Kotan. Can Economists Make People Happier. the Free Mind. 2007

8/4/2019 Kotan. Can Economists Make People Happier. the Free Mind. 2007

1/616 the free mind|issue 04|October 2007

GUEST WRITING

Can Economists Make People Happier?The insufficiency of the First Theorem of Welfare Economics

Guest Writing

By Murat Kotan1

1. Introduction

Economists have great influence worldwide on the

design and implementation of policies. In the Ne-

therlands, for example, no political party can escape

running their proposed policies through the eco-

nomic models of the Centraal Plan Bureau. The

models predict the impact of these policies on for

instance national income growth, inflation, unem-

ployment and government finance. In view of the

great importance attached in the media to these ty-pes of variables, people generally think that econo-

mics 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 nati-

onal income have onlyderivedvalue: they are of im-

portance as far as they contribute towelfare. Whatever

welfare may mean in ordinary use, in mainstream

economics it ultimately means utility: the experienceof pleasure and the absence of pain.2 Simply put:

economists are - just like psychologists concerned

1 Faculty of Economics and Business, University ofAmsterdam; e-mail: [email protected]. I would like to thank Petra Bo-ers and Geert Reuten for their textual comments, which much impro-ved 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 evaluationof economic policies and economic structures is based. But, as Sen(1991: 19) rightly notes: In the welfarist approach dominant in tra-

ditional welfare economics the case for basing the social evaluationof states on individual preferences turns on the correctness or falsityof the identification of preference with welfare or utility.

with making people happier.

Within the field of economics, welfare economics is

concerned with the evaluation of different eco-

nomic policies and structures. Given that utility is

the variable of interest, welfare economics should

thus be expected to investigate into the many ways

in which the economy and economic policies affect

individuals experience of utility. Unfortunately, this

is not the case. The main focus in mainstream eco-

nomics has been the satisfaction derived from the

consumption of commodities, instead of utility in

general. Among others because of this, competitivemarkets are seen by mainstream economics as the

ideal economic system.

Much of the pleas for competitive markets are ba-

sed on an important theorem in welfare economics,

the so-called First Fundamental Theorem of Welfa-

re Economics. But, as I argue, mainstream welfare

economics narrowness of view concerning well-

being, makes it unfit for the evaluation and recom-mendation of economic structures and policies.

In this paper I broaden the view by treating two

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 first is procedural utility. It concerns

among others the fact that individuals well-being is


2/6the free mind|issue 04| October 2007 17

Guest Writing

affected by the specific procedures under which they

participate in the economy and interact with each

other. The second source is social well-being, arising

from the social embeddedness of individuals.

Before treating these two sources of well-being in

section 3, I explain the First Welfare Theorem for

non-economists in section 2. Can economists make

people happier? They can, concludes section 4. But

not without the help of psychologists and social psy-

chologists.

2. The First Fundamental Theorem of Welfare

Economics: Competitive markets lead to maxi-

mum utility achievable

Competitive markets are advocated by mainstream

economists on utility grounds. Much of the pleas of

economist for markets and competition are (im-

plicitly) based on a major theoretical proposition in

welfare economics: the so-called First FundamentalTheorem of Welfare Economics.

This theorem, henceforth referred to as the first wel-

fare theorem (FWT), states that competitive markets

lead to an economic state of affairs in which every

individual achieves maximum utility from the con-

sumption of commodities, given his scarce resour-

ces, and in which firms provide these commodities

at the lowest possible cost.3

As Gowdy (1) notes this is not an innocent theoreti-

cal result lacking practical consequences:

3 There is, as might be expected, also a Second Fundamen-tal Theorem which will not be treated here. The second theorembasically states that any allocation of commodities that satisfies the

first welfare theorem can be achieved by an initial redistribution ofresources. For a treatment and more formal statement of the welfaretheorems, see any introductory microeconomics textbook.

Armed with the two fundamental Pareto theorems

[the fundamental theorems of welfare economics],

economists attack any problem by attempting to

create the conditions for a competitive economy

Welfare economic models are much more than mild-

ly interesting theoretical toys. These models lie be-

hind the pronouncements of leading economists on

a variety of critical issues including global warming,

international trade and development policies, and bi-

odiversity protection.

To 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 pos-

sible.

Assume Adam has six pears in his possession and

no apples. Assume also that Adam derives pleasu-

re both from the consumption of pears and from

the consumption of apples. However, the additio-nal amount of satisfaction he obtains from pears or

apples decreases with the consumption of an ad-

ditional unit of that fruit. Thus the first pear may

provide Adam a lot of pleasure. The second he also

enjoys but less so then the first. Even the sixth pear

provides him some satisfaction, but little compared

to the first pear.4 The following utility function gi-

ves the relation between the amounts of apples and

pears Adam consumes and the amount of utility heexperiences:

UA

= a1/2 + p1/2 ,

where UA

is Adams utility level, ais the amount of

apples and p is the amount of pears he consumes.

4 The decrease in the additional satisfaction obtained froman additional unit of a good is called decreasing marginal utility ineconomics.



This utility function is used to obtain the tables be-

low.

No fruit market

When no exchange is possible Adam can only con-

sume the pears he has. Table 1 illustrates the amount

of utility Adam experiences from each amount of

pears consumed.

Table 1: Adams level of utility when no market

for fruit exists

Pears utility

0 0

1 1

2 1.41

3 1.73

4 2

5 2.24

6 2.45

Thus, when no exchange is possible, the maximum

level of utility Adam can achieve is 2.45.

Fruit market

Now look how the maximum amount of utility

Adam can achieve changes when trade becomes

possible and he can exchange pears for apples. As-

suming he could exchange one pear for one apple,table 2 illustrates different feasible combinations of

pears and apples Adam can consume, and his corre-

sponding levels of utility.

Table 2: Adams level of utility when a market

for pears exists

Apples utility Pears utility Total

utility

6 2.45 0 0 2.45

5 2.24 1 1 3.24

4 2 2 1.41 3.41

3 1.73 3 1.73 3.46

2 1.41 4 2 3.41

1 1 5 2.24 3.24

0 0 6 2.45 2.45

The maximum amount of utility Adam can achieve

when there isa 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 possi-ble the outcome of the trading process will lead to a

higher level of utility achievable compared to when

trading is not possible. This is in its simplest form

the reason why a lot of economists plea for compe-

titive markets.5 But is Adam really a happier man?

3. Two shortcomings of the First Welfare The-

orem

Quite a few things can be said against the significanceof the First Welfare Theorem in any real-world situ-

ation. 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 utilityand social

well-being.

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

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3.1 Procedural Utility

Procedural utility means that individuals do not care

only about outcomes, but also about the conditionsand

processesthat 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

pear. In other words: he considers the price unfair.

When this is the case, consuming the same amount

of apples and pears his utility derived from con-

sumption may nevertheless be lower than the 3.46 in

table 2. It may even be lower than the 2.45 in table

1.

Frey and Pommerehne (3) find that in a situation

in which unexpected shortages exist, people find

the process through which markets deal with these

shortages (namely by raising prices) unfair. Compa-

red to the market mechanism, other procedures ofdealing with the shortage, such as using the principle

of first come first served or letting local authorities

distribute the goods according to their own judg-

ment, are perceived to be more fair. Only randomly

assigning the goods to individuals is perceived to be

less fair than the market process.

Competition and well-being

A laboratory study by Brandts et al. finds that gene-ral subjective well-being and the emotional state of

players strongly depend on the competitiveness of

the institution players participate in as well as their

position in the competitive environment. (4)

It is important to note that the effects of competi-

tion on well-being and emotions go beyond the ef-

fect it has on material payoffs or consumption. For

example, if Adam gets excluded from trading pears

for apples because the apple seller chose to sell his

limited amount of apples to Eve, Adam will have to

do with the pears he has. Referring back to table 1,

one may expect in line with economic theorys out-

come 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,

competition is detrimental for the subjective well-

being and emotional state of those who are as a con-

sequence of competition excluded from trade. This

means that Adam will experience less well-being

than in the situation where no markets existed.

Brandts et al. (4) find that competition lowers subjec-

tive well-being and triggers more negative emotions

like sadness, envy, anger, irritation and contempt

for those excluded from trade as a consequence of

competition, compared to those who do not expe-

rience competition. This study provides evidence

that markets affect procedural utility and therebywell-being in ways that are usually not accounted for

in mainstream welfare economics.

Thus the exclusive focus on the outcomesof econo-

mic and social processes leaves out import ways in

which 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 howthey got it matters tothem (5). Further research is necessary to assess the

relative importance of material sources of well-being

compared to intangible sources such as procedural

utility. One such research is provided by Frey and

Stutzer (5). The authors argue based on empirical

evidence from Swiss survey data that political par-

ticipation rights have a positive effect on subjective

well-being. According to this study the (procedural)

utility derived from participation rights, contributes

to well-being over and above the favorable outcomes

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the political process generates. The authors under-

take a quantitative comparison between the effects

of participation rights and income, concluding that:

... if the full range of participation rights is con-

sidered, procedural utility accounts for larger diffe-

rences in subjective well-being than the full range of

individual income. (Frey and Stutzer, 2004: 106)

Frey and Stutzer hypothesize that the positive well-

being effects of political participation rights stem

from a feeling of self-determination, control and

influence.

3.2 Social Well-being

Another relation between the economy and well-

being that is commonly neglected is the effect that

economic structures and policies have on social well-

being: that is, well-being stemming from individuals

being embedded in social structures and communi-ties and facing social tasks and challenges (6). Eco-

nomic environments affect individual behaviour,

which in turn affects individuals (social) well-being.

The marketization of society (making market-like

relations the cornerstone of social interaction or the

impinging of markets on all domains of social life)

has undesirable as well as desirable consequences

for individuals well-being in ways not taken into ac-

count by the analysis underlying the FWT. Referringback to Adam, it may well be that he is more satis-

fied consuming his 3 apples and 3 pears than having

to consume 6 pears. But if this situation also entails

that nobody shares any of his or her fruits anymore

with anyone, Adam may well be less happy living in

such a society.

Specifically the social and economic environments

in which individuals live their daily lives, affect (by

affecting the behaviours of others) their experience

of social integrationand social acceptance. Keyes (6) de-

fines social integration as: the evaluation of the

quality of ones relationship to society and commu-

nity. And social acceptance as: the construal of

society through the character and qualities of other

people as a generalized category. He finds that so-

cial integration and social acceptance are negatively

correlated with indicators of subjective well-being

such as anomieand dysphoriaand positively with such

indicators as global life satisfactionand global happiness

with life.

Is there reason to believe that economic structures

affect social well-being? One answer is provided by

laboratory experiments in social psychology and ex-

perimental economics. These experiments show that

social preferences, that is the way people rank dif-

ferent allocations of material payoffs to themselves

and others (7), depend on the framing of the situ-

ation and the conditions under which individuals in-teract. For instance, one experiment (8,9) finds that

when a game is framed as Wall Street Game, the

subjects behave less socially (donate less money to

the other), than when the same game is framed as

Community Game. Similarly, Hoffman et al. (10)

find that subjects donate less money to an other per-

son when a game is framed as an exchange in which

the proposer is called seller and his counterpart is

called buyer compared to when the same game isframed as divide $10. Carpenter (7) conducts a se-

ries of experiments to measure the effects of insti-

tutions on peoples social preferences. He finds that

anonymous bargaining (which he associates with

markets) and being exposed to competitive markets

generate more asocial players.

How does this link with social well-being? It seems

to me that it is plausible to expect that the strength

of social preferences affect the social integration

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and social acceptance that individuals experience,

and hence their (social) well-being. This is more ap-

parent if one considers the determinants of social

integration and acceptance. Keyes operationalizes

these concepts in the aforementioned study by the

degree of agreement with the following statements6:

You dont feel you belong to anything youd call a

community (-), You feel close to other people in

your community (+) (social integration), You belie-

ve other people are kind (-), You believe that people

are self-centered (-), You think that people live only

for themselves (-) (social acceptance) (6).

Economic environments that foster social prefe-

rences will thus, ceteris paribus, facilitate social well-

being by facilitating social integration and social ac-

ceptance.7

In sum: Economic structures are not neutral me-

chanisms that merely regulate production and prices.Markets and economic and social structures in ge-

neral, affect well-being by affecting peoples behavi-

ours and stance towards each other.

4. Conclusion

Can economists make people happier? In this pa-

per I pointed out and gave examples of two com-monly neglected sources of well-being: procedural

6 A minus behind a statement indicates that stronger ag-reement with the respective statement contributes negatively to socialintegration or social acceptance, and a plus indicates that strongeragreement contributes positively.7 The ceteris paribus clause is important. Institutions thatfacilitate social preferences and thereby social well-being, may at thesame time undermine other elements of well-being. For example, insmall villages social preferences may be higher because there is greatersocial pressure in the form of norms and less anonymity, which faci-

litates the enforcement of these norms. But while social pressure mayfacilitate social preferences and thereby social well-being it may at thesame time lower well-being by undermining for example autonomy.

utility and social well-being. Research shows that in

considering the relation between the economy and

well-being, it is not enough to take the consumption

of commodities into consideration. The examples

also caution against the rash and sometimes dogma-

tic tendency of economists (and others) to provide

competitive markets and commodification as the

solution to any social problem.

The First Fundamental Theorem of Welfare Eco-

nomics points at a beneficial aspect of competitive

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

future policies and institutions with a view to further

human well-being, we need a more comprehensive

approach. The divers elements and sources of well-

being and the divers channels through which the

economy affects peoples lives should be taken into

account.

Such an undertaking necessitates an interdisciplinary

spirit and cooperation between scientists with diffe-

rent scientific backgrounds. A crucial role is gran-

ted for psychology and social psychology as fields

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 economicand social policies and direct more of their research

efforts in this direction. Perhaps economists and

psychologists together can make Adam a happier

person.

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Kotan. Can Economists Make People Happier. the Free Mind. 2007