Vilfredo Pareto (1848 – 1924) The contemporary of Edgeworth and working with many of the same issues as he did..

The meaning of “Utility” Sandmo starts out by noticing that until now “utility” has been a word of two interpretations: Normative phenomenon as when Edgeworth discussed optimal distribution of income (if all had the same utility function, the optimal distribution would be to give all individuals the same income). Descriptive phenomenon as a way of explaining the slope of the demand curves and (therefor) of a possible GE. Are we talking about the same thing? Now it gets a little complicated!

Cardinal and ordinal utility 1 Edgeworth had a very concrete understanding of utility (Samuelsson: utility is like jam for breakfast!) “You have utility 7, I have 5 and a new car would give me an extra 2!” That obviously is strange! Edgeworth had this concept of utility and utility functions  then he drew the indifference curves  then he concluded that moving upwards to a higher curve was improving your lot  you could measure your improvement in utility from one curve to the next. You could also talk about increasing total welfare by taking from one citizen and give to another. He had a cardinal utility concept (going back to Bentham)

Cardinal and ordinal utility 2 Pareto wants to assume as little as possible and certainly does not want to work with cardinal utility (as Edgeworth does); Pareto thinks in terms ordinal utility. He is only willing to assign (increasing) numbers to the curves, while similar numbers with Edgeworth had an economic interpretation. In Pareto, indifference curves – their shape and their positions are representing that specific individual’s preferences

Trying to coin a new word: ophelimity (= cardinal utility) Pareto did not like to use the word utility (he believed it to be tainted) at all but talked about ophelimity (= cardinal utility) but did not succeed in coining a word. Economics went on talking about utility and consequently, we go on confusing cardinal and ordinal utility. On the other hand, taking cardinal utility seriously is weird. From these indifference curves, Pareto goes on, derives conditions for utility maximization for the individual consumer, and analyzes the consequences of a price increase: substitution and income effects. Irving Fisher proposed replacing ophelimity (and thus utility as it is commonly construed) with the term wantability

The Slutsky equation A change in demand for good j given a change in its price p j is equal to the substitution effect + income effect. Assume P j goes up, what happens to demand? Always?

Consequences for the analysis of welfare - the Pareto optimum. This is what created Pareto’s fame! When we have ordinal utility, is it possible to say anything about optimality at the macro level? If we cannot compare A’s loss with B’s gain what can we do? “We will say that the members of a collectivity en joy maximum utility in a certain position when it is impossible to find a way of moving from that position very slightly in such a manner that the utility enjoyed by each of the individuals of that collectivity increases”. On the other hand, maximum utility is a strange word when the entire idea is that the utility of the collectivity cannot be measured!

Pareto optimum & Pareo’s law He then compares a centrally planned economy with a market orientated and realizes that he gets nowhere within this framework. He also took an interest in the personal income distribution and believed he could demonstrate a regularity; later know as Pareto’s law – read Sandmo. Appears strange! All persons’ income placed on a scale from lowest to highest. When moving one per cent up from the median income, “Pareto’s law” says that income would increase by 1,5 per cent. Also known as (an example of) the rule. Pareto turned to sociology.