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. It attempts to maximize the level of social welfare by examining the economic activities of the individuals that comprise society. Buyers bargain for good prices while sellers put forth their best front in Chichicastenango Market, Guatemala. ... Microeconomics (literally, very small economics) is a social science which involves study of the economic distribution of production and income among individual consumers, firms, and industries. ... ...

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 prefer greater welfare to less welfare, and that welfare can be adequately measured either in monetary terms 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. This article or section does not cite its references or sources. ...

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". In the humanities and social sciences, the term positive is used in a number of ways. ... In philosophy, normative is usually contrasted with descriptive or explanatory when describing types of theories, beliefs, or statements. ...

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 consumption 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 individual's 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. Arthur Cecil Pigou (November 18, 1877 – March 7, 1959) was an English economist, known for his work in many fields and particularly in welfare economics. ... Jeremy Bentham (IPA: ) (February 15, 1748 – June 6, 1832) was an English gentleman, jurist, philosopher, and legal and social reformer. ... Edgeworth Francis Ysidro Edgeworth (February 8, 1845 - February 13, 1926) was an Irish polymath who studied at Trinity College, Dublin before obtaining a scholarship to Balliol College, Oxford where he subsequently became a professor. ... A social welfare function, in welfare economics, is a function which gives a measure of the material welfare of society, given a number of economic variables as inputs. ...

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. Vilfredo Federico Damaso Pareto (born July 15, 1848 in Paris, France - died August 19, 1923 in Lausanne, Switzerland) made several important contributions to economics, sociology and moral philosophy, especially in the study of income distribution and in the analysis of individuals choices. ... Sir John Richard Hicks (April 8, 1904 – May 20, 1989) was one of the most important and influential economists of the twentieth century. ... Nicholas Kaldor (Budapest, 1908 - Papworth Everard, Cambridgeshire, 1986) was the foremost Cambridge economist in the post-war period. ... Pareto efficiency, or Pareto optimality, is a central theory in economics with broad applications in game theory, engineering and the social sciences. ...

Efficiency

One important measure of efficiency in welfare economics was Abba Lerner's proposed distributive efficiency. Situations are considered to have distributive efficiency when goods are distributed to the people who can gain the most utility from them. ... In welfare economics, distributive efficiency occurs when goods and services are received by those who have the greatest need for 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. Pareto efficiency, or Pareto optimality, is a central theory in economics with broad applications in game theory, engineering and the social sciences. ...

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: In economics, the marginal rate of substitution (MRS for short) is the rate at which consumers are willing to give up units of one good in exchange for more units of another good. ... In economics, the production possibility frontier (the PPF, also called the production possibilities curve (PPC) or the “transformation curve”) is a graph that depicts the trade-off between any two items produced. ... In microeconomics, Production is simply the conversion of inputs into outputs. ...

• Imperfect market structures, such as a monopoly, monopsony, oligopoly oligopsony, and monopolistic competition.
• Factor allocation inefficiencies in production theory basics.
• Market failures and externalities; there is also social cost.
• Price discrimination and price skimming.
• 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 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. In economics, a monopoly (from the Greek monos, one + polein, to sell) is defined as a persistent market situation where there is only one provider of a kind of product or service. ... In economics, a monopsony is a market form with only one buyer, called monopsonist, facing many sellers. ... An oligopoly is market form in which a market is dominated by a small number of sellers (oligopolists). ... An oligopsony is a market form in which the number of buyers are small while the number of sellers in theory could be large. ... Monopolistic competition is a common market form. ... In microeconomics, Production is simply the conversion of inputs into outputs. ... An externality occurs in economics when a decision (for example, to pollute the atmosphere) causes costs or benefits to stakeholders other than the person making the decision. ... Social cost, in economics, is the total of all the costs associated with an economic activity. ... For other pricing strategies and policies see: Pricing Strategies Price discrimination exists when sales of identical goods or services are transacted at different prices from the same provider. ... Price Skimming Price skimming is a pricing strategy in which a marketer sets a relatively high price for a product or service at first, then lowers the price over time. ... In economics, a natural monopoly occurs when, due to the economies of scale of a particular industry, the maximum efficiency of production and distribution is realized through a single supplier [citation needed]. Natural monopolies arise where the largest supplier in an industry, or the first supplier in a local area... Kaldor-Hicks efficiency is a type of economic efficiency that occurs only if the economic value of social resources is maximized. ...

See also: first welfare theorem In welfare economics, the First Welfare Theorem is that a system of free markets will lead to a Pareto efficient equilibrium. ...

Income distribution

There are many combinations of consumer utility, production mixes, and factor input combinations consistent with efficiency. In fact, there are an infinity of consumer and production equilibria 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 judgements about interpersonal utility. The social welfare function is a way of mathematically stating the relative importance of the individuals that comprise society. In economics, the production possibility frontier (the PPF, also called the production possibilities curve (PPC) or the “transformation curve”) is a graph that depicts the trade-off between any two items produced. ... A social welfare function, in welfare economics, is a function which gives a measure of the material welfare of society, given a number of economic variables as inputs. ...

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 function proposed by John Rawls. 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. Jeremy Bentham (IPA: ) (February 15, 1748 – June 6, 1832) was an English gentleman, jurist, philosopher, and legal and social reformer. ...

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.

An indifference curve is a graph showing combinations of goods for which a consumer is indifferent, that is, it has no preference for one combination versus another, as they render the same level of satisfaction for the consumer. ...

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. social indifference curves File links The following pages link to this file: Welfare economics Categories: GFDL images ...

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). Supply curve shift Consumer surplus or Consumers surplus (or in the plural Consumers surplus) is the economic gain accruing to a consumer (or consumers) when they engage in trade. ...

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 behavoural 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 (labour (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 = K^x + K^y (The amount of capital used in the production of goods X and Y)

L = L^x + L^y (The amount of labour used in the production of goods X and Y)

X = X(K^x L^x) (The production function for product X)

Y = Y(K^y L^y) (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.

Efficiency between production and consumption

The relation between production and consumption in a simple seven equation model (2x2x2 model) can be shown graphicly. In the diagram below, the aggregate production possibility frontier, labeled PQ shows all the points of efficiency in the production of goods X 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 2.

In economics, the production possibility frontier (the PPF, also called the production possibilities curve (PPC) or the “transformation curve”) is a graph that depicts the trade-off between any two items produced. ...

Point A defines the boundaries of an Edgeworth 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 Edgeworth 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 B is consumption in balance with production (MRS=MRT). The curve 0BCA inside the Edgeworth box (sometimes called a contract curve) defines the locus of points of efficiency in consumption (MRS¹=MRS ²). 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. Efficiency between production and consumption File links The following pages link to this file: Welfare economics Edgeworth box Categories: GFDL images ... In economics, an Edgeworth box, named after Francis Ysidro Edgeworth, is a way of representing various distributions of resources. ... In economics, an Edgeworth box, named after Francis Ysidro Edgeworth, is a way of representing various distributions of resources. ... In economics, an Edgeworth box, named after Francis Ysidro Edgeworth, is a way of representing various distributions of resources. ... A contract curve is the set of all points in an Edgeworth box that are Pareto efficient. ...

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 B from the earlier diagram. Point D is on the social utility frontier because the marginal rate of substitution at point B is equal to the marginal rate of transformation at point A. Point E corresponds with point C 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. This is point Z (sometimes called the bliss point) where the social utility frontier MN is tangent to the highest possible social indifference curve labelled SI. social welfare maximization File links The following pages link to this file: Welfare economics Categories: GFDL images ...

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. Microeconomics (literally, very small economics) is a social science which involves study of the economic distribution of production and income among individual consumers, firms, and industries. ... Macroeconomics is the economics sub-field of study that considers aggregate behavior, and the study of the sum of individual economic decisions. ...

Cost-benefit analysis is a specific application of welfare economics techniques, but excludes the income distribution aspects. Cost-benefit analysis is the process of weighing the total expected costs vs. ...

Political science also looks into the issue of social welfare (political science), but in a less quantitative manner. Political science is a social science discipline that deals with the theory and practice of politics and the description and analysis of political systems and political behavior. ... Social welfare can be taken to mean the welfare or well-being of a society. ...

Human development theory explores these issues also, and considers them fundamental to the development process itself. Human development theory is an economic theory that merges older ideas from ecological economics, sustainable development, welfare economics, and feminist economics. ...

Criticisms

Many 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.

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. The well-being or quality of life of a population is an important concern in economics and political science. ... Consumerism is a term used to describe the effects of equating personal happiness with purchasing material possessions and consumption. ... Productivism is the (purported) ideology that measurable economic productivity and growth is the purpose of human organization and perhaps the purpose of life itself. ...

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. This can make it controversial. If these value assumptions are hidden or uncritically accepted, welfare economics could be dangerous.

See also

• Arrow's impossibility theorem
• Consumer surplus
• Social welfare function
• Microeconomics
• Pareto efficiency
• Kaldor-Hicks efficiency
• Income inequality metrics
• Gini coefficient
• Lorenz curve
• Social welfare (political science)
• Copenhagen Consensus
• National Income (national income accounting)
• Sustainable National Income at wikinfo
• List of economics topics
• List of business ethics, political economy, and philosophy of business topics
• Important publications in welfare economics

In voting systems, Arrow’s impossibility theorem, or Arrow’s paradox, demonstrates that no voting system can possibly meet a certain set of reasonable criteria when there are three or more options to choose from. ... Supply curve shift Consumer surplus or Consumers surplus (or in the plural Consumers surplus) is the economic gain accruing to a consumer (or consumers) when they engage in trade. ... A social welfare function, in welfare economics, is a function which gives a measure of the material welfare of society, given a number of economic variables as inputs. ... Microeconomics (literally, very small economics) is a social science which involves study of the economic distribution of production and income among individual consumers, firms, and industries. ... Pareto efficiency, or Pareto optimality, is a central theory in economics with broad applications in game theory, engineering and the social sciences. ... Kaldor-Hicks efficiency is a type of economic efficiency that occurs only if the economic value of social resources is maximized. ... Income inequality metrics or income distribution metrics are techniques used by economists to measure the distribution of income among members of a society. ... Graphical representation of the Gini coefficient The Gini coefficient is a measure of inequality of a distribution, defined as the ratio of area between the Lorenz curve of the distribution and the curve of the uniform distribution, to the area under the uniform distribution. ... The Lorenz curve was developed by Max O. Lorenz in 1905 as a graphical representation of income distribution. ... ... Copenhagen Consensus is a project which seeks to establish priorities for advancing global welfare using methodologies based on the theory of welfare economics. ... Measures of national income and output are used in economics to estimate the value of goods and services produced in an economy. ... This aims to be a complete list of the articles on economics. ... See business ethics, political economy and Philosophy of business for an overview. ... This is a list of important publications in economics, organized by field. ...

References

• Atkinson, A. (1975) The Economics of Inequality, Oxford University Press, London.
• Little, I. (1973) A Critique of Welfare Economics, 2nd edition, Oxford University Press, London.
• O'Connell, J. (1982) Welfare Economic Theory, Auburn House Publishing, Boston.
• Just, et al (2004) "The Welfare Economics of Public Policy", Edward Elgar Publishing, Cheltenham and Northampton.