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Home > Welfare economics

Welfare economics is concerned with the welfare of individuals, as opposed to groups, communities, or societies because it assumes that the individual is 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".

1 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 differences 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.

2 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 productProduction, in microeconomics is simply the conversion of inputs into outputs. It is an economic process that uses resources to create a commodity that is suitable for exchange. This can include manufacturing, storing, shipping, and packaging. Some econom 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)

There are a number of conditions that, most economists agree, may lead to inefficiency. They include:

• imperfect market structures (such as monopolyAlternate use: Monopoly (game In economics, a monopoly (from the Greek monos one + polein to sell) is defined as a market situation where there is only one provider of a product or service. Monopolies are characterized by a lack of economic competition fo, monopsonyIn economics, a monopsony is a market with only one buyer in the market, often an input market. This is analogous to the case of a monopoly in which there is only one seller in a market. During the era of the robber barons, John D. Rockefeller used his mo, oligopolyAn oligopoly is a market form in which a market is dominated by a small number of sellers (oligopolists). The word is derived from the Greek for few sellers''. Because there are few participants in this type of market, each oligopolist is aware of the act, oligopsonyAn oligopsony is a market characterised by a small number of consumers for a product or a service. See also Monopsony., and monopolistic competitionThe form of economic competition known as Monopolistic competition occurs when: #There are many producers and many consumers in a given market. Consumers have clearly defined preferences the goods and services are heterogeneous #Freedom of entry. See also)
• factor allocation inefficiencies (see production theory basicsProduction, in microeconomics is simply the conversion of inputs into outputs. It is an economic process that uses resources to create a commodity that is suitable for exchange. This can include manufacturing, storing, shipping, and packaging. Some econom)
• market failures and externalitiesAn externality occurs in economics when a decision (e. to wear obnoxious perfume or to dress up in nice clothes) causes costs or benefits to individuals or groups other than the person making the decision. In other words, the decision-maker does not bear (see also social costSocial cost in economics, is the total of all the costs associated with an economic activity. It includes both costs borne by the economic agent and also all costs borne by society at large. It includes the costs reflected in the organization's production)
• price discrimination (see also price skimming)
• long run declining average costs (see 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 Kaldor 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 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 referred to as Kaldor-Hicks efficiency or the Scitovsky criterion.

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Topics: Welfare Economics Utility Social Production Point Efficiency...

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