Chapter Five
Welfare Economics
5.1 Definition of Welfare Economics
Welfare can be defined as the branch of economic science which evolutes alternative
economic situation ( i.e. alternative pattern of resource allocations) from the view
point of economic well being of the society as a whole.
To illustrate this definition assume that the total welfare in an economy or a country is
W, but given the factor endowments ( resources) and the state of technology suppose
that this welfare could be large, for example W* that tasks of welfare economics are
a. To show the present state W <W* and
b. To suggest ways of raising W to W*
Criteria of Social Welfare
Various criteria of social welfare have been suggested by economists of different
times. We will discuss briefly some of these criteria. The whole discussion is
broadly divided into:
I. Classical welfare criteria
II. Neo classical welfare criteria
III. Paretian welfare economics
IV. Post Paretian contributions to welfare economics
I. Classical Welfare Economics
( Adam smith’s Welfare Criteria)
Adam smith implicitly accepted the growth of the wealth of the society, i.e. the
growth of the GNP as welfare criteria. The final aim of all production is consumption
and increase in consumption results in increase in the level of satisfaction. Therefore
an increase in GNP ( or wealth) leads to an increase in the level of satisfaction ( or
welfare) ( It shows that there is direct r/n b/n the two).
Distribution of national wealth was only a subsidiary theme to Adam smith.
With respect to resource allocation, he assumed that free competition in the market
leads to optimum allocation of resources.
Adam smith’s welfare criteria assumes existing income distribution as just.
Since growth in GNP might result in inequalities of income distribution and reduction
of social welfare
I. Neo – classical welfare economics
The neo- classical welfare economics refers to the welfare propositions which
emerged from the mixture b/n classical economic ideas and those of the marginal
utility school.
* Major contributors of the Neo- classical welfare
1. Sidegewick:- He accepts the classical view that increases in
production of the total national output increases total social welfare. In
addition he favored the view that a more equal distribution of income
tends to increase welfare.
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2. Bentham:- He argued that welfare is improved when the greatest good
is secured for the greatest number Implicate in this opinion is that total
welfare is the sum of the utilities of the individuals of the society
W = UA + UB + UC+------+ UN
3. Pigou:- Pigou argued that the economic welfare of an individual
implies the total utility he derives from the goods and services.
Following Bentham, he defined the welfare of a society as the
arithmetic sum of utilities of individuals of the society.
Pigou adopted dual criteria for judging the improvement in social welfare. His dual
criteria may be stated as increases in the value of national income without
corresponding to increase in the supply of factors and transfer income from rich to
poor indicate increase in welfare He provided additional qualifications to his dual
criteria as follows.
In regard to the first criterion he felt that national dividend could be increased given
constant factors supply, either by increasing some goods without diminishing the
production of others or transferring factors to activities in which their social value is
higher. Any such increase in national dividend without decreases in the share of the
share of the poor is to be regarded as improvement in social welfare.
Regarding the 2nd criterion he suggested that redistribution of national income must
not lead to decrease the national dividend. Thus, he proposed that any reorganization
of the economy or redistribution of income which increases the shares of the poor
without causing reduction in the national dividend as an improvement in the social
welfare
Weakness of the Neo- classical economics
- Utility can not be measured cardinally.
- Composition of national output is was not taken to account.
II. The Paretian welfare Economics / pareto optimality
criteria/
According to Pareto criterion any change that makes at least one person better off
without making some one else worse off definitely causes an improvement in
social welfare. Conversely any change that makes at least one person worse off
and no one better off causes decreases in social welfare.
The criterion can be stated in some what d/nt way A situation in which it is
impossible to make any one better off without some making some one worse off
is said to be pareto optimal or pareto – efficient for the attainment of a pareto
efficient situation .In an economy three marginal conditions must be satisfied
i. Efficiency of distribution of commodities among consumers ( efficiency in
exchange)
ii. Efficiency of the allocation of factors among firms ( efficiency of
production)
iii. Efficiency of in allocation of factors among commodities ( efficiency in
the product – mix or composition of output)
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Assumptions for 2x2x2 model
1. Tow commodities (X & Y) two consumers (A&B) two factors (K & L)
and two firms
2. consumers maximize their respective utility functions which are
independent of each other
3. Factors K&L are homogeneous perfectly divisible and available in
fixed quantities which are exogenously determined. Both factors are
used in production of each goods.
4. Production function of both goods are given
5. There is perfect competition in both product & factor markets .
A. Efficiency of Distribution of Commodities among
Consumers
Pareto optimality in exchange is achieved when allocation of the given commodities
X & Y b/n the two consumers is impossible by redistribution of these goods to
increase the utility of one individual without reducing the utility of the other.
Points on the contract curve of exchange satisfy the Pareto optimality conditions;but
any movement by person A towards B’s origin will make A better off and B worse off
and vice versa
Any other distribution of the contract curve is inefficient and any movement towards
the contract curve improves social welfare. At each point on the contract curve of
exchange the following condition is satisfied
MRSAx,y = MRSBx,y
The marginal condition for a pareto – optimal or efficient distribution of
commodities among consumers requires that the MRS b/n the two goods be
equal for all consumers
B. Efficiency of Allocaiton of factors Among producers
Pareto optimality in allocation of factors (L&K) requires that factors are so allocated
to the various goods (x&y) that it is not possible to increase the output of any
commodity, by reallocating factors, without causing decrease in the production of
another. This will be on the contract curve of production. At each points on this
curve
MRTSxL,K = MRTSyL,K
The marginal condition for pareto optimal or efficient allocation of factor
input requires that the MRTS b/n labor and capital be equal for all
commodities produced by all firms.
C. Efficiency in the Composition of out put ( product Mix)
Recall that the slope of PPC is called MRPTx,y and it shows the amount of Y that must
be sacrificed in order to obtain an additional unit of X. In other words, the MRPT x,y is
the rate at w/c a good can be transformed in to another.
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The marginal condition for pareto – optimal or efficient composition of output
requires that MRPT b/n any two commodities be equal to the MRS b/n the same two
goods.
MRPT xy = MRSA x,y = MRSx,By
In summary a pareto – optimal state in the economy can be attained in if the following
marginal conditions are fulfilled.
1. The MRS x,yb/n any two goods equal for all consumers
2. The MRTSL,K b/n any two inputs be equal in production of all commodities
3. The MRPT x,y be equal to the MRSx,y for any two goods.
A situation may be pareto – optimal with out maximizing social welfare, i.e. pareto
optimality is a necessary but not sufficient condition for welfare maximization.
The main Weaknesses of the pareto criteria are:-
1. A pareto optimal situation doesn’t guarantee the maximization of social
welfare. Any points on the PPC represent a pareto – efficient situation but to
decide w/c of these points yields maximum social welfare we need an
interpersonal comparison of individual’s utility. Thus, Pareto – optimality
offers only a necessary but not sufficient condition of welfare maximization.
2. The pareto – optimality cannot evaluate a change that makes some individuals
better off and others worse off since most government policies involve
changes that benefit some and harm others it is obvious that the strict pareto
criterion is of limited applicability in real world situations.
IV Past Paretian Welfare Economics
A The Kaldor – Hicks “compensation Criterion
Assume that a change in the economy is being considered, w/c will benefit some
(‘gainers’) how much money they would be prepared to pay in order to have the
change and the ‘losers’ how much money they would be prepared to pay in order to
prevent the change. If the amount of money of the ‘gainers’ constitutes an
improvement in social welfare b/c the ‘gainers’ could compensate the ‘losers’ and still
have some ‘net gain’. Thus, the Kaldor –Hicks ‘compensation criterion’ states that a
change constitutes an improvement in social welfare if those who benefit from it
could compensate those who are hurt, and still be left with some ‘net gain’.
Whether compensation is actually paid or not is in kaldor’s opinion is that, it is a
matter of political or ethical decision. In the welfare criteria, compensation is simply
a measure of loser’s lose. In formulating his criterion for judging the social
desirability of economic change, Kaldor merely suggests that gainers must be
potentially able to compensate the losers ( out of their gain) and yet retain some gain
to themselves. kaldor- Hicks criterion are thus considered as potentially superior and
improvement in welfare criterion.
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B. The Bergson Criterion ( The Social Welfare Function)
The various welfare criteria so far discussed show that when a change in the economy
benefits some individuals and hurts the others it is impossible to evaluate without
making some value judgment about the deservingness of the d/nt individuals or
groups. Bergson suggested the use of an explicate set of value judgments in the form
of social welfare function. A social welfare function analysis to the individual’s
consumer’s utility function. It provides a ranking of alternative states ( situations,
configurations) in w/c d/nt individuals enjoy d/nt utility levels. If the economy
consists of two individuals the social welfare function could be presented by a set of
social indifference contours ( in utility space) like the ones shown below.
Each curve is the locus of combinations of utilities of A & B w/c yield the same level
of social welfare the further to the right a social indifference contours is the higher the
level of social welfare will be with such as set of social indifference contours
alternative states in the economy can be unambiguously evaluated.
UB W = f(UA,UB)
c
W4
b W3
a W2
W1
O UA
Bergso’s welfare contours
For example a change would move the society from point b to c (or d) increases the
social welfare. A change moving the society from a to b leaves the level of social
welfare unaltered.
Criticisms
1. Bergson criteria requires explicitly value judgments of d/nt categories of judges
may differ. Bergson doesn’t offer a solution to resolve such differences in
value judgment.
2. There is no easy method of constructing social welfare function. Bergson’s
criterion doesn’t come out with necessary instructions for drafting welfare
judgments w/c are required in the formula of welfare function
The Utility possibilities frontier
Utility possibility frontier is a curve that shows all efficient allocations of resources
measured in terms of resource utility levels of two individuals.
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Recall our two consumers, two firm and two input model along with its assumptions.
Efficiency in product mix requires that MRSAx,y = MRSBx,y MRPTx,y the point that
satisfies this condition is point K ( fig on page 8) the output mix at this point is O AX1
+ OAY1= The distribution of OAX1 and OAY1 b/n A & B will be some where on the
exchange contract curve OAK, and some points of tangency b/n A’s B’s indifference
curves
Grand utility possibility
frontier
G
K is the locaus of utility combination of two
cansumers
W/c satisfy the three marginal conditions MRPT=
MRS for each commodity
J
Let the distribution of two goods between the two individuals takes place at point C.
point C satisfy the optimality condition i.e, MRSA x,y = MRSTx,y b/c line e’f’ & ef are
parallel to each other. The distribution of O AX1 and OAY1 at point C yields some
utility to A & some utility to B suppose by plotting their utility on the utility surface,
we get point K w/c represents the point of grand utility available to the society of two
persons A &B
This procedure can be repeated for each point on PPC ( i.e. transformation curve).
For example if point J gives the product mix ( i.e O AX2 + OAY2) and point d gives the
distribution of OAX2 and OAY2 b/n A & B, the grand utility is represented by point J.
If we repeat this procedure continuously for other points on the PPC, we get a curve
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GU through points K & J. At shows the maximum utility available to the society,
given the PPC.
Determination of the point of bliss:-
( The point of maximum welfare) Social
welfare is maximized when
the envelop of utility possibility
UB Bliss point frontier is tangent is tangent to the
N the highest possible social
Indifference contour
UB* W*
W4
W3
W2
W1
UA*
Maximization of social welfare
This point is called the point of bliss. It is denoted by W* (fig on page8). The
maximum social welfare attainable in our example is the level implied by the
indifference contour W3 .The two consumers will enjoy the levels of utility UA* UB*.
Any other point on the GU curve, say, N, is inferior b/c it lies on a lower social
indifference curve. The figure reveals that pareto optimality conditions are only
necessary but not sufficient conditions. Each point of the GUC satisfies the first three
marginal conditions. But only point W* is Pareto optimal