The Market’s Social Welfare Function
Balancing Present Needs and Future Growth
Social welfare functions have played a significant, if at times understated, role in the history of economics, serving as a formal framework through which economists attempt to capture the overall wellbeing of society. Even though support for social welfare functions has waned in some circles, they remain vital for understanding how private behavior can, under favorable conditions, promote overall prosperity. In this post, I will explore how the “market’s social welfare function” aims toward two goals: first, allocating resources more efficiently in the present; and second, accumulating capital to support long-term growth.
Two Types of Efficiency
As I have pointed out elsewhere, it’s useful to distinguish between static and dynamic efficiency. Static efficiency refers to the optimal allocation of current output given present preferences. This is the type of efficiency usually emphasized in undergraduate economics textbooks. Dynamic efficiency, meanwhile, concerns whether resources are allocated in a way that achieves a “golden rule” rate of economic growth—one that maximizes consumption, broadly defined, over time.
To improve social welfare, according to the logic of the market, an activity should improve static and dynamic efficiency simultaneously. This is notable because these two forms of efficiency are often in conflict. If profits today are reinvested in pursuit of returns tomorrow, this often requires sacrifices to current consumption that we’d rather not make. Likewise, satisfying present preferences typically involves saving less than the golden rule rate of growth would require, resulting in a cost in the form of lower economic growth.
Capital as the “Term of the Highest Degree”
Capital accumulation, broadly defined, is a primary driver of long-run well-being. The evidence over centuries shows how expanding a society’s capital stock creates a virtuous cycle. Profitable enterprises accumulate capital, whose returns are then reinvested in more capital, spurring new technologies, human capabilities and production frontiers. This process fuels economic growth and supports higher levels of future consumption.
The returns to capital tend to be larger than the returns to other benefits typically included in a cost-benefit type analysis. Returns from environmental amenities, for example, generally cannot be reinvested in a way that compounds over time like returns from financial, physical or human capital can. Even when such benefits do have compounding effects, it is often because they indirectly influence capital accumulation—for instance, through the impact of pollution on human health, which in turn affects labor productivity. In this sense, capital is the “term of the highest degree” in the cost-benefit function. It grows exponentially at the most rapid rate, making it the sole determinant of long-run welfare “in the limit.”
The phenomenon of increasing returns further reinforces capital’s dominance in economic analysis relative to nonmarket factors. Thanks to mechanisms like learning-by-doing, network effects, and technological and information spillovers, each additional unit of capital investment often generates more output than the previous one. This dynamic helps explain the persistent dominance of certain individuals, firms, cities, and even nations, and it is a recurring feature of capital accumulation in many markets. Even where returns are diminishing, the fungibility of money allows investors to easily move their financial capital in and out of markets.
Meanwhile, at the same time as profit-seeking firms contribute to capital deepening, they also respond to current consumer demand. If they fail to do so, they go out of business. In this way, the market naturally incorporates static concerns into its logic. Firms have no ability to expand their capital base if they do not simultaneously earn profits producing goods and services that someone wants to buy.
Where the Invisible Hand Can Go Wrong
Once we understand how markets can get things right, it’s equally important to recognize where they can go wrong. While markets can allocate resources efficiently and promote long-term growth, they are not immune to failure. Some ventures that are profitable and satisfy consumers can ultimately be socially unproductive for a variety of reasons.
For example, “unproductive entrepreneurship” can attract capital but waste societal resources. Rent seeking for public funds is well-known, but competition for private investment among startups and established firms can also devolve into rent-seeking behavior. This occurs when excessive amounts of capital are expended jostling for the favor of venture capitalists or other financiers. Such competition can generate useful information by helping to discover the best new ideas, but it can also introduce waste and inefficiency, particularly when the costs of competing exceed the value of the investment capital being pursued.
Another problem arises when buyers and sellers have different savings rates. If business profits are distributed to entities that save less relative to the original buyers, profitable activities can lead to capital stock reductions. Yet another issue arises when the returns to capital investments are prematurely exhausted or liquidated. When this happens, other forms of investment, such as in environmental protection, may be more efficient than investment in market capital.
Beyond that, it is already well-known that externalities can degrade efficiency, in both static and dynamic terms. A polluting factory might maximize profit for its owners and provide sought-after goods to consumers, while still imposing external costs on third parties both now and in the future.
Characteristics of the Objective Social Welfare Function
Of the market social welfare function’s two requirements, one takes priority over the other. The compounding returns from capital accumulation are so powerful that, over time, returns from investments in capital, technology, and skills tend to dwarf static concerns in their impacts on welfare. Put differently, improvements in dynamic efficiency can usually pay for losses in static efficiency stemming from the wealth generated.
In a business context, no business can survive indefinitely if it provides goods and services at a loss. The risk of business failure must take priority over serving present needs, though both profit and consumer satisfaction are ultimately required for a business venture to succeed.
One reason this two-tier arrangement is compelling is that it aligns with our ethical concern for balancing the needs of present and future generations. The market’s social welfare function attempts to accommodate these competing interests. Indeed, a major problem with modern cost-benefit analysis is that it elevates the secondary matter, short-run static concerns, to the primary objective, while largely neglecting dynamic efficiency.
Why Trust the Market’s SWF?
History repeatedly shows that market-driven capital accumulation has lifted societies from subsistence to abundance. Time and again, profit incentives have proven essential for driving progress. This empirical track record offers strong support for the market’s social welfare function. It likewise provides a strong empirical basis for using dollars—or other relevant monetary unit—as the numeraire, or measuring stick, in any social welfare analysis.
The compounding effects of capital will tend to dominate over other concerns in the long run, so focusing on promoting dynamic efficiency eventually promotes higher living standards. In this sense, we may observe a long-run convergence between what the market evaluates and what is conventionally understood as social welfare.
Importantly, market logic also provides a potential solution to the ethical challenge of balancing interests across time. Economists continue to struggle with defining a welfare measure that gives appropriate weight to both current preferences and future well-being. The market approach offers a plausible framework for doing so.
Concluding Thoughts
When the market process works well, profit-seeking entities’ interests align with social welfare in a manner akin to the fabled invisible hand, delivering goods for today’s consumers and a foundation for future prosperity. Recognizing where this process succeeds and where it fails is a core job of economists.
By examining institutional, cultural, and legal conditions that enable or impede these efficiency objectives, we can improve our understanding of how real-world markets operate and guide society toward improved outcomes. A natural process has emerged that is “the product of human action but not of human design,” one which promotes social welfare, albeit imperfectly. By addressing externalities, discouraging unproductive entrepreneurship, and promoting capital accumulation, market outcomes can be further improved upon through human ingenuity.