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What is Welfare economics? Explained

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 Contents

  1. Introduction
  2. Approaches
  3. Criteria
  4. Fundamental theorems
  5. Criticisms  

Introduction

Welfare economics is a branch of economics that evaluates well-being (welfare) at the aggregate (economy-wide) level using microeconomic techniques.

The field of public economics is the study of how government can intervene to improve social welfare by attempting to apply the principles of welfare economics. Welfare economics also provides the theoretical foundations for specific public economic instruments, such as cost–benefit analysis, and the combination of welfare economics and behavioural economic insights has resulted in the creation of a new subfield, behavioural welfare economics.

Two fundamental theorems underpin the field of welfare economics. The first states that competitive markets produce (Pareto) efficient outcomes under certain assumptions; it captures Adam Smith's invisible hand logic. Given additional constraints, any Pareto efficient outcome can be supported as a competitive market equilibrium, according to the second. Thus, a social planner could use a social welfare function to determine the most equitable and efficient outcome, then implement it through lump sum transfers and competitive trade. Arrow's impossibility theorem is sometimes listed as a third fundamental theorem because of welfare economics' close ties to social choice theory.

A common methodology starts with the creation (or assumption) of a social welfare function, which can then be used to rank economically feasible resource allocations in terms of the social welfare they imply. Economic efficiency and equity are common examples, but more recent attempts to quantify social welfare have included a broader range of indicators, such as economic freedom (as in the capability approach).

Approaches

Cardinal utility

Edgeworth, Sidgwick, Marshall, and Pigou developed the early Neoclassical approach. It is presumptive that:
  • 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 commensurable utility functions (an assumption that Edgeworth avoided in his Mathematical Psychics). 
With these assumptions, a social welfare function can be constructed by summing all of the individual utility functions. It's worth noting that such a metric would still be concerned with income distribution (distributive efficiency), but not with final utility distribution. Such authors were writing in the Benthamite tradition in a normative sense.

Ordinal utility

The work of Pareto, Hicks, and Kaldor is the foundation of the New Welfare Economics approach. It recognises the distinctions between the efficiency and distribution aspects of the discipline and treats them differently. Questions of efficiency are evaluated using criteria like Pareto efficiency and the Kaldor–Hicks compensation tests, whereas questions of income distribution are addressed in the social welfare function specification. Furthermore, efficiency replaces cardinal utility measures with ordinal utility, which simply ranks commodity bundles (with an indifference-curve map, for example).

Criteria

Efficiency

When goods are distributed to those who can benefit the most from them, a situation is said to be distributive efficient.

In economics, the Pareto efficiency goal is a useful efficiency goal. Only if no individual can be made better off without making someone else worse off is a situation Pareto-efficient. For example, if Smith owns an apple but prefers to eat an orange, while Jones owns an orange but prefers to eat an apple, this is an inefficient situation. Trading could benefit both parties.

Only four criteria must be met for a pareto-efficient state of affairs to emerge:
  1. The marginal rates of substitution in consumption for any two goods are identical for all consumers. We cannot reallocate goods between two consumers and make both happier. 
  2. The marginal rate of transformation in production for any two goods is identical for all producers of those two goods. We cannot reallocate production between two producers and increase total output. 
  3. The marginal physical product of a factor input (e.g. labor) must be the same for all producers of a good. We cannot reduce production cost by reallocating production between two producers. 
  4. The marginal rates of substitution in consumption equal the marginal rates of transformation in production for any pair of goods. Producers cannot make consumers happier by producing more of one good and less of the other. 
There are a number of conditions that lead to inefficiency. They include:
  1. Imperfect market structures such as monopoly, monopsony, oligopoly, oligopsony, and monopolistic competition. 
  2. Factor allocation inefficiencies in production theory basics.
  3. Externalities. 
  4. Asymmetric information, including principal–agent problems. 
  5. Long run declining average costs in a natural monopoly. 
  6. Taxes and tariffs. 
  7. Government restrictions on prices and quantities sold and other regulation resulting from government failure.  
It's worth noting that if one of these conditions causes inefficiency, another condition may be able to help by preventing it. A tax on tyres, for example, could restore the efficient level of production if a pollution externality causes overproduction of tyres. In the "second-best," a condition that is inefficient in the "first-best" may be desirable.

Two compensation tests have been developed to determine whether an activity is moving the economy towards Pareto efficiency. Because policy changes usually benefit some while harming others, these experiments examine what would happen if the winners compensated the losers. The change is desirable if the maximum amount the winners would be willing to pay is greater than the minimum the losers would accept, according to the Kaldor criterion. The change is desirable if the maximum the losers are willing to offer the winners to prevent the change is less than the minimum the winners would accept as a bribe to give up the change, according to the Hicks criterion. The Hicks compensation test is from the perspective of the losers, while the Kaldor compensation test is from the perspective of the winners. If both conditions are met, the proposed change will lead to Pareto optimality in the economy. Kaldor–Hicks efficiency is the name for this concept. The Scitovsky paradox occurs when the two conditions are incompatible.

Equity

There are numerous consumer utility, production mix, and factor input combination combinations that are efficient. There are an infinite number of consumption and production equilibria that produce Pareto optimal outcomes. On the aggregate production–possibility frontier, there are as many optima as there are points. As a result, while Pareto efficiency is a necessary condition for social welfare, it is not sufficient. Each Pareto optimum in the economy corresponds to a different income distribution. Some may have significant income disparities. So, how do we figure out which Pareto optimum is the best? When we specify the social welfare function, we make this decision, either implicitly or explicitly. This function encapsulates interpersonal utility value judgments. 

A utilitarian welfare function (also known as a Benthamite welfare function) adds up each person's utility to determine society's overall welfare. Regardless of their initial utility level, everyone is treated the same. A millionaire's extra unit of utility is not seen as having any greater value than a starving person's extra unit of utility. The Max-Min, or Rawlsian utility function, is on the other end of the spectrum. The Max-Min criterion states that welfare is maximised when the utility of those in society who have the least is greatest. No economic activity will improve social welfare unless it improves the situation of the most vulnerable members of society. The majority of economists define social welfare functions that fall somewhere in the middle of these two extremes.

The social welfare function is usually represented by social indifference curves in order to be used in the same graphic space as the other functions with which it interacts. A utilitarian social indifference curve is straight and slants rightward. The Max-Min curve of social indifference is made up of two straight lines joined at a 90-degree angle. A social indifference curve is a right-sloping curve derived from an intermediate social welfare function. The majority of economists define social welfare functions that fall somewhere in the middle of these two extremes.

The intermediate form of the social indifference curve can be interpreted as showing that as inequality rises, a larger increase in the utility of relatively wealthy people is required to compensate for the loss of utility of relatively poor people.

The subjective dollar value of goods and services distributed to economy participants can be used to construct a crude social welfare function.

Fundamental theorems

Two fundamental theorems underpin the field of welfare economics. The first states that competitive markets (price equilibria with transfers, e.g. Walrasian equilibria) produce Pareto efficient outcomes under certain assumptions. The assumptions that must be met are generally described as "very weak." More precisely, competitive equilibrium implies both price-taking behaviour and complete markets, with the only additional assumption being local non-satiation of agents' preferences – that consumers would like slightly more of any given good on the margin. The first fundamental theorem is said to capture Adam Smith's invisible hand logic, though there is no reason to believe that the "best" Pareto efficient point (of which there are several) will be chosen by the market without intervention, only that one will be.

Given additional constraints, the second fundamental theorem states that any Pareto efficient outcome can be supported as a competitive market equilibrium. These constraints are more stringent than for the first fundamental theorem, with convexity of preferences and production functions serving as a sufficient but not sufficient condition. A benevolent social planner could use a system of lump sum transfers to ensure that the "best" Pareto efficient allocation was supported as a competitive equilibrium for some set of prices, as a direct consequence of the second theorem. More broadly, it suggests that redistribution should be accomplished as efficiently as possible without affecting prices (which should continue to reflect relative scarcity), ensuring that the final (post-trade) outcome is efficient. In practise, such a policy could be compared to predistribution.

Arrow's impossibility theorem is sometimes listed as a third fundamental theorem because of welfare economics' close ties to social choice theory.

Criticisms

Some economists, such as those from the Austrian School, question whether or not a cardinal utility function, or cardinal social welfare function, is useful. The reason given is that aggregating the utilities of people with different marginal utility of money, such as the wealthy and the poor, is difficult. Furthermore, Austrian School economists question the relevance of Pareto optimal allocation in situations where the framework of means and ends is not perfectly known, because neoclassical theory assumes that the framework of ends and means is perfectly defined.

The efficacy of ordinal utility functions has been called into question. Other methods of measuring well-being, such as willingness to pay using the revealed or stated preference method, have been proposed by economists as alternatives to price indices. Subjective well-being functions are those that are based on people's ratings of their happiness or life satisfaction rather than their preferences.

Many people believe that price-based measures promote consumerism and productivism. It is possible to conduct welfare economics without using prices, but this is not always the case. Welfare economics is a normative and possibly subjective field due to value assumptions made explicit in the social welfare function used and implicit in the efficiency criterion chosen. This may cause it to be divisive. Concerns about the limits of a utilitarian approach to welfare economics are perhaps the most important of all. According to this line of reasoning, utility is not the only factor that matters, and a comprehensive approach to welfare economics should take other factors into account as well.

The capability approach is a theoretical framework that includes two core normative claims: first, that the freedom to achieve well-being is of primary moral importance, and second, that this freedom is best understood in terms of people's capabilities, or their actual opportunities to do and be what they have reason to value.



































































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