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Application of the Theory of Riskless Choices to Welfare Economics 4
The classical utility theorists assumed the existence of interpersonally comparable cardinal utility. They were thus able to find a simple answer to the question of how to determine the best economic policy: That economic policy is best which results in the maximum total utility, summed over all members of the economy.
Theabandonment of interpersonal comparability makes this answer useless. A sum is meaningless if the units being summed are of varying sizes and there is no way of reducing them to some common size. This point has not been universally recognized, and certain economists (e.g., 82, 154) still defend cardinal (but not interpersonally comparable) utility on grounds of its necessity for welfare economics.PARETO’s PRINCIPLE
The abandonment of interpersonal comparability and then of cardinal utility produced a search for some other principle to justify economic policy. Pareto (146), who first abandoned cardinal utility, provided a partial solution. He suggested that a change should be considered desirable if it left everyone at least as well off as he was before, and made at least one person betteroff.
COMPENSATION PRINCIPLE
Pareto’s principle is fine as far as it goes, but it obviously does not go very far. The economic decisions which can be made on so simple a principle are few and insignificant. So welfare economics languished until Kaldor (98) proposed the compensation principle. This principle is that if it is possible for those who gain from an economic change to compensate thelosers for their losses and still have something left over from their gains, then the change is desirable. Of course, if the compensation is actually paid, then this is simply a case of Pareto’s principle.
But Kaldor asserted that the compensation need not actually be made; all that was necessary was that it could be made. The fact that it could be made, according to Kaldor, is evidence that thechange produces an excess of good over harm, and so is desirable. Scitovsky (173) observed an inconsistency in Kaldor’s position: Some cases could arise in which, when a change from A to B has been made because of Kaldor’s criterion, then a change back from B to A would also satisfy Kaldor’s criterion. It is customary, therefore, to assume that changes which meet the original Kaldor criterion areonly desirable if the reverse change does not also meet the Kaldor criterion.
It has gradually become obvious that the Kaldor-Scitovsky criterion does not solve the problem of welfare economics (see e.g., 18, 99). It assumes that the unpaid compensation does as much good to the person who gains it as it would if it were paid to the people who lost by the change. For instance, suppose that anindustrialist can earn $10,000 a year more from his plant by using a new machine, but that the introduction of the machine throws two people irretrievably out of work. If the salary of each worker prior to the change was $4,000 a year, then the industrialist could compensate the workers and still make a profit. But if he does not compensate the workers, then the added satisfaction he gets from his extra$10,000 may be much less than the misery he produces in his two workers. This example only illustrates the principle; it does not make much sense in these days of progressive income taxes, unemployment compensation, high employment, and strong unions.
SOCIAL WELFARE FUNCTIONS
From here on the subject of welfare economics gets too complicated and too remote from psychology to merit extensiveexploration in this paper. The line that it has taken is the assumption of a social welfare function (21), a function which combines individual utilities in a way which satisfies Pareto’s principle but is otherwise undefined. In spite of its lack of definition, it is
possible to draw certain conclusions from such a function (see e.g., 164). However, Arrow (14) has recently shown that a social...