ARROW AND THE FOUNDATIONS OF THE THEORY OF ECONOMIC POLICY Also by George R. Feiwel *ARROW AND THE ASCENT OF MODERN ECONOMIC THEORY (companion volume) *ISSUES IN CONTEMPORARY MACROECONOMICS AND WELFARE (editor) *ISSUES IN CONTEMPORARY MACROECONOMICS AND DISTRIBUTION (editor) SAMUELSON AND NEOCLASSICAL ECONOMICS (editor) THE INTELLECTUAL CAPITAL OF MICHAL KALECKI GROWTH AND REFORMS IN CENTRALLY PLANNED ECONOMIES THE SOVIET QUEST FOR ECONOMIC EFFICIENCY INDUSTRIALIZATION AND PLANNING UNDER POLISH SOCIALISM (2 volumes) NEW ECONOMIC PATTERNS IN CZECHOSLOVAKIA THE ECONOMICS OF A SOCIALIST ENTERPRISE In preparation *JOAN ROBINSON AND MODERN ECONOMIC THEORY (editor) *IMPERFECT COMPETITION REVISITED: JOAN ROBINSON AND BEYOND (editor) *Also published by Palgrave Macmillan Kenneth J. Arrow Arrow and the Foundations of the Theory of Economic Policy Edited by George R. Feiwel Alumni Distinguished Service Professor and Professor of Economics, University of Tennessee M MACMILLAN PRESS © George R. Feiwel 1987 Softcover reprint of the hardcover 1st edition 1987 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright Act 1956 (as amended). Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. First published 1987 Published by THE MACMILLAN PRESS LTD Houndmills, Basingstoke, Hampshire RG2l 2XS and London Companies and representatives throughout the world British Library Cataloguing in Publication Data Arrow and the foundations of the theory of economic policy l. Arrow, Kenneth J. 2. Economics I. Feiwel, George R. 330.1 HBll9.A75 ISBN 978-1-349-07359-7 ISBN 978-1-349-07357-3 (eBook) DOI 10.1007/978-1-349-07357-3 Two-volume set ISBN 978-0-333-42410-0 'The Theory of Economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, a technique of thinking, which helps its possessor to draw correct conclusions.' JoHN MAYNARD KEYNES 'Practical interest in welfare economics has always rested on its role in putting debates on economic policy on a deeper foundation. Arrow's formulation of the problem makes that deeper foundation explicit, and his approach is of central importance to economic policymaking.' AMARTYA SEN 'If I am not for myself, then who is for me? And if I am not for others then who am I? And if not now, when?' RABBI HILLEL Contents Notes on the Contributors xvii Preface xxxiii 1A The Many Dimensions of Kenneth J. Arrow 1 George R. Feiwel 1 Formative Years 2 1.1 Background and Early Outlook 2 1.2 City College and Columbia 9 1.3 Cowles and Rand 15 2 An Impressionistic Portrait of the Man and Scholar 23 3 Values and Opportunities 41 4 Design of Organization 51 4.1 What is an Organization? 52 4.2 Externalities, Transaction Costs, Property Rights, and Profit 55 4.3 Market Failure and Non-market Organizations 67 4.4 Government and Economic Policy 70 5 Freedom, Equality, and Democracy 79 6 Distributive Justice and Efficiency 89 1B Social Choice: the Science of the Impossible? 116 Peter J. Hammond 1 Introduction 116 2 Background 117 3 The Borda Rule and Irrelevant Alternatives 119 4 Independence of Irrelevant Alternatives 122 5 Is Dictatorship the Only General Possibility? 123 6 Interpersonal Comparisons and Independence of Irrelevant Utilities 125 7 Which Alternatives are Relevant? 127 8 Conclusion 128 PART 1: SOCIAL CHOICE, UTILITARIANISM, AND BEYOND 2 Ordinal Utilitarianism 135 Allan F. Gibbard 1 The Problem 137 2 Dividing a Cake 139 Vll Vlll Contents 3 The Egalitarian Planet 141 4 The Bases of Moral Concern 143 5 Epistemological Worries 145 6 Quantities, Norms, and Economics 147 7 Paretian Income Distribution 149 3 Sparks from Arrow's Anvil 154 Paul A. Samuelson 1 Lerner-Vickrey-Samuelson (L-V-S) 'Extended Sympathy' 155 2 No Necessity for Additive Utilities 157 3 Taking the Sympathy Out of 'Extended Sympathy' 157 4 Lerner's Way 159 5 A Better Way? 160 6 Harsanyi's Additive Ethics 161 7 The Bentham-Harsanyi Straitjacket 163 8 Rawls's Gratuitism 166 9 Foley-Varian Fairness 168 10 Relevance of So-called Irrelevants? 169 11 Finale 171 4 On Reconciling Arrow's Theory of Social Choice With Harsanyi's Fundamental Utilitarianism 179 Peter J. Hammond 1 Introduction and Outline 179 2 Motivation for Consequentialism 183 3 Consequentialism and Ordinal Choice 184 4 Consequentialism and Expected Utility 188 5 Social Choice of Interpersonal Consequences 189 6 Individual Norms and Ethical Liberalism 190 7 An 'Idealized' Vickrey-Harsanyi Utilitarianism 193 8 The Fundamental Individual Norm and Harsanyi's Utilitarianism in Idealized Form 195 9 Independence of Irrelevant Althernatives and Dictatorship 198 10 Independence of Ethically Irrelevant Consequences 200 11 Domain Restrictions Implied by Ethical Liberalism and the Fundamental Individual Norm 203 12 Ethical Dictatorship of the Fundamental Individual Norm 205 13 Consumer Sovereignty, Attitudes to Risk, and the Distribution of Income 208 Contents IX 14 Risk-Taking Behaviour and the Basic Theorems of Classical Welfare Economics 210 15 Conclusion 214 5 Arrow's Independence Condition and the Bergson-Samuelson Tradition 223 Murray Kemp and Yew-Kwang Ng 1 The Three Components of Condition IIA: Individualism, Ordinalism, and Independence 224 2 The Bergson-Samuelson Tradition Implies All Three Components 228 3 Samuelson's and Mayston's Counter Arguments 230 Appendix: Arrow, Samuelson, and Ordinalism 235 I Background 236 2 Ordinalism in Name 236 3 Ordinalism in Substance 238 6 Maximizing Freedom of Decision: an Axiomatic Analysis 243 Patrick Suppes 1 Axioms on Freedom 244 1.1 Basic Concepts 244 1.2Axioms 244 2 Models of the Axioms 245 2.1 Benthamite Maximizer 247 2.2 Cardinality Maximizer 248 2.3 Qua-Maximizer 248 3 Aggregation of Freedom Preferences 249 4 Approximate Measurement of Freedom 251 7 Arrow and the Problem of Social Choice 255 Kotaro Suzumura and Koichi Suga 1 Introduction 255 2 Pareto Libertarian Paradox: hie rhodus, hie salta 256 3 Golden Rule: First Interpretation 258 4 Golden Rule: Second Interpretation 259 5 A Formal Model of Social Decision Making 262 6 Conclusion 268 8 Utilitarianism and Modern Economics 273 Gunnar M yrdal X Contents PART II: WELFARE AND DISTRIBUTION 9 The Optimum Order Revisited 281 Jan Tinbergen 1 Scope and Nature of the Subject 281 1.1 Why Revisit the Subject? 281 1.2 The Concept of Social Order and the Variables Entering its Analysis 282 1.3 Institutions, their Operation Equations, and the Optimal Order 283 1.4 Scientific Strategy Chosen 284 1.5 Notation Used in Illustrative Models 286 1.6 Organization of the Argument 287 2 Relevance of the Concept of an Optimal Social Order 288 2.1 Co-existence of Many Differing Social Orders 288 2.2 Opinions on Optimal Social Order 289 2.3 An Optional Social Order as a Long-term Goal 290 2.4 Changes in Data and Preferences 290 2.5 Changes in Different Cultures 291 2.6 Conclusion 292 3 Variables, Relations, and Simplifying Assumptions 292 3.1 Goods and Services, Private or Collective; Role in Welfare Functions 292 3.2 Actors, Production Factors; Workers and Occupations; Learning 293 3.3 Production Processes; Hierarchies; Counterproduction; Production Functions 295 3.4 Welfare: its Measurement, Determinants, and Aggregation 297 3.5 The Social Welfare Function 298 3.6 Externalities and the Costs of Institutions 299 3. 7 Role of Ownership 300 4 Aspects of the Optimal Order 301 4.1 The Role of Markets; Two-part Pricing as a General Device 301 4.2 Labour of Different Qualities and Occupations 303 4.3 Private and Collective Goods 308 4.4 Income Redistribution; Equity 312 4.5 The International Division of Labour 314 4.6 Optimum Level of Decision Making 316 Contents xi 4. 7 Dynamics of the Optimum Order; Exhaustibility of Resources 317 5 Relevant Differences Between Optimal and Existing Orders 319 5.1 Introduction; Discrimination 3I9 5.2 Oligopolies 320 5.3 Deviations in Redistribution 321 5.4 Non-optimal Collective Sector 322 5.5 International Division of Labour 323 5.6 Decision Structure 323 10 Information, Welfare, and Product Diversity 328 Steven C. Salop and Joseph E. Stiglitz 1 Introduction 328 2 The Model 330 3 Effects of Reducing the Cost of Information 334 4 Effect of Imperfect Information on the Value of Diversity 336 5 Conclusion 339 11 On the Fair Allocation of Indivisible Goods 341 Eric S. Maskin 1 Introduction 341 2 The Model 342 3 Fair Allocations 345 12 Income Distribution and Differences in Needs 350 Anthony B. Atkinson and Franfois Bourguignon I Introduction 350 2 Dominance for All Groups 352 3 The Interrelation Between Income and Needs 356 4 Second-degree Dominance for Incomes 359 5 Second-degree Dominance for Needs 364 6 Conclusion 366 Appendix: Necessity of Dominance Conditions 367 13 When is a Fixed Income Distribution Optimal? 371 John S. Chipman I Introduction 371 2 Formulation and Solution of the Problem 373 3 Conclusion 378 Xll Contents 14 Peak Pricing, Congestion, and Fairness 382 William J. Baumol and Dietrich Fischer 1 Fairness and Peak Pricing 383 1.1 On the Criteria of Equity 383 1.2 The Possibility of Pareto Improvement in the Classical Peak-Pricing Model 385 1.3 Sufficient Conditions for Peak Pricing not to be a Pareto Improvement 385 1.4 Cases where Peak Pricing can be a Pareto Improvement 388 1.5 Pareto Improvement under Scale Diseconomies 389