Quiet Revolution in Welfare Economics- by Michael Albert and Robin Hahnel
Was it not only the timidity of an age which had lost all confidence in ultimate values which led us to attempt to claim scientific justification for attitudes which in the nature of things could not be justified (or refuted) by appeal to laboratory methods?
- Lionel Robbins,
An Essay on the Nature and Significance of Economic Science
ESTABLISHED ORDERS, be they social or intellectual, often acquire an aura of permanence beyond what is warranted by the facts. All too often incongruities go unnoticed longer than is reasonable, and what is obvious in retrospect eludes inhabitants of crumbling orders. Hence the logic of heeding the cries of heretics, even though most tremors they report are due to faulty seismographic equipment. But as John Stuart Mill remarked, what harm can come to a self-confident majority from granting an audience to heretical prophesies in hopes of uncovering a rare truth?1.
We admit to heresy. In this book we argue that traditional welfare theory has little more to teach us, that the traditional welfare paradigm has become an obstacle to progress on most important frontiers of welfare economics, and that a new welfare paradigm is ready to yield substantive new results. In other words, we argue that traditional welfare theory is in crisis, and a "quiet revolution" in welfare economics is already under way. Refinement of the relationship between competitive equilibria and Pareto efficient allocations has entered the region of diminishing returns.
Traditional theorists have every reason to be proud of their work to isolate the minimal assumptions necessary to justify Adam Smith's twohundred-year-old vision that it is as if competitive markets are guided by an "invisible hand" to yield social efficiency even though economic actors neither conceive nor pursue this goal. But this task is largely accomplished, and there is no need to quibble over when diminishing returns set in. The important point is that one of the few remaining frontiers of welfare economics which proves tractable to traditional approaches is the extension of familiar conclusions to situations involving uncertainty. Without demeaning important recent work in this area, we believe the final touches are already foreseeable, and few "surprises" remain to be uncovered.2
In other areas of ongoing research in welfare economics, the traditional paradigm no longer helps researchers define problems and uncover solutions. In many respects the traditional paradigm impedes progress. As we will see in part 1, the traditional paradigm has thwarted, rather than facilitated, advances in analyses of the labor process, externalities, public goods, preference development, and institutional structures. The traditional misconception of labor as an input indistinguishable from other production inputs yields questionable analyses of the efficiency of private enterprise production and hinders investigations in the economics of discrimination. The traditional presumption of "external effect exceptionality" not only biases evaluation of market institutions, but hinders development of "incentive compatible" mechanisms for solving the "free rider problem." And the traditional injunction not to question the origins of preference orderings frustrates a coherent analysis of the logic of preference development as well as an understanding of the relation between economic institutions and patterns of preference development.
Yet a different paradigm can facilitate progress along many of these frontiers that have proved intractable to traditional methods. By elaborating a conception of people as conscious, social beings who develop capacities and needs based on innate potentials as a result of the activities they engage in, we are able to clarify and consolidate important recent advances of others as well as derive new results of our own. In part 2 we develop the new paradigm and the "New Welfare Theory" based on it, and in part 3 we present "New Results" derived with the new theory. We show how the "conflict theory of the firm" and previous analyses of externalities and endogenous preferences can be fortified by using the new welfare theory. And we present substantive new critiques of markets, private enterprise, and central planning that challenge traditional conclusions. We also contribute to the theory of comparative economic systems by revealing fundamental properties of private enterprise market economies, public enterprise market economies, and public enterprise centrally planned economies ignored in traditional analyses.
Why has the current "crisis" in welfare economics gone largely unnoted? And why do we feel the situation is ripe for change?
Much work on the frontiers of welfare theory that casts doubt on the further usefulness of the traditional paradigm is highly technical and inaccessible even to professional economists. Not so long ago differential calculus was sufficient for perusing journal articles on welfare theory. By the early 1970s familiarity with convex set theory and fixed point theorems was necessary to follow critical developments in welfare theory. But a glance at the literature on endogenous preferences in the Journal of Economic Theory, iterative planning mechanisms in Econometrica, or incentive compatible mechanisms in the Review of Economic Studies reveals that the investment in mathematical tools necessary to follow recent developments in welfare theory has been raised another notch.
The relationship between welfare theory and the rest of economics has also become increasingly schizophrenic. Those results that refine and bolster the traditional economic paradigm relating competitive equilibria and Pareto allocations have, for the most part, been effectively communicated by welfare theorists through survey articles3 in the American Economic Review and Journal of Economic Literature, and in mathematical economic texts.4And these refinements have been absorbed by the rest of the profession in graduate microeconomics curricula. But to a great extent the unsettling work on the frontiers of welfare theory has not been effectively brought to the attention of those outside the tiny elite of practicing theorists. And when work in areas such as endogenous preferences and incentive compatible mechanisms has been presented to the profession at large, the discussions have frequently emphasized only aspects that can be readily interpreted within the traditional paradigm. 5
Those working on different frontiers of welfare theory have communicated little. Separate pieces of work remain isolated gems, unrelated to one another or to an overall critique of the traditional welfare paradigm. This is partly because of the incredible division of labor that exists even within this single area of economic theory and partly because most contributors do not see their work in a critical light and are not looking for critical connections.
Finally, political divisions have delayed a comprehensive reappraisal of traditional welfare theory. Although most of the unsettling work has been done by highly respected economists well within the mainstream of the profession, some innovations have been developed by "radical" economists. Since the profession falls far short of achieving the optimal degree of crossfertilization between its mainstream and radical components, radical and mainstream theorists alike have remained ignorant of important work by those in different political quarters.
Beyond detecting an "unnoticed crisis," we are optimistic that a change in paradigm can break the log jam. Much current work on the frontiers of welfare theory requires a new view of people and society adequate to formulate problems it addresses and envision directions to proceed. This "pressure from within" is very different from "pressure from without." After all, the traditional welfare paradigm has not gone unchallenged. William Morris, Peter Kropotkin, Karl Marx, and Thorstein Veblen each presented a plausible case that the traditional conception of "economic man" inherited from Adam Smith precluded addressing important issues they wished to examine. Likewise, most modern psychologists and sociologists reject the view of human behavior envisioned in the traditional economic paradigm as ill-suited to defining and addressing the problems that concern them.
These challenges were not compelling for traditional welfare theorists because they were premised on different priorities and concerns than those operative in the economic mainstream. The traditional paradigm might have lost its appeal to outsiders, but its primary users were content because their model of "economic man" was invaluable for their purpose: studying the logic of individual rational choice in a particular social context. Challenges were not compelling as long as economists saw many remaining solvable problems in the theory of individual rational choice in the traditional social context and no means for solving problems of individual rational choice in more complex, albeit realistic, contexts.
These conditions that sustained the traditional paradigm no longer pertain. Not only is the work of unraveling the nonintuitive logic of rational choice in the traditional context largely complete, welfare theory "puzzlesolving" has led to a growing list of "anomalies" and "dead ends" that cannot be productively addressed within the traditional framework. Many remaining problems in welfare theory, such as preference development, incentive compatible mechanisms, the labor process, externalities, public goods, and social choice, fail to yield to familiar welfare assumptions and approaches. Moreover, in some cases conceptualizing new settings and reformulating questions is nearly impossible under the spell of the old paradigm. It is as if the traditional paradigm were a fence that once served the useful purpose of keeping welfare theorists from wandering outside a zone of rich oil reserves exploitable with existing technology. But now, instead of turning theorists away from barren rock and back toward high-expectation drillings, the fence is keeping welfare theorists drilling in an area already pumped dry and preventing them from exploiting solar energy with newly available technology6.
In chapter 1 we review traditional welfare theory. We trace its evolution from classical utilitarianism to modern neoclassical welfare theory and discuss recent contractarian interpretations. But while we distinguish between utilitarian, neoclassical, and contractarian formulations and compare their advantages and disadvantages, our major purpose is to understand the essential features of traditional welfare theory as a whole and identify the paradigm it seeks to represent.
In chapters 2, 3, and 4 we discuss specific failures of traditional welfare theory. Our criticism is not that a particular formulation of traditional welfare theory imperfectly represents the traditional paradigm. We argue that the traditional welfare paradigm itself is incapable of posing important questions and defining the concepts necessary for answering them and has become an obstacle to progress.
In chapter 2 we show how the traditional concept of the production function has obfuscated important effects of private enterprise on the labor process. We review challenges from the "conflict school" and "segmented labor market" traditions to standard conclusions that profit maximization in competitive environments promotes social efficiency and ameliorates economic discrimination. We conclude that despite much confusion and inconsistency the thrust of these challenges is sound.
In chapter 3 we review criticism of the traditional treatment of externalities and public goods and the exciting literature on "incentive compatible mechanisms" for solving the "free rider problem." We conclude that the unwarranted presumption of "external effect exceptionality" that is buried in the traditional paradigm must bear part of the blame for retarding theoretical progress in the field of public finance as well as for inducing fundamental misconceptions regarding the efficiency of markets.
In chapter 4 we evaluate the work of those few economists who dared to ignore the traditional taboo against inquiring into the origins of preferences and evaluate the decision of traditional theorists to ignore the effect of economic institutions on preference development. We reveal considerable disagreement among previous analysts about the ultimate significance of treating preferences as endogenous and discover that institutionalist economists have had virtually no influence on welfare theorists regarding the impact of institutions on preferences. In this chapter we complete our case that progress in pursuing important tasks facing welfare theory today has been hampered rather than aided by the traditional paradigm and lay the groundwork for our own major innovation: clarification of the welfare significance of the relation between economic institutions and preference development.
In chapter 5 we begin to replace the traditional paradigm with a new one that emphasizes human development, human sociality, and the structuring of individual choice by economic institutions.
In chapter 6 we present a new welfare theory based on the alternative paradigm. Using an original model of human development and endogenous preferences, we present a set of theorems that reveal an important mechanism whereby individual rationality proves counterproductive to social rationality. But while these striking new results do not hinge on any specific assumptions about preferences other than their endogeneity, we also elaborate a qualitative welfare theory that addresses fundamental philosophical issues.
In chapter 7 we use the new welfare theory to reevaluate markets. Adam Smith's vision of markets as cybemetic/incentive miracles is not sustained by our new welfare paradigm and theory. Instead new analysis suggests that "market failure" is likely to be far more pervasive than usually admitted and the cybernetic and incentive properties of markets compound the problem. Moreover, the argument in this chapter proves that once it is recognized that preferences are endogenous, the extent of the damage from "market failures" is greater than traditional theory leads one to suspect.
In chapter 8 we reanalyze the institution of private enterprise. The new theory sustains a careful reformulation of the "conflict theory of the firm" yielding the conclusion that individual employers have an incentive to engage in discriminatory practices, regardless of how competitive labor markets may be. We argue that conflict theory need not reduce to an implicit "conspiracy theory" whose conclusions obtain only under highly restrictive, unrealistic assumptions. Rather it is the traditional conclusion that profit maximization under competitive conditions acts to ameliorate economic discrimination that hinges on unrealistic assumptions. In this chapter we defend the charge that private enterprise generates inefficiency, even when "disciplined" by competitive market structures, from wellreasoned objections to previous formulations. And again we show how the discrepancy between employer rationality and social rationality will yield an increasingly inefficient use of productive capabilities in private enterprise economies to the extent preferences are endogenous. The result in chapters 7 and 8 imply two independent sources of increasing inefficiency in private enterprise, market economies, no matter how competitive their market structures or how fully informed their participants.
In chapter 9 we reexamine the principal alternative to market allocations - central planning. We demonstrate that traditional claims that central planning cannot calculate a socially efficient plan, even in theory, are overstated. While information and incentive problems certainly exist, these "practical" problems of central planning are not unlike "practical" problems in market economies that traditional theorists are willing to "abstract from." But while we argue that an evenhanded application of traditional welfare theory should grant public enterprise, centrally planned economies as much claim to efficiency as private and public enterprise market economies, our new welfare theory reveals an intrinsic flaw in central planning that no generous assumptions can disguise. We show that regardless of how democratic a process it adopts for determining society's social welfare function, central planning is inherently biased against selfmanaged labor. Consequently, no centrally planned economy can provide a socially optimal menu of job roles. When preferences are recognized as endogenous, we prove this deficiency leads centrally planned economics to increasingly inefficient allocations of society's laboring capabilities as well as to growing apathy among workers. This concludes our reexamination of the welfare properties of the major economic institutions and systems of our time.
In our conclusion we point out that traditional theory is increasingly unable to distinguish between the welfare properties of different economic systems except on "practical" grounds. Under equally generous assumptions, all the major economic systems appear equally efficient and flexible according to traditional theory. But our new results demonstrate that this conclusion is misleading because different economic systems will develop along very different trajectories. We offer new insights about why different kinds of economies will predictably have different distributional trajectories, despite theoretical flexibility. But more surprisingly, we show that the human development and resource allocation trajectories of different kinds of economies will differ precisely to the extent inhabitants make individually rational choices. Moreover, we show why the allocative trajectories of each traditional economic system will be increasingly inefficient.
Not too long ago, Leonid Hurwicz issued a challenge to welfare theorists to embrace the exciting research program of devising "new economic mechanisms" that improve upon traditional models.7 The deficiencies we demonstrate in markets, central planning, and private enterprise institutions testify to the importance of accepting his challenge.