Welfare Economics

Definition
A branch of economics that focuses on the optimal allocation of resources and goods
and how this affects social welfare. Welfare economics analyzes the total good or
welfare that is achieve at a current state as well as how it is distributed. This relates to
the study of income distribution and how it affects the common good.
Other Meaning
Welfare economics uses the perspective and techniques of microeconomics, but they
can be aggregated to make macroeconomic conclusions. Because different "optimal"
states may exist in an economy in terms of the allocation of resources, welfare
economics seeks the state that will create the highest overall level of social welfare.

Some people object to the idea of wealth redistribution because it flies in the face of
pure capitalist ideals, but economists suggest that greater states of overall social good
might

be

achieved

by

redistributing

incomes

in

the

economy.

TWO FUNDAMENTAL THEOREMS OF WELFARE ECONOMICS

1. The first states that any competitive equilibrium or Walrasian equilibrium leads to
a Pareto efficient allocation of resource (It captures the logic of Adam
Smith's invisible hand) and
2. The second states the converse, that any efficient allocation can be sustainable
by a competitive equilibrium.
Thus a social planner could use a social welfare function to pick the most equitable
efficient outcome, then use lump sum transfers followed by competitive trade to bring it
about. Because of welfare economics' close ties to social choice theory, theorem is
sometimes listed as a third fundamental theorem.

RATIONALE
The first fundamental theorem of welfare economics states that any Walrasian
equilibrium

is Pareto-efficient.

This

was

first

demonstrated

graphically

by

economist Abba Lernerand mathematically by economists Harold Hotelling, Oskar

Lange, Maurice Allais, Kenneth Arrow and Grard Debreu. The theorem holds under
general conditions.
The theorem relies only on three assumptions: (1) complete markets (i.e., no
transaction costs and where each actor has perfect information), (2) pricetaking behavior (i.e., no monopolists and easy entry and exit from a market), and
(3) the relatively weak assumption of local nonsatiation of preferences (i.e., for
every bundle of goods there is another similar bundle that would be preferred).
However, no convexity assumptions are needed.
The formal statement of the theorem is as follows: If preferences are locally
nonsatiated, and if (x*, y*, p) is a price equilibrium with transfers, then the allocation (x*,
y*) is Pareto optimal. An equilibrium in this sense either relates to an exchange
economy only or presupposes that firms are allocatively and productively efficient,
which can be shown to follow from perfectly competitive factor and production market.
The second fundamental theorem of welfare economics states that, under the
assumptions that every production set

is convex and every preference relation

is

convex and locally nonsatiated, any desired Pareto-efficient allocation can be supported
as a price quasi-equilibrium with transfers. Further assumptions are needed to prove
this statement for price equilibriums with transfers.
The proof proceeds in two steps: first, we prove that any Pareto-efficient allocation can
be supported as a price quasi-equilibrium with transfers; then, we give conditions under
which a price quasi-equilibrium is also a price equilibrium.
MEASURING SOCIAL WELFARE

*Cardinal utility
The early Neoclassical approach was developed by Edgeworth, Sidgwick, Marshall,
and Pigou. 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 Edgeworth 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. Note that such a measure would still be
concerned with the distribution of income (distributive efficiency) but not the distribution
of

final

utilities.

In

normative

terms,

such

authors

were

writing

in

the Benthamite tradition.

*Ordinal utility
The New Welfare Economics approach is based on the work of Pareto, Hicks,
and Kaldor. 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 Kaldor-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 indifferencecurve map, for example).
CRITERIA
Utility, welfare, and efficiency

Our first concern will be a question of definitions. What is the difference between, and
the relationship of, welfare and utility? The two terms sound similar, and seem often
to be used in similar ways. But the difference between them is stark and important.
Utility is a construct of descriptive or positive economics. The classical tradition
asserts that economic behavior can be usefully described and predicted by imagining
economic agents who rank the consequences of possible actions and choose the action
associated with the highest-ranking. Utility, strictly speaking, has nothing whatsoever to
do with well-being. It is simply a modeling construct that (it is hoped) helps organize and
describe observed behavior. To claim that people value utility is a claim very similar to
nature abhors a vacuum. Its a useful way of putting things, but natures abhorrence is
not meant to signal an actual discomfort demanding remedy in an ethical sense.
Subjective well-being, of an individual human or of the universe at large, is simply not a
topic amenable to empirical science. By hypothesis, human agents strive to maximize
utility, just as molecules strive to find lower-energy states over the course of a
chemical reaction. Utility is important not as a desideratum of scientifically inaccessible
minds, but as a tool invented by economists, a technique for describing and modeling
human behavior that may (or may not!) turn out to be useful.
Welfare is a construct of normative economics. While utility is a thing we imagine
economic agents maximize, welfare is what economists seek to maximize when they
offer policy advice. There is no such thing as, and can be no such thing as, a scientific
welfare economics, although the discipline is still burdened by a failed and incoherent
attempt to pretend to one. Whenever a claim about welfare is asserted, assumptions
regarding ethical value are necessarily invoked as well. If you believe otherwise, you
have been swindled.
If claims about welfare cant be asserted in a value-neutral way, then neither can claims
of efficiency. Greg Mankiw teaches that [under] free market [transactors] are
together led by an invisible hand to an equilibrium that maximizes total benefit to buyers
and sellers. That assertion becomes completely insupportable. Even the narrow and
technical notion of Pareto efficiency, often omitted from undergraduate treatments, is

rendered problematic, as nonmarket allocations can also be Pareto efficient and valueneutral ranking of allocations becomes impossible. Welfare economics is the very heart
of introductory economics. Market efficiency, deadweight loss, tax incidence, price
discrimination, international trade all of these topics are diagrammed and understood
in terms of what happens to the area between supply and demand curves. If we cannot
redeem those diagrams, all of that becomes little more than propaganda.

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

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

Factor allocation inefficiencies in production theory basics.

as

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 mo