Welfare economics

Welfare economics is a branch of economics that uses microeconomic techniques to simultaneously determine the allocational efficiency of a macroeconomy and the income distribution consequences associated with it.

Welfare economics is concerned with the welfare of individuals, as opposed to groups, communities, or societies because it assumes that the individual is the the basic unit of measurement. It also assumes that individuals are the best judges of their own welfare, that people will prefer greater welfare to less welfare, and that welfare can be adequately measured either in dollars (or some other unit of currency) or as a relative preference.

Social welfare refers to the overall utilitarian state of society. It is often defined as the summation of the welfare of all the individuals in the society. Welfare can be measured either cardinally in terms of dollars or "utils", or measured ordinally in terms of relative utility. The cardinal method is seldom used today because of aggregation problems that make the accuracy of the method doubtful.

There are two sides to welfare economics: economic efficiency and income distribution. Economic efficiency is largely positive and deals with the "size of the pie". Income distribution is much more normative and deals with "dividing up the pie".

Table of contents

1 Two approaches
2 Efficiency
3 Income distribution
4 Welfare economics in relation to other subjects
5 Criticisms
6 See also

Two approaches

There are two approaches that can be taken to welfare economics: the Neo-classical approach and the New welfare economics approach.

The Neo-classical approach was developed by Pigou, Bentham, Sidgwich, Edgeworth, and Marshall. It assumes that utility is cardinal and that additional utils provide smaller and smaller increases in utility (diminishing marginal utility). It further assumes that all individuals have similar utility functions, therefore it is meaningful to compare one individuals utility to another's. Because of this assumption, 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 Kaldor. It explicitly recognizes the differnces between the efficiency part of the discipline and the distribution part and treats them differently. Questions of efficiency are assessed with criteria such as Pareto efficiency and the Kaldor-Hicks compensation tests, while questions of income distribution are covered in social welfare function specification. Further, efficiency need not require cardinal measures of utility: ordinal utility is adequate for this analysis.

Efficiency

Most 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 must be identical for all consumers (no consumer can be made better off without making others worse off)
The marginal rate of transformation in production must be identical for all products (it is impossible to increase the production of any good without reducing the production of other goods)
The marginal resource cost must equal the marginal revenue product for all production processes. (the marginal physical product of a factor must be the same for all firms producing a good)
The marginal rates of substitution in consumption must be equal to the marginal rates of transformation in production. (production processes must match consumer wants)

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 Kaldor criterian 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 criterian, 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 Kaldor 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 refered to as Kaldor-Hicks efficiency.

Income distribution

Social welfare can be measured by a hypothetical social welfare function (which specifies how a societies total welfare can be increased), and its tangency with an aggregate production possibilities frontier (which describes the most efficient mix of production for that society).

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).

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 excluding 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.

Criticisms

Many doubt whether a cardinal utitity function (or social welfare function) is of any value. How do you aggregate the utilities of various people that have differing marginal utility of money (ie, the rich and the poor)?

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 which are seen as promoting consumerism and productivism by many.

Value assumptions explicit in the social welfare function used and implicit in the efficiency criterion chosen, make welfare economics a highly normative and subjective field.