History of Economic Thoughts II Welfare Economics

2. Welfare Economics
2.0. Overview of Welfare Economics

Welfare economics is the branch of economic analysis concerned with discovering principles for
maximizing social well-being. Welfare economics is a branch of economics that uses
microeconomic techniques to evaluate well-being at the aggregate level. Welfare economics is the
study of how the allocation of resources and goods affects social welfare. This relates directly to
the study of economic efficiency and income distribution, as well as how these two factors affect
the overall well-being of people in the economy. In practical terms, welfare economists seek to
provide tools to guide public policy to achieve beneficial social and economic outcomes for all of
society. Welfare economics is the study of how the structure of markets and the allocation of
economic goods and resources determines the overall well-being of society. Welfare economics
seeks to evaluate the costs and benefits of changes to the economy and guide public policy toward
increasing the total good of society, using tools such as cost-benefit analysis and social welfare
functions.

Welfare Economics 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. Nevertheless, several
important contributors to economics have focused specifically on either or both of the following:
defining welfare optimality and analyzing how maximum welfare can be achieved; identifying
factors that impede the achievement of maximum wellbeing and suggesting ways that the
impediments might be removed. We refer to these individuals as welfare economists.

Welfare Economics was a direct refutation of classical economics, especially the laissez-faire
doctrine. As against the objectives of maximization of production and wealth, pursued by the
classical economists, the welfare economists emphasize ‘welfare’, to be the direct objective of all
economic thought and policies. Whereas the classical economists emphasized production, supply
and costs, the welfare economists lay stress on consumption, utility and demand. This emphasis of
welfare economists was not new but it received fillip only after the World War I, mainly because
of the existence of poverty amidst plenty. Hence, in, general, Welfare Economics has been
described as a tendency to modify the classical doctrines and to make economics deal with social
policies, directed towards achieving the goal of social welfare.

Compiled by NET 1|Page

History of Economic Thoughts II Welfare Economics

2.1. Approaches to Welfare Economics

There are two mainstream approaches to welfare economics: the early Neoclassical approach and
the New welfare economics approach. The early Neoclassical approach was developed by
Edgeworth, Sidgwick, Marshall, and Pigou. It assumes the following:

Utility is cardinal, that is, scale-measurable by observation or judgment.

Preferences are exogenously given and stable.
Additional consumption provides smaller and smaller increases in utility (diminishing
marginal utility).
All individuals have interpersonally comparable utility functions (an assumption that
Edgeworth avoided in his Mathematical 'Psychics).

With these assumptions, it is possible to construct a social welfare function simply by summing
all the individual utility functions. 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. Questions of efficiency are
assessed with criteria such as Pareto efficiency and the Kaldor-Hicks compensation tests, while
questions of income distribution are covered in social welfare function specification. Further,
efficiency dispenses with cardinal measures of utility, replacing it with ordinal utility, which
merely ranks commodity bundles (with an indifference-curve map, for example).

2.2. Contributors to Welfare Economics

A. Vilfredo Pareto (1848–1923)

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. 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 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. 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.

Compiled by NET 2|Page

History of Economic Thoughts II Welfare Economics

Pareto optimality

Of particular relevance to the topic at hand, 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 quanti
ties of outputs.

We can demonstrate these conditions by supposing the existence of a simple economy containing
two consumers (Smith and Green), two products (hamburger and potatoes), and two resources
(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 Smith and Green each have identical marginal rates
of substitution between the two goods. Therefore, the Pareto optimal distribution of goods among
consumers occurs where the consumers’ marginal rates of substitution are equal. Let’s assume
two person, two goods and two resources economy. We express this symbolically as:

MRShpS = MRShpG

where MRShpS and MRShpG are Smith’s and Green’s respective marginal rates of
substitution of hamburger for potatoes.

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 hamburger and potatoes are equal.
The marginal rate of technical substitution of labor for capital (MRTSlk) is the maximum number

Compiled by NET 3|Page

History of Economic Thoughts II Welfare Economics

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

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

If these rates differ between the two uses, then a Pareto improvement is possible. Suppose, for
example, that the MRTSlk in producing hamburger is two, whereas in producing potatoes it is three.
We would need to substitute only 2 units of capital for 1 unit of labor to maintain a given output
of hamburger. However, to hold the output of potatoes constant, we would need to substitute 3
units of capital for the single unit of labor. Thus, at the margin, capital is relatively more efficient
in producing hamburger than potatoes. Or, as viewed from the opposite perspective, labor has
relatively greater productivity at the margin in producing potatoes than hamburger. By using more
capital to produce ham- burger, thus freeing some labor to be used to produce potatoes, we would
achieve a higher level of total output from the same level of input use. The additions to output
where resources were added would exceed the losses in output where they were removed. Because
no one is worse off and someone is better off, this is a Pareto improvement.

At some point, the rearrangement of factor inputs would come to a halt because diminishing returns
in each use would cause the marginal product of the added resource to fall and the marginal product
of the deleted resource to rise. Once the marginal rates of technical substitution in producing the
two goods became equal, no further reallocation of resources would help someone without hurting
someone else.

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 hamburger for potatoes—the rate at which each of the two consumers is willing to give up
potatoes to get hamburger—equals the marginal rate of transformation (MRT) of potatoes for
hamburger. This is the rate at which it is technically possible to transform potatoes into hamburger.
Symbolically,

MRShp = MRThp

Compiled by NET 4|Page

History of Economic Thoughts II Welfare Economics

Suppose, for example, that the MRShp and the MRThp are four and three, respectively. The rate at
which the two consumers are willing to give up units of potatoes for hamburger (four to get one)
exceeds the rate at which it is technically necessary to give up potatoes to get an additional unit of
hamburger (three to get one). Consequently, the welfare of each consumer will rise by increasing
the output of hamburger and reducing the output of potatoes. At the margin, the gains to the
consumers will exceed society’s opportunity costs. Only where the marginal rate of substitution of
one product for the other product equals the marginal rate of transformation will there be no further
opportunity to increase one or more person’s well-being while not reducing someone else’s
welfare.

Critics on Pareto Welfare Economics

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 the immigration be allowed? Because there is a net gain to society
in both examples, gainers theoretically could fully compensate the losers, thereby converting the
situation to one that is consistent with Pareto’s criteria.

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

Compiled by NET 5|Page

History of Economic Thoughts II Welfare Economics

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.

B. Arthur Cecil Pigou (1877 – 1959)

A.C. Pigou is considered to have done a pioneering work in the field of welfare economics; he is
credited for establishing a scientific welfare economics. Others who preceded him had provided
what may be called ‘case-to-case’ studies and the areas where there was a need for state
intervention for improving the welfare of the society, but Pigou was the first to put the whole thing
into a system. Those who had tried to concern themselves with the overall performance of the
economy had primarily concentrated upon changes in wealth of the society; Pigou shifted on to
the consideration of national welfare. He provided a general rule where by the social welfare was
to be judged with reference to social marginal cost and social marginal benefit.

On the objective of economics

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 starts with the assertion
that the primary task of economics is to be a fruit- bearing discipline and for that reason it has to
shun abstraction wherever it can though maintain its analytical character.

On the economics of welfare

Pigou emphasizes that welfare is a very wide-range phenomenon and for practical purposes it is
essential to delimit the scope of economic welfare. He stressed the need to choose that portion of

Compiled by NET 6|Page

History of Economic Thoughts II Welfare Economics

welfare which can be put into quantitative terms. “The one obvious instrument of measurement
available in social life is money. Hence the range of our inquiry becomes restricted to that part of
social welfare that can be brought directly or indirectly into relation with the measuring-rod of
money. This part of welfare may be called economic welfare.”

He studied the factors which affect economic welfare with reference to three things. These are:

i. the size of the national dividend;

ii. the distribution of national dividend; and

iii. the variability of national dividend.

Pigou recognizes that economic welfare and non-economic welfare may move in opposite
directions and he gives many instances in which this happens. But he thinks it a plausible
assumption that total welfare of the society would move in the same direction as the economic
welfare. He does not think it necessary to provide a proof for this presumption and instead claims
that ‘in all circumstances the burden of proof lies upon those who hold that the presumption should
be overruled.”

As far as the effect of variations in national dividend on economic welfare is concerned, Pigou
would rather run the argument in terms of per capita income. Here also he maintains that though
in general an increase in per capita national dividend goes with increased economic welfare, it
need not necessarily be so. It is essential that we should keep in mind two things: Firstly, welfare
being a subjective thing, it does not follow that any increase in per capita income will necessarily
add to economic welfare. At the income levels which are sufficiently low, of course, it can be
safely said that an addition to per capita national dividend would lead to a corresponding increase
in economic welfare also. But once per capita income exceeds a certain level, this need not be true.
We may say that a principle of diminishing utility applies to income in general also. Secondly, the
increase in per capita national dividend may be obtained at the cost of too high disutility of work.
The rule should be that additional national dividend should not be produced when marginal
disutility from work is equated with marginal utility form income.

Pigou extends his general principle of equality between social and marginal cost and benefit even
to the field of public finance. His principle of optimum budget or optimum state activity stresses

Compiled by NET 7|Page

History of Economic Thoughts II Welfare Economics

that the public budget should ensure equality between marginal benefit to public expenditure with
the marginal sacrifice which taxation imposes. This is his famous principle of maximum social
advantage. Similarly, within the field of taxation, he provides the principle of least aggregate
sacrifice which is ensured by imposing the tax liability upon different members of the society such
that the marginal disutility of taxation is the same for every taxpayer. Ordinarily, this would entail
progressive tax structure.

On theory of unemployment

Pigou’s classical theory of unemployment (Pigou 1933) is based on two fundamental postulates,
namely: The wage is equal to the marginal product of labour. That is to say, the wage of an
employed person is equal to the value which would be lost if employment were to be reduced by
one unit (after deducting any other costs which this reduction of output would avoid); subject,
however, to the qualification that the equality may be disturbed, in accordance with certain
principles, if competition and markets are imperfect. The utility of the wage when a given volume
of labour is employed is equal to the marginal disutility of that amount of employment. That is to
say, the real wage of an employed person is that which is just sufficient (in the estimation of the
employed persons themselves) to induce the volume of the actually forthcoming labour; subject to
the qualification that the equality for each individual unit of labour may be disturbed by
combination between employable units analogous to the imperfections of competition which
qualify the first postulate.

The Second postulate is compatible with what may be called “frictional” unemployment. For an
elastic interpretation of it, we must legitimately allow for various in exactnesses of adjustment
which stand in the way of continuous full employment. For example, unemployment due to a
temporary loss of balance between the relative quantities of specialized resources as a result of
miscalculation or intermittent demand; or to time-lags consequent on unforeseen changes; or to
the fact that the changeover from one employment to another cannot be effected without a certain
delay, so that there will always exist in a non-static society a proportion of resources unemployed
“between jobs.” In addition to “frictional” unemployment, the postulate is also compatible with
“voluntary” unemployment due to the refusal or inability of a unit of labour, as a result of
legislation or social practices or of combination for collective bargaining or of slow response to

Compiled by NET 8|Page

change or of mere human obstinacy, to accept a reward corresponding to the value of the product
attributable to its marginal productivity.

But in his thinking, these two categories of “frictional” unemployment and “voluntary”
unemployment are considered comprehensive. The classical postulates do not admit of the
possibility of the third category, which we might define as “involuntary” unemployment. Subject
to these qualifications, the volume of employed resources is duly determined, according to the
classical theory, by the two postulates. The first gives us the demand schedule for employment,
the second gives us the supply schedule; and the amount of employment is fixed at the point where
the utility of the marginal product balances the disutility of the marginal employment. From this it
follows that there are only four possible means of increasing employment: An improvement in
organization or in foresight which diminishes “frictional” unemployment. A decrease in the
marginal disutility of labour, as expressed by the real wage for which additional labour is available,
so as to diminish “voluntary” unemployment. An increase in the marginal physical productivity of
labour in the wage-goods industries (to use Pigou’s convenient term for goods upon the price of
which the utility of the money-wage depends); or an increase in the price of non-wage-goods
compared with the price of wage-goods, associated with a shift in the expenditure of non-wage-
earners from wage-goods to non-wage-goods.

The Pigou effect

What is now known as the Pigou effect was first popularized by Pigou in 1943. The term refers to
the stimulation of output and employment caused by increasing consumption due to a rise in real
balances of wealth, particularly during deflation. Pigou had proposed the link from balances to
consumption earlier, Gottfried Haberler having made a similar objection the year after the
publication of John Maynard Keynes’ General Theory. In fact, Haberler in 1937 and Pigou in 1943
both showed that a downward wage-price spiral had the effect of increasing real money balances.
As price declines drove up the value of the existing money supply, the increase in real money
balances would at some point satisfy savings desires and result in a resumption of consumption.
Wealth was defined by Pigou as the sum of the money supply and government bonds divided by
the price level. He argued that Keynes’ General theory was deficient in not specifying a link from
“real balances” to current consumption, and that the inclusion of such a “wealth effect” would
make the economy more “self-correcting” to drops in aggregate demand than Keynes predicted.

Compiled by NET 9|Page

Because the effect derives from changes to the “Real Balance,” this critique of Keynesianism is
also called the Real Balance effect. Pigou later dismissed his “Pigou effect” or “real balance effect”
as an academic exercise, because a government would no employ a downward wage-price spiral
as a means of increasing the real money supply. In contrast, Karl Polanyi recognized the real-world
policy implications of the real balance effect. He dismissed the wage price flexibility discussion
as irrelevant and stated the “Pigou effect” in terms of constant prices and increases in the nominal
stock of money. In Polanyi’s approach, the policy issue is not obscured by adverse effects on
expectations caused by price level declines.

All this, moreover, has its reverse side. In an exchange economy everybody’s money income is
somebody else’s cost. Every increase in hourly wages, unless or until compensated by an equal
increase in hourly productivity, is an increase in costs of production. An increase in costs of
production, where the government controls prices and forbids any price increase, takes the profit
from marginal producers, forces them out of business, and means a shrinkage in production and a
growth in unemployment. Even where a price increase is possible, the higher price discourages
buyers, shrinks the market, and also leads to unemployment. If a 30 percent increase in hourly
wages all around the circle forces a 30 percent increase in prices, labour can buy no more of the
product than it could at the beginning; and the merry go-round must start all over again.

On capitalism

Though Pigou was a supporter of capitalism, he believed that it required some modification. He
held that a moderate form of socialism was needed to solve certain important is a purely
psychological one since he emphasized on the demand for labour and rejected the role of
investment. He held that cyclical changes take place on account of changes in the demand schedule
of labour. The main force underlying this schedule is the expectations regarding prospective yield.
In this way he rejected the investment element and emphasized the psychological factor.

C. Amartya Sen (1933–)

Born on a university campus in Santiniketan, India, Amartya Sen seemed destined for a life in
academia. His father was a professor of chemistry at Dhaka University, and his grandfather taught
Sanskrit and Indian culture at Tagore’s Vista-Bharati. After contemplating the study of Sanskrit,
mathematics, and physics, Amartya Sen eventually chose, as he put it, “the eccentric charms of

Compiled by NET 10 | P a g e
economics.” Most of Sen’s accomplished life has been spent on college campuses on three
continents. He earned B.A. degrees from Calcutta University and Trinity College in Cambridge,
and his Ph.D. from Cambridge, where Joan Robinson supervised his doctoral thesis. His thesis
earned him a Prize Fellowship at Trinity College, which he used to support four years of study in
philosophy. Sen’s teaching positions have ranged from Presidency College in Calcutta, India, to
Trinity College, to Harvard University in Cambridge, Massachusetts, including stops at Delhi
University, the London School of Economics, Oxford University, U.C. Berkeley, Cornell, MIT,
and Stanford.

Despite considerable time spent in academic circles, during his early years Sen witnessed poverty
and famine, as well as the violence that resulted from people struggling to survive. Through early
observation and later study, he concluded that problems such as famine were due less to a lack of
food than to a lack of access, often resulting from income inequality, undemocratic institutions,
and ineffective social policies. Sen’s interest in these problems led him to work with the United
Nations Development Programme (UNDP) to help improve measures of poverty and inequality.
Sen’s major works include Collective Choice and Social Welfare (1970), and On Economic
Inequality (1973). For his contributions to welfare economics, in 1998 he was awarded the Nobel
Prize in economics. The combination of his theoretical work and humanitarian efforts led Business
Week to refer to Sen as “The Mother Teresa of Economics.”

Social choice

As we have seen, Kenneth Arrow concluded that no system of majority voting could
simultaneously maximize social welfare and respect individual preferences independent of the
ordering of votes. While accepting much of the work of his col- league, Sen attempted to refute
the impossibility theorem and improve collective choice theory.

Sen thought that the impossibility theorem could be resolved by including two considerations that
Arrow (and others) assumed away. Arrow’s model of collective choice depends on a simple rank
ordering (I like A more than B, and B more than C), but says nothing about the intensity of
preferences (I like A much more than B, but B only a little bit more than C). Economists refer to
this simple rank ordering as an ordinal measure—it puts items in order of preference but assigns
no numeric value to their worth. Cardinal measures (A gives me 20 utils, B gives me 10) would
make it easier to measure preference intensity, but they are generally rejected on the grounds that

Compiled by NET 11 | P a g e
they are difficult to obtain and interpret (20 utils might be a lot on my scale, but hardly any on
yours).

Why might intensity of preferences matter in collective choice? In a simple majority voting
scheme, it wouldn’t, except to the extent that voters only slightly more in favor of policy A over B
might decide that the cost of voting outweighs the benefits received from casting the deciding vote
for A. In a decision-making framework where preferences could be more fully incorporated—for
example, in a voting system through which voters distribute a fixed allotment of points—the
paradox of voting is much less likely to occur. Those stronger preferences will carry more “voting
weight” than they do in majority voting.

The other restriction imposed by Arrow (and many others) is that interpersonal comparisons are
not allowed in the model. The rationale for this is that such com- parisons are, at best, difficult to
make and are most often useless. If two people determine that they will receive 20 utils from a
proposed policy, this may indicate strong support from the first person and mild interest for the
second. The problem is the lack of a commonly understood and accepted utility scale.

Sen also suggested that people may make interpersonal comparisons in formulating preferences as
they consider how policy options will affect not only themselves but those around them. The
society in which a person lives, the class to which he belongs, the relation that he has with the
social and economic structure of the community, are relevant to a per- son’s choice not merely
because they affect the nature of his personal interests but also because they influence his value
system including his notion of “due” concern for other members of society. The insular economic
man pursuing his self-interest to the exclusion of all other considerations may represent an
assumption that pervades much of traditional economics, but it is not a particularly useful model
for under- standing problems of social choice.25

Sen’s work reveals a deep concern for equity and justice in social choice—that out- comes not
simply maximize total welfare but that the distribution of income also is fair. Drawing from the
philosophy of John Rawls, Sen suggests that one approach to generating equitable decisions is
what he calls “maximin justice.”26 In such a scheme, individuals choose among alternative social
states from an unknown starting position. In other words, maximin justice asks a person to choose
the distributional arrangements for society under the assumption that they have not yet been born.
Sen chose the word “maximin” because in choosing between different social states, people will

Compiled by NET 12 | P a g e
select that set of arrangements that “maximizes their minimum welfare.” Put another way, because
of the risk of being the worst-off person in society, one will choose a society where the worst off
are still better off than in any alternative scenario.

Inequality

Sen argued that the traditional social choice framework, centered on the concepts of utilitarianism
and Pareto optimality, often precludes a meaningful analysis of the equity effects of a policy.
Jeremy Bentham’s utilitarianism, the philosophy that society should pursue the greatest good for
the greatest number, promotes the maximization of total social utility, but gives no consideration
to equity.

For Sen, Pareto optimality is also an unsatisfactory criterion for distribution. The condition of
Pareto optimality only says that no one can be made better off without making someone else worse
off. It says nothing about the distribution in society. There could be multiple states that are Pareto
optimal, each reflecting vastly different levels of income inequality, which Sen demonstrates with
the following example:

Suppose we are considering the division of a cake. Assuming that each person prefers to have more
of the cake rather than less of it, every possible distribution will be Par- eto optimal, because any
change that makes someone better off is going to make someone else worse off. Since the only
issue in this problem is that of distribution, Pareto optimality has no cutting power at all. The
almost single-minded concern of modern welfare economics with Pareto optimality does not make
that engaging branch of study particularly suitable for investigating problems of inequality.27

For Sen, traditional welfare economics was not up to the task of analyzing distribu- tional issues.
As Sen wrote,

…To conclude, we do not seem to get very much help in studying inequality from the main schools
of welfare economics—old and new. The literature on Pareto optimality … avoids distributional
judgements altogether. The standard approach of ‘social welfare functions’ because of its
concentration on individual orderings only (without any use of interpersonal comparisons of levels
and intensities) fails to provide a framework for distributional discussions…. Finally,
utilitarianism, the dominant faith of ‘old’ welfare economics, is much too hooked on the welfare
sum to be concerned with the problem of distribution, and it is, in fact, capable of producing

Compiled by NET 13 | P a g e
strongly anti-egalitarian results. As an approach to the measurement and evaluation of inequality
it cannot take us very far. For the problem of inequality evaluation, the royal roads of welfare
economics do look a trifle bleak.

Sen’s dissatisfaction with existing theory drove him to offer his own insights. Distri- butional
concerns generally focus on extreme inequality, often implying that greater equality would
improve society. Taking this premise to its logical conclu- sion would suggest total equality, but
as Sen points out, equality is important to the extent that it reflects an equitable (fair) distribution.
For Sen, that can take one of two forms.

There are essentially two rival notions of the ‘right’ distribution of income, based respectively on
needs and desert. It is easy to recognize the contrast between arguments of the kind: ‘A should get
more income than B since his needs are greater’, and those of the type: ‘A should get more income
than B since he has done more work and deserves a higher reward’. Inequality can, therefore, be
viewed not merely as a measure of dispersion but also as a measure of the difference between the
actual distribution on income on the one hand and either (i) distribution according to needs, or (ii)
that according to some concept of desert.29

Sen focuses most of his attention on the needs side of the argument as he examines how to
maximize social welfare. Needs are often dismissed in the literature as an unsolvable problem
because they involve interpersonal comparisons of utility functions that are difficult, if not
impossible, to specify. Sen presented two cases sup- porting a more equal distribution, both
acknowledging and embracing the incomparability of individual utility functions.

Probabilistic egalitarianism, built from the work of Abba Lerner (1903–1982), argues that
precisely because of uncertainty, incomes should be equalized. Assuming that (1) there is a fixed
amount of income to distribute, (2) that both society and individuals are subject to diminishing
marginal utility, and (3) that everyone has equal probability of having a given utility function, Sen
demonstrated that the expected total utility is maximized with an equal distribution. This does
not mean that a completely equal distribution would necessarily maximize total welfare.

In fact, the theory recognizes that individuals possess different welfare functions, suggesting that
there is likely some unequal distribution that would yield higher welfare. However, given that we
do not know the specifications and distribution of those welfare functions, the best we can say is

Compiled by NET 14 | P a g e
that, on average, welfare is maximized with an equal distribution of a fixed total output and
income.

Maximin egalitarianism, similar to maximin justice, argues that society should choose the
distributional system that maximizes the gain to the least well-off per- son. Under circumstances
of complete ignorance about people’s needs, Sen demonstrates that the society’s welfare is
maximized with an equal distribution.31

Although he favored a more egalitarian, needs-based approach, Sen recognized that equalizing
incomes is problematic from both a fairness and an efficiency perspective. He presents four
approaches to the concept of desert.

(1) Incentives. Desert-based systems create more incentives for work effort. To the
extent that people are driven by their needs, the system can be defended on
distributional grounds. Otherwise it must be defended on some other basis, such as
the total amount of income generated.

(2) Merit. People who accomplish more should receive more. Sen finds this approach
particularly troublesome in that often those who accomplish more have been given
an advantage, by genetics, cultural proclivities, or simply luck. He points specifically
to those who, through no fault of their own, would receive less income because of
their age, infirmity, or genetic defect. As Sen put it, “A system based on needs
would seem to have greater use for the complex idea that we call humanity.”

(3) Marxist exploitation. As we saw in Chapter 10, Marx’s theory of exploitation “Marx
himself regarded this right to the ‘fruits’ of labour as a ‘bourgeois right’ to be
supplanted by the principle of needs when the opportunity arose.”

(4) Neoclassical marginal productivity theory. From Sen’s perspective, J. B. Clark’s

marginal productivity theory of income distribution is less of a normative theory than
the others, and to the extent that it is, offers little substance. The primary criterion is
Pareto optimality, which offers little perspective on the optimal distribution.

Compiled by NET 15 | P a g e