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.… Read the rest

Poverty Trap

Poverty trap is a situation where an unemployed person receiving social security benefits not encouraged to seek work because his or her after‐tax earnings potential in work is less than the benefits currently obtained by not working. The poverty trap occurs due to benefits such as income support, housing benefit, single parent allowance and family tax credit. Given that social security benefits represent the ‘bottom line’ (that is, the provision of some socially and politically ‘acceptable’ minimum standard of living), the problem is how to reconcile this with the ‘work ethic’.

For example, consider the case of a low-skilled person in the UK. He is unable to get a high-paid job because he doesn’t have the right skills, training or experience. He has two options. First one is to get a low-paid job or second option is to claim unemployment benefits. If he gets a low paid job he will have to pay taxes and national insurance so he decides he is actually financially better-off just claiming benefits for being unemployed. As time goes by he carries on claiming benefits and continues to lose his ability and confidence in himself. This makes it more difficult for him to get a decent-wage job and more appealing to continue living on benefits. We can say that he is in the poverty trap.

One suggested way to release people from poverty trap is for government to provide employers with employment subsidies that allow them to pay wages higher than the minimum level of social security, even though the marginal revenue product of the work undertaken does not warrant it.… Read the rest

The Edgeworth Box

In 1881, Francis Y. Edgeworth came up with a way of representing, using the same axis, indifference curves and the corresponding contract curve in his book “Mathematical Psychics: an Essay on the Application of Mathematics to the Moral Sciences”. It was Vilfredo Pareto, in his book “Manual of Political Economy”, 1906, who developed Edgeworth’s ideas into a more understandable and simpler diagram, which today we call the Edgeworth box.

Edgeworth box a conceptual device for analyzing possible trading relationships between two individuals or countries, using indifference curves. It is constructed by taking the indifference map of one individual (B) for two goods (X and Y) and inverting it to face the indifference map of second individual (A) for the same two goods. Thus, Edgeworth box is a traditional visualization of the benefits potentially available from international trade.

Individual A’s preferences are depicted the three indifference curves A1, A2 and corresponding to higher levels of satisfaction as we move outward from origin OA. Individual B’s preferences are depicted by the three indifference curves B2 and B3, corresponding to higher levels satisfaction as we move outward from origin OB. Both consumers’ preferences between the reflected in the slopes of their indifference curves, with the slope of a curve at any point reflecting the Marginal Rate of Substitution of X for Y. Only where individual A’s indifference curves are tangential to individual B’s indifference curves (points E, F and G) will A’s marginal rate of substitution of product X for product Y be the same as B’s marginal rate of substitution of X for Y, so that their relative valuations of the two products are the same.… Read the rest

Objectives of Fiscal Policy

By fiscal policy we mean, the government’s tax efforts, public expenditure and public borrowing. Through these the government can effectively encourage consumption, investment and savings habits and also restrict them. For example, suppose there is inflation in a country. Inflation implies that the people have high purchasing power and so they demand goods. To curb this, the government may raise the personal tax and also the corporate tax. Similarly, by altering its expenditure on various public projects, the government would be able to influence the prevailing economic condition. Public borrowing  involves government issuing bonds and encouraging common public and other institutions to buy them. By this, the government would be able to bring down the level of purchasing power in the economy and control the inflation.

The following are the objectives of fiscal policy:

  1. Maximization of the aggregate saving is the first objective. Tins are achieved by encouraging people to reduce the current and future consumption. Specifically the attempt is to bring down and control the conspicuous consumption of the rich people. The government can impose taxes on them and can provide the basic necessities of life to the poor class on low rate. In this way by providing incentives, savings can be increased.
  2. Maximization of capital formation is the second objective. Through this objective the country can try to achieve an accelerated economic growth. This will help the country to overcome the stagnation and achieve a higher rate of economic growth.
  3. The third objective is to divert the available resources from the less productive to most productive purposes. 
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Economic Policies to Control Inflation

Inflation has to be controlled, otherwise the extent of damage done to the economy will be something substantial and the economy would take a long time to recover from the effects of inflation. In this direction of control of inflation, the following are the theoretical measures available. These measures could be classified into three groups viz. Monetary measures, Fiscal measures and Other measures.

1. Monetary Measures

Monetary measures are steps taken by the Central bank of a country as the head of the monetary system. These measures are usually refereed to as the, quantitative credit controls and qualitative credit controls. The former include bank rate, open market operations and the variable reserve ratio. The, latter include margin requirements, moral suasion, direct action, control through directives, consumer credit regulation or rationing, publicity, etc.

  1. Quantitative Credit Controls: Bank rate is the first, measure to curb credit creation activity of the commercial banks, as during inflationary period the volume of money supply has to be reduced. Bank rate is the rate at which the central bank of a country re-discounts the bills already discounted by the commercial banks. When the central bank wants to control credit creation by commercial banks, it would simply increase the bank rate. Correspondingly the commercial banks would increase the discount rate which acts as a disincentive for the businessmen and others to approach the commercial banks for discounting their bills. However, the success of this policy depends on the co-operation of the commercial banks. Open market operations are another quantitative credit control measure. 
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Types of Unemployment

The population of an economy is divided into two categories, the economically active and the economically inactive. The economically active population (labor force) or working population refers to the population that is willing and able to work, including those actively engaged in the production of goods and services (employed) and those who are unemployed. Whereas, unemployed refers to people who are willing and a capable of work but are unable to find suitable paid employment. The next category, the economically inactive population refers to people who are neither working nor looking for jobs. Examples include housewives, full time students, invalids,those below the legal age for work, old and retired persons.

Unemployment is of different types. The important types of unemployment are:

  1. Structural unemployment: This is a type of unemployment caused mainly by the change in the development strategy adopted by an economy. For example, suppose a country basically agricultural in nature, plans to adopt industrialization as a strategy. This will result in displacement of labor in agriculture and not all of them can be accommodated in the industries. This type of unemployment caused is called Structural unemployment. This type of unemployment is also known as the chronic unemployment or the Marxian or long-term unemployment. It is mostly to be found in the underdeveloped countries. This type of unemployment is due to the deficiency of capital resource sin relation to their demand. The problem in the underdeveloped countries is to get rid of this age-old chronic unemployment by accelerating the process of economic growth.
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