers in the skilled labor markets. Should
government legislate such policies as free trade and open immigration, even if such
compensating payments are not actually made?

A third objection to the Pareto criteria is that they are based on a static view of efficiency. Short-
run movements away from Pareto optimality conceivably could increase long-run or dynamic
efficiency. For example, some contemporary economists contend that by focusing on static
efficiency some of the provisions of antitrust laws may impede private actions-such as joint
development of new technologies-that would increase the nation's long-run growth of output and
welfare.

Finally, the moral judgments that the Pareto criteria purposely exclude are often legitimate and
dominant factors in policy formulation. Some private transactions-for example, prostitution, the
sale of babies, and the purchase of drugs-that may be Pareto optimal may also conflict with
society's moral values. Such values often dwarf considerations of economic efficiency in debates
on public policy.
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3.4 Caldor and Hicks criterion of efficiency condition

Kaldor-Hicks criterion is named by Nicholas Kaldor and John Hicks. Kaldor-Hicks criterion is
also known as Kaldor-Hicks efficiency. These Economists have made efforts to evaluate the
changes in social welfare resulting from any economic reorganisation which harms somebody
and benefits the others. These economists have sought to remove indeterminacy in the analysis
of Pareto optimality.

This new Welfare Economics is also called compensation criteria. Accepting Pareto‘s ordinal
measurement of utility and the impossibility of its interpersonal comparisons, they tried to show
that social welfare could be increased without making value judgment. Kaldor–Hicks postulated
that each individual‟s satisfactions are independent from the others so that he is the best judge of
his welfare. There is the absence of external effects in production and consumption. The tastes of
each individual are constant. It is possible to separate the problems of production and exchange
from the problem of distribution. It is assumed that utility is measured ordinarily and
interpersonal comparisons are impossible. A Kaldor–Hicks improvement is an economic
reallocation of resources among people that captures some of the intuitive appeal of a Pareto
improvement, but has less stringent criteria and is hence applicable to more circumstances.

Kaldor – Hicks Criterion state that a reallocation is said to be a Pareto efficient, 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 efficient if they make
third parties worse off. Pareto efficiency occurs where at least one party benefits and nobody is
made worse off. Kaldor- Hicks states that a decision can be more efficient as long as there is a
net gain to society. The criterion enables any potential losers to be compensated from the net
gain.

Kaldor–Hicks criterion is an improvement on Pareto efficiency. A resources allocation is

considered efficient and 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
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transaction even if they have to fully compensate the victims of the pollution. Kaldor–Hicks
does not require compensation actually be paid. It means mere existence of possibility for
compensation. Under Kaldor–Hicks efficiency, an improvement can in fact leave some people
worse off while Pareto efficiency require making every party involved better off (or at least
none worse off). While Pareto efficiency is a Kaldor–Hicks criterion most, Kaldor–Hicks
criterion are not Pareto efficient. This is because the set of Pareto efficient is a proper subset of
Kaldor–Hicks criterion. This reflects the greater flexibility and applicability of the Kaldor–
Hicks criterion relative to the Pareto criterion.

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