Market Failures and Welfare Economics: A Comprehensive Analysis

Posted on Dec 28, 2024 in Economy

Market Failures

  • Non-competitive markets
  • Public goods and externalities
  • Public services
  • Economic imbalances
  • Natural monopolies
  • Problems in the distribution of income
  • Asymmetric information

Classical Welfare Economics

Marshall was the first economist to use the terms “happiness and welfare” to refer to both production and economic growth.

Pigou argued that economic welfare is the set of satisfactions that can be expressed in money and also presented us with the objective of the economy, which is growth, and that it should be distributed between the richest resources. Resources should be transferred to the poor because this will cover more intense desires in exchange for less intense desires.

Pareto entered the “unanimity principle,” used to compare utilities. He noted that a state 2 is better than a situation 1 if, from 1 to 2, all win, or some win and none lose. Pareto also introduced two other issues that impact this principle:

  • Consumer sovereignty
  • Individualism in social choice: Social welfare includes the welfare of all individuals in society (except for idiots and children).

Compensation Principle

These authors depart from Pareto’s contribution but will try to overcome the “unanimity principle” with the “principle of compensation.”

These authors state the principle of compensation: A state 2 is better than state 1 if no one wins and loses, or if the winners can compensate the losers. They emphasize that compensation is potential: the winners “could” compensate the losers, but whether compensation occurs depends on ethics. It is an approach that is based more on efficiency than on redistribution. We also have to consider Scitowsky’s contribution, which adds an additional test in which he states that those who lose in state 2 cannot bribe the winners of state 1 to not make that step.

Role of Social Welfare

These authors will try to sort the variables on which the welfare of individuals depends. They put down a general social welfare function:

W = W (C, E, P, B, Y)

If we relate this social welfare function with the Pareto optimum, these variables would be the means to maximize the utility of individuals in a society. Accordingly, we will be able to configure a role in which economic welfare will depend on the utility of each individual. Arrow criticizes it on the ground that it is very difficult to raise social welfare if no useful comparisons are made between individuals and no dictatorial orderings are given.

Arrow’s Impossibility Theorem

  • The classification of all possible outcomes must be consistent: If “a” is preferred to “b” and “b” is preferred to “c”, then “a” is preferred to “c”.
  • The social organization should respond positively to changes in individual assessments. If society is carrying out a given action and a subset of the population who would be opposed to such activity decides to be for them, society cannot go back and cease its activity to “do against” the subgroup.
  • Independence of irrelevant alternatives.
  • Social preferences must satisfy the Pareto condition.
  • Non-dictatorial: Social orders cannot be determined solely by the preferences of a member of society.

Cost-Benefit Analysis (CBA) and its Benefits

During the 1960s, welfare economics was already in decline and a new technique emerged, which led to a resurgence of the contributions of different authors. There are those in welfare economics who depart from the relationship between costs and benefits to try to put a price on what is priceless. This is the so-called “shadow price,” so that a social value of public goods and services can be obtained. These approaches are linked to the issue of externalities. One of the problems from this point, as Lancaster and Lipsey point out, is that if we apply the second best, sometimes you cannot get the best. That is, there may be situations other than the absolute welfare optimum (i.e., full employment is almost impossible, but there are close situations that are satisfactory).

Keynesian Contributions

The Keynesian macroeconomic model supports three cases: short-term analysis, the existence of rigidities in prices, and the availability of exogenous expectations.

Harvey Road’s Assumptions

  • Confidence in economic policymakers who seek the common good and economic progress.
  • Objectives: To combine economic efficiency, social justice, and individual freedom.
  • Inclination toward fiscal policy, especially government spending.
  • Maintenance of long-term employment: Public corporations, semi-autonomous public employment (staff).
  • Influence of government spending: 1/3 or 1/4 of the investment.
  • Capital budget and current budget: The first is long-term, with the aim of being balanced, but it could be the case that there were small gaps. The second is used in the short term and serves to correct the gaps that arise in the capital budget.

Old Institutionalism

Fundamental Authors: Veblen, Mitchell, Commons, and Ayres.

Fundamental Idea: Institutions establish the rules of action of individuals and thus shape the structure of incentives, opportunities, and constraints under which economic agents have to operate. Institutionalists indicate that the market is an institution with other subsidiary institutions. Therefore, institutions are to be ordered to make a balanced distribution of economic resources. Thus, they develop between a group of institutions that introduce norms, rules, and property rights. Institutionalists are interested in problems of organization and control of the economy, but not in prices or the allocation of resources.

Veblen’s Contribution (20th Century)

Emulation/copy status. He believed it was the main force in shaping economic behavior. The different social classes were linked by the institutions, so that there is no conflict between them. Workers do not move to raise their heads, but they want to be like them.

Post-Veblen Contributions

They will accept the class struggle, but you can find a reasonable solution to capitalism, building institutions that allow for cooperation between classes – “Reasonable Capitalism.”

Ideology of the Old Institutionalists

  • Social change: Motivated by the role of institutions in economic activities. Institutional change is a result of human actions (deliberate or not).
  • Social control and collective choice: Guided by the power structure of the institutions that control the behavior of individuals and subgroups. The institutions will control the behavior of individuals.
  • Government’s economic role: Develop a social process intertwined with other institutions.
  • Technology: Technology is the variable determining the relative scarcity of resources and the main force of economic structural evolution.

Fundamental Principle

The real determinant of resource allocation is the institutional and structural organization of society, not the market.

Conception of Value

It includes various aspects such as habits and customs of social life, the rules of law, and the structural powers.

Economic Analysis of Law

This perspective focuses on the study of the effect that legal rules have on the behavior of economic agents. Laws can devise a system of constraints and rewards that promote efficiency in the conduct of individuals. This theory will analyze the impact of laws on markets (trade, competition, etc.), and moreover, it will also examine the effect of laws outside the market. These authors note that the property right is manifested in: wearing good and excluding others from its use, benefiting from its use, physical transformation, change, and transmission.

Heterodox Tendencies

From the standpoint of economic policy, the authors will introduce the concept of “Limited Democratic National Planning,” which should focus on the strategic aspects of the economy, but we must also have the market to achieve the basic objectives. A good tool to carry it out would be the use of the “government budget.”

Galbraith’s Contribution: 5 Points

  1. In a polyglot society, one must try to reduce the influence of market uncertainty.
  2. In the American economy, social purposes are adapted to the needs of the techno-structures (managers, directors, economic power of a country’s finances).
  3. Industrial planning required that prices were always under control. They must be low to sell high to make profits but to enable economic growth.
  4. He noted how in Western societies there is a gigantic apparatus for handling demand, which is connected with state regulation and protects the technostructure.
  5. The existence of a power compensator, which occurs when there are conflicts between economic agents.

Neoinstitutionalism

Main Assumptions

  • Social rules of exchange and property rights.
  • Transaction costs.
  • Qualitative variations of goods and services.

Theory of Transaction Costs

Subject: These are the costs of exchanging ownership rights over economic assets between individuals. It refers to the exercise of exclusive rights of the individual.

Fundamental Ideas: These costs are related to information, negotiation, contract enforcement, and property rights protection.

Economic Policy: Attempts to reduce transaction costs through instruments such as reducing red tape, establishing standards of measurement, monetary unions, or searching for currency stability.

Theory of Agency

The principal delegates some rights to an agent bound by contract to defend their interests in exchange for a fee.

Ideas: Asymmetric information, agency costs, and controls.

Economic Policy: Social norms, adequate supply of public goods, political information, and human capital.