Welfare Economics
• Chapter 3 Lecture Slides
• Focus: Social Welfare and Economic Efficiency
Introduction
• Welfare Economics studies social well-being
• Welfare economics analyzes social welfare.
• Social welfare refers to the overall welfare of society.
• Focuses on individuals and society
• Concerned with efficiency and fairness
• how resources can be allocated to maximize social welfare.
• It evaluates economic policies based on their impact on:
✓ Efficiency
✓ Equity (fairness)
✓ Overall social welfare
Social Welfare
• Sum of individual well-being
• Individuals are the basic units
• No welfare without individuals
Measurement of Welfare
• Cardinal: measured in numbers (money, utils)
• Ordinal: measured by ranking preferences
Pareto Efficiency
• Improves welfare if:
• At least one person is better off
• No one is worse off
Allocation vs Distribution
• Efficiency: proper use of resources
• Equity: fair distribution of income
• Both are important
• Early economists focused onevolution
3.2. Historical wealth of welfare
• Later included happinesseconomics
and equality
• Welfare idea expanded over time
• The classical economists emphasized production, supply and
costs
• the welfare economists lay stress on consumption, utility and
demand.
• England is the home of the welfare economics.
• Classical economics ignores the interdependence of diverse
dimension of economy
• concentrate on one dimension at a time.
• Early economists focused onevolution
3.2. Historical wealth of welfare
• Later included happinesseconomics
and equality
• Welfare idea expanded over time
• The classical economists emphasized production, supply and
costs
• the welfare economists lay stress on consumption, utility and
demand.
• England is the home of the welfare economics.
• Classical economics ignores the interdependence of diverse
dimension of economy
• concentrate on one dimension at a time.
Continued……
• The 20th Century welfare economics is realistic and pragmatic.
• Alfred Marshall has been regarded as the founder of welfare
economics.
• He provided the concepts of consumer’s surplus and producers’
surplus.
• Positive economics tended to judge the allocation of productive
resource.
3.3. Approaches of welfare
economics
• There are two mainstream approaches to welfare economics: the old
neoclassical approach and the new welfare economics approach
• Utility is cardinal, that is, scale-measurable by observation or judgment.
• Preference is exogenously given and stable.
• Additional consumption provides smaller and smaller increases in utility
• All individuals have interpersonally comparable utility functions.
❖ Old welfare economics: value is measured in terms of usefulness.
• Efficiency-based (Pareto)
• Distribution-based (equity)
• Modern approach combines both
3.3.1. Early Neo-classical approaches
[Link]. Sidgwick( 1838-1900)
✓ He argues that there may be externalities.
✓ Positive externalities are activities that yield benefit
✓ negative externalities are activities that impose costs on others
✓ government intervention is necessary if such divergence prevails.
[Link]. Alfred Marshall (1842-1924)
✓ raised the possibility & significance of divergence between
private & social product.
✓ The possibility is associated with associated with the cases of
long run increasing & decreasing cost industries.
✓ His analysis was based on two assumptions:
1. Marginal utility of real money is constant, implying that
demand is independent of income.
2. 2. Utility is measurable (can be quantified) – cardinal utility.
Mux/Px= P Muy/ PY
Key Principles
• Individual preferences matter
• Efficiency is important
• Equity improves welfare
[Link] ARTHUR CECIL PIGOU
❖ He dealt with three things
(1) a definition of economic welfare
(2) spelling out the condition under which welfare is maximized
(3) pronouncement of policy recommendations for increasing
welfare.
❖ He may be credited with establishing a scientific welfare
economics.
❖ He had also suggested that the problem of unemployment
could be solved through the manipulation of wages.
❖ For him, the chief aim of economic science will be unrealistic.
A. Definition of economic welfare
➢ Economic welfare refers to the part of human well-
being that can be measured in monetary terms and is
directly related to the consumption of goods and
services.
➢ Economic welfare depends upon the size, the manner of
distribution, and the variability of the national dividend.
➢ Economic welfare is the level of satisfaction or well-being
people get from consuming goods and services that can
be measured in money.
B. Condition for maximization of
social welfare
➢ According to Marshall, the national income represents the
general welfare.
➢ Pigou believes that welfare is not only dependent on the size of
the nation’s income but also on the equality of its distribution,
i.e. the more the equality of the distribution of income the
higher will be the level of welfare.
➢ Economic welfare is generally proportional to the size of the
national income.
➢ He argued that state should protect transfer of purchasing
power from the rich to the poor.
➢ He favored an income equalization policy.
Continued….
➢ He lays down two conditions for the maximizations of
welfare:
(i) given the taste and income distribution, an increase in
national income represents an increase in welfare.
(ii) (ii) For welfare maximization, the distribution of
national income is equally important.
➢ If national income remains constant, transfer of income
from rich to the poor would improve welfare.
C. Difference between social and private benefit
and cost
❑ private product being the product that accrues to the individual making a
decision concerning production.
❑ Social net product being the net product that accrues to society as a result
of the decision.
❑ The private marginal, cost of a commodity is the cost of producing an
additional unit.
❑ The social marginal cost is the expense or damage to society as a
consequence of producing that commodity.
❑ Private marginal benefit can be measured by the selling price of the
commodity.
❑ Social marginal benefit refers to the total benefit that society gets from the
production of an additional unit.
Pigou lists three groups of divergence between social
and private costs and benefits.
1. There is the fact that the tenancy and ownership of
certain durable instruments of production are in effect
separated from each other.
2. The source of divergence between social and private
measures of marginal benefits may be put in terms of
what we now call the public goods to the principle of
exclusion.
3. Pigou also talks of the elasticity of demand which these
specific goods and the criterions as to whether their
consumption is to be encouraged or discouraged.
[Link] Wilfred Pareto
A. Pareto Optimality
✓ everyone is the best judge of his own interests and that this
welfare depends upon economic variables only and there are no
externalities involved in the process.
✓ Maximum welfare occurs when there are no longer any changes
that will make someone better off while making no one worse
off.
✓ This implies that society cannot rearrange the allocation of
resources or the distribution of goods and services in such a
way that it aids someone without harming someone else.
According to Pareto, the following
are the conditions of this optimum:
1. Optimal distribution of goods:
2. Optimal technical allocation of resources
3. Optimal quantities of output
❖There are a number of conditions that, most economists
agree, may lead to inefficiency. They are:
❖imperfect market structures, such as a monopoly,
monopsony, oligopoly, oligopsony, and monopolistic
competition, factor allocation inefficiencies in production
theory basics, market failures and externalities.
3.3.1 New Welfare Economics
▪ The new welfare economics is normative in character and is free from value
judgments and utility measurement.
▪ New Welfare Economics accepted the argument that utility is not
comparable across people.
▪ There are three objectives of the new welfare economics:
✓ To clarify and express in terms of quantity the vague concepts of riches.
✓ To clarify what it is that the economists have to say on matters of public
policy which are, from the economic point of view, desirable or not
✓ To develop those propositions which are scientifically free from ethical
considerations and which can serve as a basis for policy making.
[Link] Basic assumptions and tools to new
welfare economics.
I. Ordinal preferences and indifference curves
✓ NWE rests on the assumption of rational preferences.
✓ The notion of rationality here essentially only states that
preferences are complete and transitive.
✓ The indifference curve separates preferred from less preferred
alternatives.
✓ the individual is indifferent between all the alternatives that lie
exactly on the curve.
✓ An important assumption often made is that preferences are
convex.
II. The Edgeworth box, Pareto efficiency and
the two fundamental theorems of Welfare
economics
✓ It illustrates all possible allocations of two goods
among two individuals.
✓ Any point in the box represents an allocation of the
two goods between the two individuals.
✓ These allocations are called Pareto efficient or Pareto
optimal.
[Link]. The Kaldor-Hicks compensation criterion and
the Bergson-Samuelson social welfare function
• attempted to show that the choice of social optimum was
a positive question rather than a normative.
[Link]. Bergson-Samuelson approach to new welfare
economics
✓ successful in establishing criteria for a social optimum.
✓ also used a more controversial method: the social welfare
function (SWF).
✓ W=f(u,u2,u3…..un)