Welfare economics:Welfare economics is a branch of economics that uses microeconomic techniques

to evaluate well-being from allocation of productive factors as to desirability

and economic efficiency within an economy, often relative to competitive general
equilibrium. It analyzes social welfare, however measured, in terms of economic
activities of the individuals that compose the theoretical society considered.
Accordingly, individuals, with associated economic activities, are the basic
units for aggregating to social welfare, whether of a group, a community, or a
society, and there is no "social welfare" apart from the "welfare" associated with its
individual units.
Welfare economics typically takes individual preferences as given and stipulates a
welfare improvement in Pareto efficiency terms from social state A to social
state B if at least one person prefers B and no one else opposes it. There is no
requirement of a unique quantitative measure of the welfare improvement implied
by this. Another aspect of welfare treats income/goods distribution,
including equality, as a further dimension of welfare.

Social welfare:Social welfare refers to the overall welfare of society. With sufficiently strong
assumptions, it can be specified as the summation of the welfare of all the
individuals in the society. Welfare may be measured either cardinally in terms of
"utile" or dollars, or measured ordinally in terms of Pareto efficiency. The cardinal
method in "utile" is seldom used in pure theory today because of aggregation
problems that make the meaning of the method doubtful, except on widely
challenged underlying assumptions. In applied welfare economics, such as in costbenefit analysis, money-value estimates are often used, particularly where incomedistribution effects are factored into the analysis or seem unlikely to undercut the
analysis.
The capabilities approach to welfare argues that freedom - what people are free to
do or be - should be included in welfare assessments, and the approach has been
particularly influential in development policy circles where the emphasis on multidimensionality and freedom has shaped the evolution of the Human Development
Index.
Other classifying terms in welfare economics include externalities, equity, justice,
inequality, and altruism.

Contents

1 Two approaches

2 Efficiency

3 Income distribution

4 A simplified seven-equation model

5 Efficiency between production and consumption

6 Social welfare maximization

7 Welfare economics in relation to other subjects

8 Parisian welfare economics

9 Criticisms

1. Two approaches:There are two mainstream approaches to welfare economics: the

early neoclassical approach and the new welfare economics approach.
The early Neoclassical approach was developed by Edge
worth, Sedgwick, Marshall, and Pig-out. It assumes the following:

Utility is cardinal, that is, scale-measurable by observation or judgment.

Preferences are exogenously given and stable.

Additional consumption provides smaller and smaller increases in utility

(diminishing marginal utility).

All individuals have interpersonally comparable utility functions (an

assumption that Edge worth avoided in his Mathematical 'Psychics).

With these assumptions, it is possible to construct a social welfare function simply

by summing all the individual utility functions.
The New Welfare Economics approach is based on the work of Pareto, Hicks,
and Caldor. It explicitly recognizes the differences between the efficiency aspect of
the discipline and the distribution aspect and treats them differently. Questions of
efficiency are assessed with criteria such as Pareto efficiency and the Caldor-Hicks
compensation tests, while questions of income distribution are covered in social
welfare function specification. Further, efficiency dispenses with cardinal measures
of utility, replacing it with ordinal utility, which merely ranks commodity bundles
(with an indifference-curve map, for example).

2. Efficiency:Situations are considered to have distributive efficiency when goods are

distributed to the people who can gain the most utility from them.
Many economists use Pareto efficiency as their efficiency goal. According to this
measure of social welfare, a situation is optimal only if no individuals can be made
better off without making someone else worse off.
This ideal state of affairs can only come about if four criteria are met:

The marginal rates of substitution in consumption are identical for all

consumers. This occurs when no consumer can be made better off without
making others worse off.

The marginal rate of transformation in production is identical for all

products. This occurs when it is impossible to increase the production of any
good without reducing the production of other goods.

The marginal resource cost is equal to the marginal revenue product for all
production processes. This takes place when marginal physical product of a
factor must be the same for all firms producing a good.

The marginal rates of substitution in consumption are equal to the marginal

rates of transformation in production, such as where production processes must
match consumer wants.
There are a number of conditions that, most economists agree, may lead to
inefficiency. They include:

Imperfect market structures, such as

a monopoly, monopsony, oligopoly, oligopoly, and monopolistic competition.

Factor allocation inefficiencies in production theory basics.

Market failures and externalities; there is also social cost.

Price discrimination and price skimming.

Asymmetric information, principalagent problems.

Long run declining average costs in a natural monopoly.

Certain types of taxes and tariffs.

To determine whether an activity is moving the economy towards Pareto

efficiency, two compensation tests have been developed. Any change usually
makes some people better off while making others worse off, so these tests ask
what would happen if the winners were to compensate the losers. Using the Caldor
criterion, an activity will contribute to Pareto optimality if the maximum amount
the gainers are prepared to pay is greater than the minimum amount that the losers
are prepared to accept. Under the Hicks criterion, an activity will contribute
to Pareto optimality if the maximum amount the losers are prepared to offer to the
gainers in order to prevent the change is less than the minimum amount the gainers
are prepared to accept as a bribe to forgo the change. The Hicks compensation
test is from the losers' point of view, while the Caldor compensation test is from
the gainers' point of view. If both conditions are satisfied, both gainers and losers
will agree that the proposed activity will move the economy toward Pareto
optimality. This is referred to as Caldor-Hicks efficiency or the Scitovsky

3. Income distribution:There are many combinations of consumer utility, production mixes, and
factor input combinations consistent with efficiency. In fact, there is infinity of
consumption and production equilibrium that yield Pareto optimal results. There
are as many optima as there are points on the aggregate production possibilities
frontier. Hence, Pareto efficiency is a necessary, but not a sufficient condition for
social welfare. Each Pareto optimum corresponds to a different income distribution
in the economy. Some may involve great inequalities of income. So how do we

decide which Pareto optimum is most desirable? This decision is made, either
tacitly or overtly, when we specify the social welfare function. This function
embodies value judgments about interpersonal utility. The social welfare function
shows the relative importance of the individuals that comprise society.
A utilitarian welfare function (also called a Benthamite welfare function)
sums the utility of each individual in order to obtain society's overall welfare. All
people are treated the same, regardless of their initial level of utility. One extra unit
of utility for a starving person is not seen to be of any greater value than an extra
unit of utility for a millionaire. At the other extreme is the Max-Min,
or Rawlins utility function (Stieglitz, 2000, p102) [incomplete reference].
According to the Max-Min criterion, welfare is maximized when the utility of
those society members that have the least is the greatest. No economic activity will
increase social welfare unless it improves the position of the society member that is
the worst off. Most economists specify social welfare functions that are
intermediate between these two extremes.
The social welfare function is typically translated into social indifference
curves so that they can be used in the same graphic space as the other functions
that they interact with. A utilitarian social indifference curve is linear and
downward sloping to the right. The Max-Min social indifference curve takes the
shape of two straight lines joined so as they form a 90 degree angle. A social
indifference curve drawn from an intermediate social welfare function is a curve
that slopes downward to the right.
The intermediate form of social indifference curve can be interpreted as
showing that as inequality increases, a larger improvement in the utility of
relatively rich individuals is needed to compensate for the loss in utility of
relatively poor individuals.

A crude social welfare function can be constructed by measuring the

subjective dollar value of goods and services distributed to participants in the
economy (see also consumer surplus).

4. A simplified seven-equation model:The basic welfare economics problem is to find the theoretical maximum of
a social welfare function, subject to various constraints such as the state of
technology in production, available natural resources, national infrastructure, and
behavioral constraints such as consumer utility maximization and producer profit
maximization. In the simplest possible economy this can be done by
simultaneously solving seven equations. This simple economy would have only
two consumers (consumer 1 and consumer 2), only two products (product X and
product Y), and only two factors of production going into these products (labor (L)
and capital (K)). The model can be stated as:
Maximize social welfare: W=f (U1 U2) subject to the following set of
constraints:
K = Ki + KY (The amount of capital used in the production of goods X and
Y)
L = Lx + Ly (The amount of labor used in the production of goods X and Y)
X = X (Ki Lx) (The production function for product X)
Y = Y (KY Ly) (The production function for product Y)
U1 = U1(X1 Y1) (The preferences of consumer 1)
U2 = U2(X2 Y2) (The preferences of consumer 2)
The solution to this problem yields a Pareto optimum. In a more realistic
example of millions of consumers, millions of products, and several factors of
production, the math gets more complicated.
Also, finding a solution to an abstract function does not directly yield a policy
recommendation! In other words, solving an equation does not solve social
problems. However, a model like the one above can be viewed as an argument
that solving a social problem (like achieving a Pareto-optimal distribution of
wealth) is at least theoretically possible.

5. Efficiency between production and consumption:-

The relation between production and consumption in a simple seven

equation model (2x2x2 model) can be shown graphically. In the diagram below,
the aggregate production possibility frontier, labeled PQ shows all the points of
efficiency in the production of goods And Y. If the economy produces the mix
of good X and Y shown at point A, then the marginal rate of transformation
(MRT), X for Y, is equal to 3.

Point A defines the boundaries of an Edge worth box diagram of consumption.

That is, the same mix of products that are produced at point A can be consumed
by the two consumers in this simple economy. The consumers' relative
preferences are shown by the indifference curves inside the Edge worth box. At
point B the marginal rate of substitution (MRS) is equal to 2, while at point C
the marginal rate of substitution is equal to 3. Only at point C is consumption in
balance with production (MRS=MRT). The curve 0BCA (often called
the contract curve) inside the Edge worth box defines the locus of points of
efficiency in consumption (MRS1=MRS ). As we move along the curve, we are
changing the mix of goods X and Y that individuals 1 and 2 choose to consume.
The utility data associated with each point on this curve can be used to create
utility functions.

6. Social welfare maximization:-

Utility functions can be derived from the points on a contract curve.

Numerous utility functions can be derived, one for each point on the production
possibility frontier (PQ in the diagram above). A social utility frontier (also
called a grand utility frontier) can be obtained from the outer envelope of all
these utility functions. Each point on a social utility frontier represents an
efficient allocation of an economy's resources; that is, it is a Pareto optimum in
factor allocation, in production, in consumption, and in the interaction of
production and consumption (supply and demand). In the diagram below, the
curve MN is a social utility frontier. Point D corresponds with point C from the
earlier diagram. Point D is on the social utility frontier because the marginal
rate of substitution at point C is equal to the marginal rate of transformation at
point A. Point E corresponds with point B in the previous diagram, and lies
inside the social utility frontier (indicating inefficiency) because the MRS at
point C is not equal to the MRT at point A.

Although all the points on the grand social utility frontier are Pareto
efficient, only one point identifies where social welfare is maximized. Such
point is called "the point of bliss". This point is Z where the social utility
frontier MN is tangent to the highest possible social indifference curve labeled
SI.

7. Welfare economics in relation to other subjects:-

Welfare
economics
uses
many
of
the
same
techniques
as microeconomics and can be seen as intermediate or advanced
microeconomic theory. Its results are applicable to macroeconomic issues so
welfare economics is somewhat of a bridge between the two branches of
economics.
Cost-benefit analysis is a specific application of welfare economics
techniques, but often excludes the income distribution aspects.
Political science also looks into the issue of social welfare (political science),
but in a less quantitative manner.
Human development theory explores these issues also, and considers them
fundamental to the development process itself.

8. Parisian welfare economics:Parisian welfare economics rests on the assumed value judgment that, if a
particular change in the economy leaves at least one individual better off and no
individual worse off, social welfare may be said to have increased.

9. Criticisms:Some, such as economists in the tradition of the Austrian School, doubt

whether a cardinal utility function, or cardinal social welfare function, is of any
value. The reason given is that it is difficult to aggregate the utilities of various
people that have differing marginal utility of money, such as the wealthy and
the poor.
Also, the economists of the Austrian School question the relevance of pare
to optimal allocation considering situations where the framework of means and
ends is not perfectly known, since neoclassical theory always assumes that the
ends-means framework is perfectly defined.
Some even question the value of ordinal utility functions. They have
proposed other means of measuring well-being as an alternative to price
indices, "willingness to pay" functions, and other price oriented
measures. These price based measures are seen as
promoting consumerism and productivism by many. It should be noted that it is

possible to do welfare economics without the use of prices, however this is not
always done.
Value assumptions explicit in the social welfare function used and implicit in
the efficiency criterion chosen tend to make welfare economics a normative and
perhaps subjective field. This can make it controversial.
However, perhaps most significant of all are concerns about the limits of a
utilitarian approach to welfare economics. According to this line of argument
utility is not the only thing that matters and so a comprehensive approach to
welfare economics should include other factors. The capabilities approach to
welfare is an attempt to construct a more comprehensive approach to welfare
economics, one in which functionings, happiness and capabilities are the three
key aspects of welfare outcomes that people should seek to promote and foster.