Happiness and Economics: How the Economy and Institutions Affect Human Well-Being

CHAPTER 2 Well-Being and Economics

Chapter 2 WELL-BEING AND ECONOMICS 2.1 The Conventional View of Utility in Economics The 1930s witnessed a revolutionary change in the concept of utility . Economists—in particular, those inspired by the influential Lionel Robbins (1932)—became convinced that utility could not be cardinally measured. Utility should be used to explain the choices made by individuals between various goods. Empirically, utility should be inferred from the choices actually made. It is therefore appropriate to speak of “decision utility” in the sense of a preference index indicating whether good A is preferred to good B. Since World War II, this so-called new welfare economics has become the conventional view enshrined in a myriad of theoretical treatises and textbooks. The idea that utility should be cardinally measured in order to explain individual choices has been given up completely in favor of ordinal utility. In order for utility to be reflected in revealed behavior, individuals are required to be well (or even completely) informed, aware of the choices made, and consistent in their wishes. Utility has just become a number without any further substantive meaning whatsoever. The switch from the idea of measurable cardinal utility to a preference index of ordinal utility—graphically represented by the consumer indifference curves—was successful in economics for two good reasons: (a) States of minds, such as how much satisfaction or pleasure a good yields, are inherently difficult to measure. Economists endeavoring a scientific approach to their discipline are deeply skeptical about the possibility of being able to measure utility. (b) Cardinal utility is not necessary for economic theory. Hicks (1934) and Allen (1934) demonstrated early on that demand theory can be entirely grounded on ordinal utility in the form of a preference index. Samuelson (1938) formulated the general behav- 20 CHAPTER 2 ioristic foundations of standard theory, in which it is axiomatically taken that utility is no more than preference. A definitional chain is established, relating utility exclusively to choice behavior. Observed choice, in turn, is the only basis of empirical knowledge about individuals’ utility. But no empirical knowledge of persons’ emotional states or opinions about their utility is needed to explain the choices individuals make between goods in markets . Houthakker (1950) and Uzawa (1960) gave revealed preference theory its present form: For any observed demand function satisfying some undisputed conditions of regularity, there exist unique, well-ordered preferences over commodities rationalizing the demand function if, and only if, a set of axioms of revealed preference is satisfied by demand. The preference axioms require consistency, in the sense that choices made by consumers from different budget sets correspond to the choices individuals would have made had they consciously maximized a binary preference relation. Everyone is thus assumed to have pursued their wellde fined goals in markets in the best possible way. Gary Becker (1962) was able to go one step further. He showed that it is possible to derive the most important implication of demand theory—that a price rise induces a fall in demand, all other influences being constant—without using any concept of utility. Modern economic theory has thus taken a huge step away from a substantive and empirically measurable idea of utility in terms of satisfaction or pleasure. A major exception where cardinal utility is needed is cost-benefit analysis, in which specific projects such as bridges, harbors , or roads are evaluated. But otherwise, especially in prestigious “pure” theory, the arguments adduced in favor of empty preferences still have wide prevalence today. 2.2 A Reconsideration Another dramatic change has taken place recently: A movement has arisen within economics that claims that utility should be given content in terms of happiness, and that it can, and should, be measured. This turnaround has resulted from four major developments: (a) More and more evidence has been accumulated suggesting that individual preferences and individual happiness are distinct and WELL-BEING AND ECONOMICS 21 may often diverge. Most importantly, it has become clear that much behavior observed in real life—such as giving to charities or offering volunteer labor—cannot be well explained by solely self-concerned preferences. This applies not only to market behavior , but even more to social activities, such as voting in politics or contributing to public goods. To the extent that such behavior is attributed to altruistic motives, it is no longer possible to establish a direct relationship between observed...