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GUEST WRITING

Can Economists Make People Happier?

The insufficiency of the First Theorem of Welfare Economics
By Murat Kotan1 1. Introduction with making people happier. Within the eld of economics, welfare economics is concerned with the evaluation of different ecoEconomists have great inuence worldwide on the nomic policies and structures. Given that utility is design and implementation of policies. In the Nerunning their proposed policies through the ecothe variable of interest, welfare economics should in which the economy and economic policies affect therlands, for example, no political party can escape thus be expected to investigate into the many ways nomic models of the Centraal Plan Bureau. The individuals experience of utility. Unfortunately, this models predict the impact of these policies on for is not the case. The main focus in mainstream ecoinstance national income growth, ination, unemgreat importance attached in the media to these types of variables, people generally think that economics is all about money and nothing else. Fortunately, this is not the case. In fact, there is gene ral consent in economics that variables such as national income have only derived value: they are of importance as far as they contribute towelfare. Whatever economics it ultimately means utility: the experience of pleasure and the absence of pain. Simply put:
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nomics has been the satisfaction derived from the general. Among others because of this, competitive markets are seen by mainstream economics as the ideal economic system. Much of the pleas for competitive markets are based on an important theorem in welfare economics, the so-called First Fundamental Theorem of Welfare Economics. But, as I argue, mainstream welfare being, makes it unt for the evaluation and recommendation of economic structures and policies. In this paper I broaden the view by treating two

ployment and government nance. In view of the consumption of commodities, instead of utility in

welfare may mean in ordinary use, in mainstream economics narrowness of view concerning well-

economists are - just like psychologists concerned sources of well-being which have been commonly neglected in mainstream welfare economics. Both sources I believe to be relevant for the evaluation of economic policies and structures and thus should be taken into account when designing policies and institutions. The rst is procedural utility. It concerns among others the fact that individuals well-being is

1 Faculty of Economics and Business, University of Amsterdam; e-mail: m.kotan@uva.nl. I would like to thank Petra Boers and Geert Reuten for their textual comments, which much improved the accessibility of the paper. 2 Some economist may object that in welfare economics (see text) it is the satisfaction of preferences on which the evaluation of economic policies and economic structures is based. But, as Sen (1991: 19) rightly notes: In the welfarist approach dominant in traditional welfare economics the case for basing the social evaluation of states on individual preferences turns on the correctness or falsity of the identication of preference with welfare or utility.

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affected by the specic procedures under which they Armed with the two fundamental Pareto theorems participate in the economy and interact with each [the fundamental theorems of welfare economics], other. The second source is social well-being, arising from the social embeddedness of individuals. economists attack any problem by attempting to create the conditions for a competitive economy Welfare economic models are much more than mildBefore treating these two sources of well-being in ly interesting theoretical toys. These models lie besection 3, I explain the First Welfare Theorem for hind the pronouncements of leading economists on non-economists in section 2. Can economists make a variety of critical issues including global warming, people happier? They can, concludes section 4. But international trade and development policies, and bi not without the help of psychologists and social psy chologists. 2. The First Fundamental Theorem of Welfare Economics: Competitive markets lead to maximum utility achievable Competitive markets are advocated by mainstream economists on utility grounds. Much of the pleas of economist for markets and competition are (imAssume Adam has six pears in his possession and no apples. Assume also that Adam derives pleasuTo illustrate the intuitive idea behind the FWT, con sider a situation in which no exchange is possible, compared to a situation in which exchange is possible. odiversity protection.

plicitly) based on a major theoretical proposition in re both from the consumption of pears and from welfare economics: the so-called First Fundamental the consumption of apples. However, the additioTheorem of Welfare Economics. This theorem, henceforth referred to as the rst welnal amount of satisfaction he obtains from pears or apples decreases with the consumption of an additional unit of that fruit. Thus the rst pear may fare theorem (FWT), states that competitive markets provide Adam a lot of pleasure. The second he also lead to an economic state of affairs in which every enjoys but less so then the rst. Even the sixth pear individual achieves maximum utility from the consumption of commodities, given his scarce resourat the lowest possible cost.3 As Gowdy (1) notes this is not an innocent theoreti cal result lacking practical consequences: UA = a1/2 + p1/2 , where UA is Adams utility level, a is the amount of apples and p is the amount of pears he consumes.
3 There is, as might be expected, also a Second Fundamental Theorem which will not be treated here. The second theorem basically states that any allocation of commodities that satises the rst welfare theorem can be achieved by an initial redistribution of resources. For a treatment and more formal statement of the welfare theorems, see any introductory microeconomics textbook.

provides him some satisfaction, but little compared to the rst pear.4 The following utility function gipears Adam consumes and the amount of utility he experiences:

ces, and in which rms provide these commodities ves the relation between the amounts of apples and

4 The decrease in the additional satisfaction obtained from an additional unit of a good is called decreasing marginal utility in economics.

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This utility function is used to obtain the tables below. No fruit market When no exchange is possible Adam can only consume the pears he has. Table 1 illustrates the amount of utility Adam experiences from each amount of pears consumed.

Table 2: Adams level of utility when a market for pears exists Apples 6 5 4 3 2 1 utility 2.45 2.24 2 1.73 1.41 1 0 Pears 0 1 2 3 4 5 6 utility 0 1 1.41 1.73 2 2.24 2.45 Total utility 2.45 3.24 3.41 3.46 3.41 3.24 2.45

Table 1: Adams level of utility when no market for fruit exists Pears 0 1 2 3 4 5 6 utility 0 1 1.41 1.73 2 2.24 2.45

The maximum amount of utility Adam can achieve when there is a market for apples and pears becomes 3.46. This is more than the U = 2.45 he can achieve when there is no market. In other words: the market makes Adam a happier man. This result holds in general (under the assumptions of the model behind the FWT): when trade is possible the outcome of the trading process will lead to a

Thus, when no exchange is possible, the maximum higher level of utility achievable compared to when level of utility Adam can achieve is 2.45. Fruit market Now look how the maximum amount of utility trading is not possible. This is in its simplest form the reason why a lot of economists plea for competitive markets.5 But is Adam really a happier man?

Adam can achieve changes when trade becomes 3. Two shortcomings of the First Welfare Theorem possible and he can exchange pears for apples. Assuming he could exchange one pear for one apple, Quite a few things can be said against the signicance table 2 illustrates different feasible combinations of pears and apples Adam can consume, and his corresponding levels of utility. of the First Welfare Theorem in any real-world situation. Here I want to draw attention to two sources of well-being that are generally neglected in welfare economics and are left out of consideration in the model behind the FWT: procedural utility and social well-being.

5 The other major reason is the idea that competition leads to cheaper and/or better products.

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3.1 Procedural Utility

limited amount of apples to Eve, Adam will have to one may expect in line with economic theorys outcome orientation, that Adams utility level will be the same as when no market existed (UA = 2.45) and he had to consume the six pears he had. But this is not true. When procedural utility is taken into account,

Procedural utility means that individuals do not care do with the pears he has. Referring back to table 1, only about outcomes, but also about the conditions and processes that lead to these outcomes (2). Procedural fairness For example. Let us assume Adam (see example sec-

tion 2) considers it unfair he gets only one apple per competition is detrimental for the subjective wellpear. In other words: he considers the price unfair. being and emotional state of those who are as a con When this is the case, consuming the same amount sequence of competition excluded from trade. This of apples and pears his utility derived from contable 2. It may even be lower than the 2.45 in table 1. Brandts et al. (4) nd that competition lowers subjec tive well-being and triggers more negative emotions Frey and Pommerehne (3) nd that in a situation like sadness, envy, anger, irritation and contempt in which unexpected shortages exist, people nd for those excluded from trade as a consequence of the process through which markets deal with these competition, compared to those who do not expeshortages (namely by raising prices) unfair. Compared to the market mechanism, other procedures of rience competition. This study provides evidence that markets affect procedural utility and thereby means that Adam will experience less well-being sumption may nevertheless be lower than the 3.46 in than in the situation where no markets existed.

dealing with the shortage, such as using the principle well-being in ways that are usually not accounted for of rst come rst served or letting local authorities in mainstream welfare economics. distribute the goods according to their own judgment, are perceived to be more fair. Only randomly Thus the exclusive focus on the outcomes of econoassigning the goods to individuals is perceived to be mic and social processes leaves out import ways in less fair than the market process. Competition and well-being A laboratory study by Brandts et al. nds that gene ral subjective well-being and the emotional state of players strongly depend on the competitiveness of position in the competitive environment. (4) It is important to note that the effects of competition on well-being and emotions go beyond the efwhich economic and social structures and policies affect well-being. People also derive utility from and their well-being is affected by processes: not only what they have, but also how they got it matters to them (5). Further research is necessary to assess the relative importance of material sources of well-being utility. One such research is provided by Frey and Stutzer (5). The authors argue based on empirical evidence from Swiss survey data that political participation rights have a positive effect on subjective

the institution players participate in as well as their compared to intangible sources such as procedural

fect it has on material payoffs or consumption. For well-being. According to this study the (procedural) example, if Adam gets excluded from trading pears utility derived from participation rights, contributes for apples because the apple seller chose to sell his to well-being over and above the favorable outcomes

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the political process generates. The authors underof participation rights and income, concluding that: ... if the full range of participation rights is considered, procedural utility accounts for larger differences in subjective well-being than the full range of individual income. (Frey and Stutzer, 2004: 106)

of social integration and social acceptance. Keyes (6) dequality of ones relationship to society and community. And social acceptance as: the construal of society through the character and qualities of other people as a generalized category. He nds that social integration and social acceptance are negatively correlated with indicators of subjective well-being such as anomie and dysphoria and positively with such

take a quantitative comparison between the effects nes social integration as: the evaluation of the

Frey and Stutzer hypothesize that the positive well- indicators as global life satisfaction and global happiness being effects of political participation rights stem with life. from a feeling of self-determination, control and inuence. 3.2 Social Well-being Is there reason to believe that economic structures affect social well-being? One answer is provided by laboratory experiments in social psychology and ex-

Another relation between the economy and well- perimental economics. These experiments show that being that is commonly neglected is the effect that social preferences, that is the way people rank dif economic structures and policies have on social wellbeing embedded in social structures and communities and facing social tasks and challenges (6). Ecoferent allocations of material payoffs to themselves ation and the conditions under which individuals in teract. For instance, one experiment (8,9) nds that being: that is, well-being stemming from individuals and others (7), depend on the framing of the situ-

nomic environments affect individual behaviour, when a game is framed as Wall Street Game, the which in turn affects individuals (social) well-being. subjects behave less socially (donate less money to The marketization of society (making market-like the other), than when the same game is framed as relations the cornerstone of social interaction or the Community Game. Similarly, Hoffman et al. (10) impinging of markets on all domains of social life) nd that subjects donate less money to an other per has undesirable as well as desirable consequences son when a game is framed as an exchange in which for individuals well-being in ways not taken into ac back to Adam, it may well be that he is more satisthe proposer is called seller and his counterpart is framed as divide $10. Carpenter (7) conducts a secount by the analysis underlying the FWT. Referring called buyer compared to when the same game is ed consuming his 3 apples and 3 pears than having ries of experiments to measure the effects of instito consume 6 pears. But if this situation also entails tutions on peoples social preferences. He nds that that nobody shares any of his or her fruits anymore anonymous bargaining (which he associates with with anyone, Adam may well be less happy living in markets) and being exposed to competitive markets such a society. generate more asocial players.

Specically the social and economic environments How does this link with social well-being? It seems in which individuals live their daily lives, affect (by to me that it is plausible to expect that the strength affecting the behaviours of others) their experience of social preferences affect the social integration

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and social acceptance that individuals experience, utility and social well-being. Research shows that in and hence their (social) well-being. This is more apconsidering the relation between the economy and parent if one considers the determinants of social well-being, it is not enough to take the consumption integration and acceptance. Keyes operationalizes of commodities into consideration. The examples these concepts in the aforementioned study by the also caution against the rash and sometimes dogmadegree of agreement with the following statements6: tic tendency of economists (and others) to provide You dont feel you belong to anything youd call a competitive markets and commodication as the community (-), You feel close to other people in solution to any social problem. your community (+) (social integration), You belie ve other people are kind (-), You believe that people The First Fundamental Theorem of Welfare Ecoare self-centered (-), You think that people live only nomics points at a benecial aspect of competitive for themselves (-) (social acceptance) (6). Economic environments that foster social prefebeing by facilitating social integration and social acceptance.
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markets. This is a partial truth. In order to evaluate the well-being effects of competitive markets and other economic structures, and in order to design human well-being, we need a more comprehensive approach. The divers elements and sources of wellbeing and the divers channels through which the economy affects peoples lives should be taken into

rences will thus, ceteris paribus, facilitate social well- future policies and institutions with a view to further

In sum: Economic structures are not neutral meMarkets and economic and social structures in general, affect well-being by affecting peoples behaviours and stance towards each other.

chanisms that merely regulate production and prices. account. Such an undertaking necessitates an interdisciplinary spirit and cooperation between scientists with different scientic backgrounds. A crucial role is gran4. Conclusion Can economists make people happier? In this paper I pointed out and gave examples of two comted for psychology and social psychology as elds concerned with inquiring into human well-being and behaviour. I would like to encourage students and researchers in these areas to get more involved in discussions concerning the desirability of economic efforts in this direction. Perhaps economists and psychologists together can make Adam a happier
6 A minus behind a statement indicates that stronger agreement with the respective statement contributes negatively to social integration or social acceptance, and a plus indicates that stronger agreement contributes positively. 7 The ceteris paribus clause is important. Institutions that facilitate social preferences and thereby social well-being, may at the same time undermine other elements of well-being. For example, in small villages social preferences may be higher because there is greater social pressure in the form of norms and less anonymity, which facilitates the enforcement of these norms. But while social pressure may facilitate social preferences and thereby social well-being it may at the same time lower well-being by undermining for example autonomy.

monly neglected sources of well-being: procedural and social policies and direct more of their research

person.

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