Understanding Welfare Economics

• Welfare economics evaluates economic situations from society's well-being.
• Welfare economics is a "normative" study that involves judgment and prescription.
• Economists use its principles to judge and form economic policies.

Welfare Economics vs. Positive Economics

• Positive economics explains why things are as they are, tracing causal relationships.
• Welfare economics is a normative branch that evaluates results and focuses on policy using judgments and prescriptions.

Normative Economics

• Normative economics focuses on economic fairness.
• Normative economics questions if resource allocations are efficient.
• A key issue is whether changes in resource allocation increase or decrease social welfare.
• Welfare economics establishes norms to judge or assess economic states and policies for efficiency and social welfare.
• The described criteria serve as the basis for recommending policies that will improve social welfare.

Role of Value Judgments

• "Value judgments" play a crucial role by shaping evaluations of economic policies, resource distribution, and societal well-being.
• Value judgments or values embody ethical beliefs about what is good or bad.
• These conceptions are based on ethical, political, philosophical, and religious beliefs.
• These conceptions are not based on scientific logic or law.

Individual Welfare vs. Social Welfare

• Individual welfare is the satisfaction a person gets at a given time.
• Individuals always attempt to maximize individual satisfaction.
• Social welfare is the sum total of the satisfaction of all the people in a society.

Fundamental Theorems of Welfare Economics

• Welfare economics is associated with two fundamental theorems.
• The First Fundamental Theorem assumes individuals and firms are self-interested price takers, resulting in a competitive equilibrium that is Pareto optimal.
• The first theorem captures Adam Smith's logic of the "invisible hand."
• Perfect competition in all markets is required.
• No externalities are permitted.
• Markets must be complete (all goods and services can be traded completely).
• Rational behavior of individuals and firms is required.
• Prices adjust until supply equals demand.
• When supply equals demand, all individuals and firms are maximizing utilities and profits, creating a competitive equilibrium.

Drawbacks and Second Fundamental Theorem

• Many economists wrongly believe that perfect competition always leads to Pareto optimality and maximizes social welfare.
• Many economists wrongly believe that perfect competition guarantees second-order conditions are met for Pareto optimality.
• The Second Fundamental Theorem states that any Pareto-efficient allocation can be achieved as a competitive equilibrium by reallocating the initial endowments of goods among individuals.
• It asserts that maximizing overall well-being through any resource allocation can be reached through competitive markets.
• To reach maximization, redistribute initial endowments of goods or resources among individuals.
• Competitive markets that redistribute resources can achieve any Pareto-efficient allocation.
• This highlights the role of government or mechanisms to redistribute resources.
• These governmental bodies ensure Pareto-efficient outcomes are achieved.

Approaches to Measuring Social Welfare

• Two approaches to measuring social welfare are: Cardinal Utility and Ordinal Utility.

Cardinal Utility

• The early Neoclassical approach was developed by Edgeworth, Sidgwick, Marshall, and Pigou.
• It assumes utility is cardinal and additional consumption provides smaller utility increases (diminishing marginal utility).
• With these assumptions, it is possible to construct a social welfare function by summing individual utility functions.

Ordinal Utility

• The New Welfare Economics approach is based on the work of Pareto, Hicks, and Kaldor.

Criteria of Social Welfare

• To evaluate alternative economic situations, a criterion of social well-being or the welfare is needed.
• Various criteria for social welfare have been suggested by economists at different times.

Classical Welfare Economics

• Included in classical welfare economics, is growth of GNP as a criteria of welfare as theorized by Adam Smith.
• Adam Smith implicitly accepted the growth of the wealth of a society as a welfare criterion.
• Adam Smith believed that economic growth resulted in social welfare because growth increased employment.
• Growth increased the goods available for consumption.
• Adam Smith, economic growth meant higher total welfare.
• This criterion implicitly assumes that the distribution of wealth and income are the same.
• If factors undergo changes, GNP growth criterion of Adam Smith can break down.

Bentham's Criterion

• Jeremy Bentham argued that welfare is improved when 'the greatest good is secured for the greatest number'.
• Bentham defined social welfare as the sum total of the happiness (welfare) of all the individuals in the society.
• Implicit in this dictum is that the total welfare is the sum of the utilities of the individuals of the society.
• Bentham's Welfare Criterion is based on cardinal utility analysis.
• Bentham's criterion is an interpersonal comparison of the deservingness of the members of the society.
• Bentham's ethical system to economics has serious shortcomings and pitfalls.
• Bentham's criterion may imply that some individuals or groups are more worthy than others.
• Bentham's criterion cannot be applied to compare situations where 'the greatest good' and the 'greatest numbers' do not exist simultaneously.

Problems in Measuring Social Welfare

• Social welfare means the satisfaction or wellbeing of the society.
• Despite the satisfaction received by people, the growth of social welfare is hard to quantify.
• The main problems in the measurement of social welfare are as follows:
• Measuring cardinal utility or satisfaction isn't possible.
• Secondly, assumptions related to value judgements and the comparison of value between people should be taken into account.
• Thirdly, marginal utility is subject to changes.
• Fourthly, both positive and negative externalities must be accounted for.
• Fifthly, individual preferences can differ.
• Sixthly, peoples preferences and the intensity with which they have them can differ.

Neo-Classical Welfare Economics

• The structures of the neo-classical welfare economics was based upon the writings of Alfred Marshall and A.C. Pigou.

Marshall's Version

• The Marshallian approach gave importance to the concept of aggregate surplus of the community.
• The community surplus is the excess of the sum of satisfactions over the sum of dissatisfactions accruing to the community from a given economic activity.
• S = Aggregate surplus of the community.
• So = the sum of satisfactions to the community from a given economic activity.
• S₁ = The sum of dissatisfactions to the community from that economic activity.
• Marshall abandoned the concept of aggregate surplus and relied upon the concept of consumer's surplus.

Pigouvian Condition of Welfare

• Pigou's welfare analysis focuses on maximizing societal welfare by increasing individual satisfaction and ensuring equitable conditions.
• Pigouvian condition of welfare introduced the concepts of external economies.
• External economies include benefits spilling over to others and external diseconomies (costs affecting others negatively).
• These conditions impact overall welfare.
• The Pigouvian condition of welfare differentiates between private costs and social costs, emphasizing the need to account for both in welfare assessments
• Redistribution of income from the rich to the poor enhances welfare if it does not harm production or investment.
• Pigou highlighted the distinction between social marginal product and private marginal product, advocating for policies like subsidies for positive externalities.
• Taxing negative externalities to align both and achieve social optimum is another way towards the Pigouvian Condition of Welfare.

The General and Economic Welfare

• Pigou made a distinction between the general and economic welfare.
• Economic factors influence the general welfare according to him, including psychological, social, cultural, and political factors.
• Many of these factors are not quantifiable, therefore Pigou says general welfare cannot be exactly measured.
• Pigou says the economic welfare is that part of social or general welfare, that can be directly or indirectly measured with money.
• Economic welfare is the welfare obtained through the use of goods and services that can be exchanged in terms of money.

According to Pigou Factors Influencing Economic Welfare

• Magnitude of National Dividend: Greater availability of goods and services leads to higher satisfaction.
• Distribution of Income: Redistribution from rich to poor increases welfare by satisfying more essential wants.
• Redistribution favoring the rich promotes luxury consumption, reducing overall welfare.
• Economic welfare depends on a balance between production, redistribution, and addressing externalities.
• There should be an increase in the real national dividend or increase in the flow of goods and services in real terms.
• There should be redistribution of national income in favor of the poor without adversely affecting the inducement to work, save and invest.

Main Assumptions of Neo-Classical Welfare Economics

• Every individual is rational and he attempts to maximise his satisfaction.
• Maximization is achieved through his spending on different products and services.
• Inter-personal comparisons of satisfaction are possible.
• It is also possible to institute intra-personal comparison of satisfaction.
• The different individuals derive the same level of satisfaction from the equal amount of real income.
• It implies that they have equal capacities to secure satisfaction.
• The marginal utility of money diminishes with a rise in money income and vice-versa.
• The gain in utility from a given increment in income in the case of a poor person is more than the loss in utility due to a reduction in income by an equivalent amount in the case of a rich person.
• There is a state of full employment in the economy.
• There are the conditions of perfect competition in the market.

Criticism of Neo-Classical Welfare Economics

• Unrealistic Assumptions: Assumes rational behavior, perfect competition, full employment, and measurable satisfaction, which often do not exist in real-world economies.
• Cardinal Measurement of Utility: Relies on the precise measurement of utility, which is subjective and practically impossible to quantify accurately.
• Interpersonal Comparisons of Utility: Assumes satisfaction levels can be compared between individuals, which is philosophically and methodologically contentious.
• Overemphasis on Income Redistribution: Focuses heavily on redistributing income as a means to increase welfare, often ignoring its potential negative effects on incentives for work, savings, and investments.
• Empirically not sound.