Welfare Economics

“The greatest meliorator of the world is selfish, huckstering trade.” (R.W. Emerson, Work and Days)

Welfare Economics is a normative branch of economics that is concerned with the way economic activity ought to be arranged so as to maximize economic welfare. The hallmark of welfare economics is that policies are assessed exclusively in terms of their effects on the well-being of individuals. Accordingly, whatever is relevant to individuals well-being is relevant under welfare economics, and whatever is unrelated to individuals well-being is excluded from consideration under welfare economics. Economists often use the term utility to refer to the well-being of an individual, and, when there is uncertainty about outcomes, economists use an ex ante measurement of well-being, so-called expected  utility. Welfare economics employs value judgement s about what ought to be produced, how production should be organized, the way income and wealth ought to be distributed, both now and in the future. Unfortunately, each individual in a community has a unique set of value judgements, which are dependent upon his or her attitudes, religion, philosophy and politics, and the economist has difficulty in aggregating these value judgement s in advising policy makers about decisions that affect the allocation of resources (which involves making interpersonal comparisons of utility).

The branch of economics called welfare economics is an outgrowth of the fundamental debate that can be traced back to Adam Smith, if not before. It is the economic theory of measuring and promoting social welfare. In The Wealth of Nations, Book IV, Smith wrote: “Every individual necessarily labors to render the annual revenue of the society as great as he can. He generally indeed neither intends to promote the public interest, nor knows how much he is promoting it … . He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.”

Economists have tried for many years to develop criteria for judging economic efficiency to use as a guide in evaluating actual resource deployments. The classical economists treated utility as if it was a measurable scale of consumer satisfaction, and the early welfare economists, such as Pigou, continued in this vein, so that they were able to talk in terms of changes in the pattern of economic activity either increasing or decreasing economic welfare. However, once economists rejected the idea that utility was measurable, then they had to accept that economic welfare is immeasurable and that any statement about welfare is a value judgement influenced by the preferences and priorities of those making the judgement. This led to a search for welfare criteria, which avoided making interpersonal comparisons of utility by introducing explicit value judgments as to whether or not welfare has increased.

The simplest criterion was developed by Vilfredo Pareto, who argued that any reallocation of resources involving a change in goods produced and/or their distribution amongst consumers could be considered an improvement if it made some people better off (in their own estimation) without making anyone else worse off. This analysis led to the development of the conditions for Pareto Optimality, which would maximize the economic welfare of the community, for a given distribution of income. Pareto optimality is thus a dominance concept based on comparisons of vectors of utilities. It rejects the notion that utilities of different individuals can be compared, or that utilities of different individuals can be summed up and two alternative situations compared by looking at summed utilities. When ultimate consumers do not appear in the model, as in the pure production framework, a situation is said to be Pareto optimal if there is no alternative that results in the production of more of some output, or the use of less of some input, all else equal. Obviously saying that a situation is Pareto optimal is not the same as saying it maximizes GNP, or that it is best in some unique sense.  The Pareto criterion avoids making interpersonal comparisons by dealing only with uncontroversial cases where no one is harmed. However, this makes the criterion inapplicable to the majority of policy proposals that benefit some and harm others, without compensation. There are generally many Pareto optima. However, optimality is a common good concept that can get common assent: No one would argue that society should settle for a situation that is not optimal, because if A is not optimal, there exists a B that all prefer. Nicholas Kaldor and John Hicks suggested an alternative criterion (the compensation principle), proposing that any economic change or reorganization should be considered beneficial if, after the change, gainers could hypothetically compensate the losers and still be better off. In effect, this criterion subdivides the effects of any change into two parts: (a) efficiency gains/losses; (b) income‐distribution consequences.

As long as the gainers evaluate their gains at a higher figure than the value that losers set upon their losses, then this efficiency gain justifies the change, even though (in the absence of actual compensation payments) income redistribution has occurred. Where the gainers from a change fully compensate the losers and still show a net gain, this would rate as an improvement under the Pareto criterion. Where compensation is not paid, then a second best situation may be created where the economy departs from the optimum pattern of resource allocation, leaving the government to decide whether it wishes to intervene to tax gainers and compensate losers.

In addition to developing welfare criteria, economists such as Paul Samuelson have attempted to construct a social‐welfare function that can offer guidance as to whether one economic configuration is better or worse than another. The social‐welfare function can be regarded as a function of the welfare of each consumer. However, in order to construct a social‐welfare function, it is necessary to take the preferences of each consumer and aggregate them into a community preference ordering, and some economists, such as Kenneth Arrow, have questioned whether consistent and noncontradictory community orderings are possible.

Despite its methodological intricacies, welfare economics is increasingly needed to judge economic changes, in particular rising problems of environmental pollution that adversely affect some people while benefiting others. Widespread adoption of the ‘polluter pays’ principle reflects a willingness of governments to make interpersonal comparisons of utility and to intervene in markets to force polluters to bear the costs of any pollution that they cause.

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