Welfare economics

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Welfare economics is a branch of economics that uses microeconomic techniques to evaluate well-being (welfare) at the aggregate (economy-wide) level. [1]

Microeconomics branch of economics that studies the behavior of individual households and firms in making decisions on the allocation of limited resources

Microeconomics is a branch of economics that studies the behaviour of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms.

Well-being, wellbeing, or wellness is the condition of an individual or group. A high level of well-being means that in some sense the individual's or group's condition is positive.

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Attempting to apply the principles of welfare economics gives rise to the field of public economics, the study of how government might intervene to improve social welfare. Welfare economics also provides the theoretical foundations for particular instruments of public economics, including cost–benefit analysis, while the combination of welfare economics and insights from behavioral economics has led to the creation of a new subfield, behavioral welfare economics. [2]

Public economics is the study of government policy through the lens of economic efficiency and equity. Public economics builds on the theory of welfare economics and is ultimately used as a tool to improve social welfare.

Cost–benefit analysis (CBA), sometimes called benefit costs analysis (BCA), is a systematic approach to estimating the strengths and weaknesses of alternatives used to determine options which provide the best approach to achieving benefits while preserving savings. A CBA may be used to compare completed or potential courses of actions, or to estimate the value against the cost of a decision, project, or policy. It is commonly used in commercial transactions, business or policy decisions, and project investments.

Behavioral economics academic discipline

Behavioral economics studies the effects of psychological, cognitive, emotional, cultural and social factors on the economic decisions of individuals and institutions and how those decisions vary from those implied by classical theory.

The field of welfare economics is associated with two fundamental theorems. The first states that given certain assumptions, competitive markets produce (Pareto) efficient outcomes; [3] it captures the logic of Adam Smith's invisible hand. [4] The second states that given further restrictions, any Pareto efficient outcome can be supported as a competitive market equilibrium. [3] 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. [3] [5] Because of welfare economics' close ties to social choice theory, Arrow's impossibility theorem is sometimes listed as a third fundamental theorem. [6]

There are three fundamental theorems of welfare economics. The first theorem states that a market will tend toward a competitive equilibrium that is weakly Pareto optimal when the market maintains the following two attributes:

Pareto efficiency or Pareto optimality is a state of allocation of resources from which it is impossible to reallocate so as to make any one individual or preference criterion better off without making at least one individual or preference criterion worse off. The concept is named after Vilfredo Pareto (1848–1923), Italian engineer and economist, who used the concept in his studies of economic efficiency and income distribution.

The invisible hand describes the unintended social benefits of an individual's self-interested actions, a concept that was first introduced by Adam Smith in The Theory of Moral Sentiments, written in 1759, invoking it in reference to income distribution. In this work, however, the idea of the market is not discussed, and the word "capitalism" is never used.

A typical methodology begins with the derivation (or assumption) of a social welfare function, which can then be used to rank economically feasible allocations of resources in terms of the social welfare they entail. Such functions typically include measures of economic efficiency and equity, though more recent attempts to quantify social welfare have included a broader range of measures including economic freedom (as in the capability approach).

In welfare economics, a social welfare function is a function that ranks social states as less desirable, more desirable, or indifferent for every possible pair of social states. Inputs of the function include any variables considered to affect the economic welfare of a society. In using welfare measures of persons in the society as inputs, the social welfare function is individualistic in form. One use of a social welfare function is to represent prospective patterns of collective choice as to alternative social states. The social welfare function provides the government with a simple guideline for achieving the optimal distribution of income.

Capability approach economic theory

The capability approach is an economic theory conceived in the 1980s as an alternative approach to welfare economics. In this approach, Amartya Sen and Martha Nussbaum bring together a range of ideas that were previously excluded from traditional approaches to the economics of welfare. The core focus of the capability approach is on what individuals are able to do.

Measuring social welfare

Cardinal utility

The early Neoclassical approach was developed by Edgeworth, Sidgwick, Marshall, and Pigou. It assumes the following:

Neoclassical economics is an approach to economics focusing on the determination of goods, outputs, and income distributions in markets through supply and demand. This determination is often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits by firms facing production costs and employing available information and factors of production, in accordance with rational choice theory, a theory that has come under considerable question in recent years.

Francis Ysidro Edgeworth Irish economist (1845-1926)

Francis Ysidro Edgeworth was an Anglo-Irish philosopher and political economist who made significant contributions to the methods of statistics during the 1880s. From 1891 onward, he was appointed the founding editor of The Economic Journal.

Henry Sidgwick English philosopher

Henry Sidgwick was an English utilitarian philosopher and economist. He was the Knightbridge Professor of Moral Philosophy at the University of Cambridge from 1883 until his death, and is best known in philosophy for his utilitarian treatise The Methods of Ethics. He was one of the founders and first president of the Society for Psychical Research and a member of the Metaphysical Society and promoted the higher education of women. His work in economics has also had a lasting influence.

Cardinal utility

In economics, a cardinal utility function or scale is a utility index that preserves preference orderings uniquely up to positive affine transformations. Two utility indices are related by an affine transformation if for the value of one index u, occurring at any quantity of the goods bundle being evaluated, the corresponding value of the other index v satisfies a relationship of the form

In economics, utility is the satisfaction or benefit derived by consuming a product; thus the marginal utility of a goods or service is the change in the utility from an increase in the consumption of that good or service.

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 indifference-curve map, for example).

Criteria

Efficiency

Situations are considered to have distributive efficiency when goods are distributed to the people who can gain the most utility from 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.

This ideal state of affairs can only come about if four criteria are met:

There are a number of conditions that, most economists agree, may lead to inefficiency. They include:

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.

Equity

There are many combinations of consumer utility, production mixes, and factor input combinations consistent with efficiency. In fact, there are an infinity of consumption and production equilibria that yield Pareto optimal results. There are as many optima as there are points on the aggregate production–possibility 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 shows the relative importance of the individuals that comprise society.

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, or Rawlsian utility function (Stiglitz, 2000, p102)[incomplete reference]. 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.

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.

Social indifference curves small.png

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.

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).

Fundamental theorems

The field of welfare economics is associated with two fundamental theorems. The first states that given certain assumptions, competitive markets (price equilibria with transfers, e.g. Walrasian equilibria [4] ) produce Pareto efficient outcomes. [3] The assumptions required are generally characterised as "very weak". [7] More specifically, the existence of competitive equilibrium implies both price-taking behaviour and complete markets, but the only additional assumption is the local non-satiation of agents' preferences – that consumers would like, at the margin, to have slightly more of any given good. [4] The first fundamental theorem is said to capture the logic of Adam Smith's invisible hand, though in general there is no reason to suppose that the "best" Pareto efficient point (of which there are a set) will be selected by the market without intervention, only that some such point will be. [4]

The second fundamental theorem states that given further restrictions, any Pareto efficient outcome can be supported as a competitive market equilibrium. [3] These restrictions are stronger than for the first fundamental theorem, with convexity of preferences and production functions a sufficient but not necessary condition. [5] [8] A direct consequence of the second theorem is that a benevolent social planner could use a system of lump sum transfers to ensure that the "best" Pareto efficient allocation was supported as a competitive equilibrium for some set of prices. [3] [5] More generally, it suggests that redistribution should, if possible, be achieved without affecting prices (which should continue to reflect relative scarcity), thus ensuring that the final (post-trade) result is efficient. [9] Put into practice, such a policy might resemble predistribution.

Because of welfare economics' close ties to social choice theory, Arrow's impossibility theorem is sometimes listed as a third fundamental theorem. [6]

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 C from the earlier diagram. Point D is on the social utility frontier because the marginal rate of substitution at point C is equal to the marginal rate of transformation at point A. Point E corresponds with point B 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.

Social indifference curve diagram.svg

Although all the points on the grand social utility frontier are Pareto efficient, only one point identifies where social welfare is maximized. Such point is called "the point of bliss". This point is Z where the social utility frontier MN is tangent to the highest possible social indifference curve labelled SI.

Criticisms

Some, such as economists in the tradition of the Austrian School, 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.

Also, the economists of the Austrian School question the relevance of Pareto optimal allocation considering situations where the framework of means and ends is not perfectly known, since neoclassical theory always assumes that the ends-means framework is perfectly defined.

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.[ citation needed ] These price-based measures are seen as promoting consumerism and productivism by many.[ citation needed ] It is possible to do welfare economics without the use of prices; however, this is not always done.[ citation needed ]

Value assumptions explicit in the social welfare function used and implicit in the efficiency criterion chosen tend to make welfare economics a normative and perhaps subjective field. This can make it controversial.

However, perhaps most significant of all are concerns about the limits of a utilitarian approach to welfare economics. According to this line of argument, utility is not the only thing that matters and so a comprehensive approach to welfare economics should include other factors. The capabilities approach is an attempt to construct a more comprehensive approach to welfare economics, one in which an individual's well-being and agency are evaluated in terms of their capabilities and functionings. [10]

See also

Notes

  1. Deardorff 2014
  2. Bernheim 2008
  3. 1 2 3 4 5 6 Hindriks & Myles 2013 , pp. 33–43
  4. 1 2 3 4 Mas-Colell 1995 , pp. 549–50
  5. 1 2 3 Mas-Colell 1995 , pp. 551–572
  6. 1 2 Feldman 2008
  7. Mas-Colell 1995 , p. 545
  8. Varian 2006 , p. 600
  9. Varian 2006 , pp. 586–89
  10. Sen, Amartya (2001). Development as Freedom. Oxford New York: Oxford University Press. ISBN   9780192893307.

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