I don’t get welfare analysis. I don’t. If you do, please let me know.
In posts on Stigler, MWG, Rothbard, and Buchanan, I have questioned the use of welfare analysis in economics. I can regurgitate the expressions that welfare economists use, but the supposed benefits of the model confuse me. That’s why I am appealing to the brighter minds online.
The standard picture is below. In any market with a market-clearing price, P, there are certain consumers who would pay more if they had to. How do we know they would pay more? Stop asking stupid questions. We know everything. Well, we assume we know everything about everything that the person wants, that’s how. OK. Let’s ignore that problem for now.
The most willing person is at point A. He would pay A dollars, but only pays P. Lucky him. Therefore, he receives a “surplus” of A minus P dollars. This approach similarly holds for producers. There is someone who would be willing to sell at price E. Instead, he sells at P and gains P minus E. Big money.
The gap in dollars is some sort of “welfare”. For this post, I’m not even worried about the comparison between dollars and utility here. I will act like a conversion between dollars and utils exists- we can’t reject all premises at once.
One popular corollary of this is a deadweight loss, depicted below. For example, if governments tax a good, the buyer now has to pay P1 and only Q1 of the good sells. Fewer people benefit from trade, because the tax discourages the marginal traders from trading. The colored area is the deadweight loss, because the potential benefit goes to no one. It is simply lost.
From this, economists derive a crude utilitarian analysis which tries to maximize the colored size, the left triangle, on the first graph. A greater area means people are better off. It is trying to measure benefits minus costs. The consumer surplus is the analog of a producer’s profit. A rational consumer/producer maximizes benefit minus cost.
The problem is that economists are creating a symmetric theory for an asymmetric world. This idea does not work for consumer theory. The cost of buying one of the goods above is not the price P, but the next best thing I could have done with that money, i.e. opportunity cost. Repeat after me, cost means opportunity cost. Economists learn this on day one and forget it on day two.
Therefore, even assuming we can use money as a measure of utility, the benefit is the willingness to pay and the cost is the willingness to pay for the next best option. This difference is then the “profit.” However, this cannot be shown using the started supply and demand graph. The above graph does not show profit, but benefits minus some constant. It is like a producer was trying to maximize revenue minus 200 dollars. This does not make sense.
The person on the far left could have a next best option, which is really good, thus making almost no “profit.” A person in the middle might have no other good option, thus making a large “profit.” All that graph shows is revenue.
The confusion reared its head when I was thinking about an extreme example. Suppose there is a market for marijuana. One day the government decides to ban it and the ban actually works. Graphically, the price is forced above the highest consumer’s willingness to pay. Then the whole triangle on the left half is a deadweight loss. There is no consumer surplus.
This does not make sense. I am not left with zero surplus. Instead, I choose to spend my P dollars on something else, where I gain a surplus. I move to a new market, with a new supply and demand, and earn a surplus there.
The problem, on top of comparing utilities, stems from the partial equilibrium analysis used in standard welfare analysis. While it makes sense to talk about a company’s profit in one market, it does not make sense to talk about a person’s profit in one market. Profits can be separated across markets. People’s welfare is necessarily a general equilibrium concept. My welfare from work cannot be separated from my welfare from home.
This is the classic partial versus general equilibrium debate. The common reason for doing partial equilibrium analysis is that it is more manageable. It is easier to focus on one market. This makes sense when the goal is making predictions.
However, when economists try to do pseudo-philosophy through welfare analysis, the prediction benefit disappears and we are left without the general part of general equilibrium. Looking at someone’s welfare in one market will clearly obscure the picture. The profit of this approach is negative.
Again, the method that economists use falls short before the point where they want to use it. Let’s stick to using partial equilibrium because it allows for predictions. If we want to do more, say provide a cost/benefit analysis, we need to use general equilibrium and incorporate opportunity cost.