| Economics (Optional) Foundation Course for CSE 2023-24 by Vibhas Jha Sir

ECONOMICS (OPTIONAL)
FOUNDATION COURSE
for CSE 2023-24

MICROECONOMICS
Theories of Welfare

by
Vibhas Jha Sir

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 | Economics (Optional) Foundation Course for CSE 2023-24 by Vibhas Jha Sir

Pareto’s Theory of Welfare (Walras’s General Equilibrium Model)

2x2x2 Model
2 people (A and B)
2 commodities (X and Y)
2 factors of production (Labour and Capital)

PX = price of X
PY = price of Y
W = wage rate
r = rental cost of capital
r = i - m + d;
i = rent
m = inflation
d = depreciation
Production Edgeworth Box

Horizontal axis = LA + LB = L
Vertical axis = KA + KB = K
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Point E represents Pareto efficiency in the production edgeworth box

because it is not possible to increase production of one commodity without
reducing production of another commodity after reaching point P. It also
means that starting from point W, all gains from trade (realisation of capital
and labour) has been exhausted.

MRTSXL,K = MRTSYL,K = W/r

In equilibrium in production edgeworth box (general equilibrium in
production), MRTSXL,K = MRTSYL,K = W/r because isocost should be tangent to
isocost to X and Y (to maintain output of X and Y subject to cost constraint)

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 | Economics (Optional) Foundation Course for CSE 2023-24 by Vibhas Jha Sir

and the two isoquant should be tangent to satisfy Pareto efficiency and
feasibility condition (demand for capital = total supply of capital, demand for
labour = total supply of labour). Therefore, starting from an initial point,
production equilibrium in a general equilibrium model is unique.

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 | Economics (Optional) Foundation Course for CSE 2023-24 by Vibhas Jha Sir

Pareto efficiency in consumption edgeworth box takes place when

indifference curves of A and B are tangent to each other, that is,
MRSAX,Y = MRSBX,Y.
This means it is not possible to make one individual better off without
making the other worse off or all gains from trade between A and B are
exhausted.
A locus of all pareto efficient points in the consumption edgeworth box is
called consumption contract curve.

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Consumption Contract Curve

Equilibrium in consumption edgeworth box should take place such that

MRSAX,Y = MRSBX,Y = Px/Py and feasibikity condition, that is, XA (total demand
for X by A) + XB (total demand for X by B) should add up to total amount of X
produced (Q1X) and similarly YA + YB = QY
Consumption Possibility Curve

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 | Economics (Optional) Foundation Course for CSE 2023-24 by Vibhas Jha Sir

General equilibrium in Production

General equilibrium in Consumption

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 | Economics (Optional) Foundation Course for CSE 2023-24 by Vibhas Jha Sir

Note: In general equilibrium we start with the production of X and Y with use
of labour and capital. After the production of X and Y, exchange of X and Y
takes place between different consumers.
- New equilibrium point with more X and less Y.

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 | Economics (Optional) Foundation Course for CSE 2023-24 by Vibhas Jha Sir

General equilibrium of exchange requires MRSAX,Y = MRSBX,Y = MRT, that is,

willingness to pay by consumers in the economy matches willingness to
charge by producers. This ratio of opportunity cost of production matches the
ratio of willingness to sacrifice one commodity for another by consumer.
If MRSX,Y > MRTX,Y then the market is willing to pay more units for commodity
X as compared to commodity Y given their ratio of marginal cost. Therefore,
it will incentivise production of X by substituting X for Y. this means there
will be higher availability of X (MUX will fall and MCX will rise and MUY will
rise and MCY will fall) and lesser availability of Y substitution will continue
until MRSX,Y becomes equal to MRTX,Y.
General equilibrium of production, consumption and exchange are
simultaneously determined starting from any point of endowment. When the
consumption contract curve is drawn in utility space, that is, utility of A on
x-axis and of B on y-axis then it represents Utility Possibility Frontier (UPF).
UPF is a combination of all Pareto efficient points in the consumption
edgeworth box. One point on UPF will represent the unique general
equilibrium.
Starting from different endowments it is possible to derive multiple UPF
which means that there can be multiple points satisfying all general
equilibrium conditions in the economy, joining each of these points on every
UPF we get Grand UPF (GUPF).

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GUPF is a combination of points which necessarily satisfy general equilibrium

conditions, in turn satisfying Pareto efficiency in both production and
consumption. Therefore, GUPF is the boundary of maximum welfare that the
economy can reach given the utility function of ‘A’ and ‘B’.
The point of social equilibrium is arrived at by satisfying seven 1st order
conditions and five 2nd order conditions.
The 1st order conditions are also called marginal principles of pareto
optimality. They are:
1. Equilibrium in production.
2. Equilibrium in exchange.
3. Equilibrium in distribution or product mix.
4. Efficiency in specialisation, that is, each firm will specialise until it can
produce the commodity at least cost combination.
5. Both the firms will use inputs such that they are under diminishing
marginal productivity.
6. A firm has a choice to strike a balance between work, leisure and
income generation, that is, the firm has to utilise resources such that
there is no incentive for the worker to substitute labour for leisure and
the other way around.
7. The trade off with future time period is complete, that is, the interest
charged on capital should reflect its future production capacity.
2nd order conditions are:
8. No factor of production should have unutilised capacity.
9. ICs should be strictly convex and PPF should be strictly concave.
10. There should be no externalities in production and consumption.
11. No firm should have increasing returns to scale.
12. Income distribution among consumers should not change.
In a practical world, the last three conditions may or may not be satisfied in
spite of perfect competition. Therefore, to argue that perfect competition
will necessarily maximise welfare may not hold true in the real world.
Pareto optimality also does not guarantee distribution equity. Therefore, if
the Pareto method is used for welfare improvement, then one should include
Amartya Sen’s suggestion of redistributing the endowment before allowing
exchange.

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 | Economics (Optional) Foundation Course for CSE 2023-24 by Vibhas Jha Sir

Prof. Sen laments that Pareto’s welfare function pays no attention to

distributional considerations of utility or welfare. He deplores that Pareto’s
welfare optimum is rooted in self-seeking behaviour of individuals which he
thinks is not something interesting in welfare economics.

Fundamental Welfare Theorems

Economists tend to believe that systems of competitive markets allocate
resources reasonably well. The theoretical grounds for this belief are
contained in the two fundamental theorems of welfare economics:
First Fundamental Theorem
According to this theorem, the allocation of goods and inputs obtained in a
general competitive equilibrium is economically efficient, i.e. such allocation
is Pareto efficient. In other words, the first fundamental theorem of welfare
tells us that any competitive general equilibrium or Walrasian equilibrium is
Pareto efficient. This theorem is also known as the "Invisible hand" theorem
because the theorem states that a general competitive equilibrium exhausts
all the possible mutual gains from trade or redistribution of the resources.
Second Fundamental Theorem
There is a difference between desirability and efficiency, i.e. an
allocation/distribution may be efficient because it satisfies Pareto's efficient
conditions but it does not mean that it is just or fair as well. It may be
unfair. Therefore, we have a question, i.e. car we achieve an allocation
which is efficient as well as desirable/fair? The second fundamental theorem
answers this question.
According to the second fundamental theorem of welfare, a general
competitive equilibrium or Walrasian equilibrium can be obtained through a
judicious distribution of the resources. The theorem states that the problem
of distribution and efficiency are separable.

Social Welfare Function

Social welfare functions are defined over the utility of individuals which is
the function of their consumption of available commodities.

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 | Economics (Optional) Foundation Course for CSE 2023-24 by Vibhas Jha Sir

Social welfare functions can be used to derive the iso welfare curve. They
are a combination of individual utilities such that social welfare remains
constant.
Rawls’s and Bentham’s Social Welfare Function
Rawls’s conception of social welfare function is of the form W = max(min U).
It implies that the society should identify a person who gets minimum utility
and then maximize this person’s utility, and having done this, the society
should repeat the process consecutively through the population. The
philosopher John Rawls in his book ‘A Theory of Justice’ (1971) proposed that
people would want to choose a social welfare that focuses on improving the
well being of the poorest or most unfortunate person in the society. Figure
below shows the social welfare contours implied by Rawls’s social welfare
function. The social welfare contours are at right angles to the 45 degree
line.

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 | Economics (Optional) Foundation Course for CSE 2023-24 by Vibhas Jha Sir

A move from point 1 to 2 does not change social welfare because the utility
of better off persons B increases but there is no change in the utility of less
well off person A. Yet this change is Pareto improvement because person B is
made better off and person A is not worse off. Pareto improvement can
therefore occur but Rawls’s social welfare function recognizes no social
improvement if better off is not the ‘weakest link’ in the society. Social
welfare increases as the consequence of a change from point 1 to point 3 in
figure above because this change increases the utility of weakest link person
A.
An alternative approach to defining social welfare is associated with the
English Political Economist Jeremy Bentham (1748-1832). Bentham proposed
that a society should follow the objective of seeking “the greatest good for
the greatest number”.
The social objective has been interpreted as implying that social welfare is
defined by adding the utilities of everybody in society though strictly
speaking; it is not correct. For, n people in a society the social welfare
function is, therefore,
W = U1 + U2 + U3 +............ + Un
When society consists of two people, social welfare is the sum of utilities.
W = U A + UB

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The straight lines with slopes of 45 degree indicate perfect substitutability in

social welfare between the utility of one person and the utility of another.
All that matters for social welfare is the sum of utilities. The distribution of
utilities does not matter. Rawls and Bentham are limiting cases of a general
social welfare function. Rawls cares only about distribution and only about
the worst person. Bentham is indifferent to distribution and wants the sum of
utilities to be maximized without regard for distribution.
Modern Social Welfare Function or Bergson-Samuelson Welfare Function
It is defined over the utility of individuals based on commodity consumed and
it is downward sloping and strictly convex to the origin.
Social welfare function, that is, iso welfare curve and GUPF can be used to
define bliss point or point of maximum satisfaction for the society. This is the
point at which GUPF is tangent to the highest possible iso welfare function
which represents Pareto welfare optimum.

Criticisms of Pareto Efficiency Conditions

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 | Economics (Optional) Foundation Course for CSE 2023-24 by Vibhas Jha Sir

1. It assumed perfect competition which may not exist in all the markets.
2. It is a static model used to describe dynamic equilibrium.
3. It doesn't consider arbitration based on compensation.
4. It does not allow any role to distinguish between allocation and
distribution.
Several of these criticisms are solved in Kaldor-Hicks model in which the
assumptions taken are:
1. Individuals are rational.
2. Tastes and preferences do not change.
3. There is no externality.
4. Problem of allocation can be separated from the problem of distribution.
5. Utility is ordinal.
According to Kaldor’s theory, social welfare can be achieved if those who are
gaining can compensate those who are losing as a result of any policy
decision.
Note: Employee pays more than employer. This is something which the
government should make up. Due to exemptions and showing expenditure
and all leads employers to pay less tax. Whereas, employers pay flat 30% tax.

Kaldor implied that it is possible to go beyond Pareto’s conditions for social

welfare. For example, point P is not pareto efficient (starting from point K)
but, according to Kaldor’s theory, if B can compensate for A such that they
finally reach point T then the society can make the choice. This is reaching
efficiency through compensation principle.

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 | Economics (Optional) Foundation Course for CSE 2023-24 by Vibhas Jha Sir

Hicks expressed the same compensation theory by assorting the other way
round, that is, if the losers can bribe the gainers from not changing the
current status quo then it is a social improvement if the status quo is
maintained.
This theory was based on compensation principle and changed the traditional
method which suggested that it is not possible to make one person better off
without making others worse off. The theory also suggested that any
improvement in resources which shifts UPF outwards to the right will make
everybody better off.

Scitovsky’s Paradox
Scitovsky suggested that if there are two possible UPF which intersect each
other then Kaldor-Hicks principle can result in contradiction.

If UPFs intersect like AB and CD then it is possible to claim that G is superior

to E because after reaching G by compensation society can move to F which
is certainly a superior bundle than E. But, it is possible to move from E to H,
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which is superior to G and this creates a contradiction in Kaldor-Hicks

principle. It was called a paradox because Kaldor-Hicks principle intended to
eliminate any contradiction in welfare distribution but perpetuated it in case
of intersection of UPF. The solution suggested by Scitovsky was double check
criteria of welfare, that is, gainers can persuade the losers to shift away
from their original position and losers cannot persuade gainers not to shift
from the original position. This could happen only if UPFs do not intersect.
Arrow’s Impossibility
Social welfare functions are defined over the utility of individuals.
W = f[u1, u2, u3….un]

Features of Social Welfare Function

1. If all individual utility forms are reflexive, transitive and complete then
social welfare function should also be reflexive, transitive and complete.
2. If society has all individuals identical and all prefer A over B, then social
welfare function should also prefer A over B.
3. Irrelevant bundles should not influence the decision of ranking of relevant
bundles.
In any public voting, there will be a paradox of voting due to agenda
manipulation.
A B C
X 1 3 2
Y 2 1 3
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 | Economics (Optional) Foundation Course for CSE 2023-24 by Vibhas Jha Sir

Z 3 2 1

Aggregate voting; X > Y |

Y > Z | Breaks transitivity
Z>X |

Rank Order
A B
X 1 3
Y 2 1
Z 3 2

Criticisms of Arrow
1. The theorem is based on an infinite horizon with no constraint which
implies that welfare can never be maximised because there is no optimal
level.
2. The theorem does not consider the role of public goods in individual
choices with respect to accessibility of individuals to public goods, that
is, individuals can vote for a public good not only for its availability but
also for its accessibility. Arrow assumed that if a public good is available
then it is automatically accessible for all in the society.
3. Amartya Sen has criticised the theory on the basis of asymmetric
information suggesting that people will make errors of transitivity
violation or irrelevant variables remaining unnoticed only when they are
not informed about the entire set of choice. He also concluded that if
sample size of voters is increased to a critical level then it made
averages dominate extremes and social preference can have all the
three characteristics.

Amartya Sen’s Theory on Social Welfare

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 | Economics (Optional) Foundation Course for CSE 2023-24 by Vibhas Jha Sir

Sen’s theory was the first social choice theory that looked beyond social
welfare functions and focused on capacity enhancement for improving
welfare. It is based on removing deprivation, building competence, improving
capacity and creating opportunities which are equitable for all. Sen believed
that if society can derive methods to identify and satisfy deprivation not only
with respect to money but with respect to capacity to make individual
choices, then it will be the first step to improve social welfare.
He cited democratic governance as the method by which the deprived could
be allowed to get more capability in the system. Capability improvement
through competence building was improvement of the ability among
individual participants to vote independently in a collective choice. It also
includes development of social and economic understanding among all in the
socio-economic system.
Rationality is the function of information set developing social competence in
decision making by minimising asymmetry in information such that there can
be more coordinated choice by society with respect to improvement in
provision of public goods. He also suggested that social welfare can be
improved by enhancement of community choice by giving more weight to
deprived sections.
Equality of opportunity is the major step required for capability improvement
and competency building. Equal opportunity for all will result in increasing
participation by all all sections and create equitable distribution of resources
as everyone will be free to choose according to their preference. Sen’s
advice that it can be achieved with affirmative actions toward deprived
sections and it should be removed once a formative action has fulfilled their
obligation will avoid the development of interest groups.
Asymmetric Information
This is based on the difference in information level of agents in a market.
In a market of lemons and plums where the producers and consumers interact
where producers have complete information about quality of product and
consumers do not know the distinction. There will be a problem of
asymmetric information.
Example, let ‘lemons’ represent poor quality used cars and ‘plums’ represent
good quality used cars in a market for second hand cars.

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Buyers don't know about the quality of cars but sellers know about the
quality.
Consumer’s willingness to pay:
For lemons = $1200
For plums = $2000
Seller’s willingness to pay:
For lemons = $800
For plums = $1800
Average willingness to pay = ½ ($1200 + $2000) = $1600.
Plum sellers will leave the market due to less price. Only lemon sellers will
remain in the market. Slowly, the buyers will also go out after realising only
lemons are there.
Insurance market is a typical example of this. This leads to adverse selection
and thinning of markets.
If consumers choose to pay on an average, then it will result in reducing
participants in the market because all plum owners will leave the market and
lemon owners will remain.
Price cannot provide the right signal in this market because there is
asymmetric information. Therefore, consumers know that it is not advisable
to participate in the market beyond a particular price. Demand curve with
respect to quality is backward bending, that is, the consumers are willing to
pay more for superior quality upto a given price level but after that price
they believe that higher price may represent poorer quality.
Supply curve is upwards sloping because higher quality will result in incurring
higher cost and therefore demand higher price.

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The market has equilibrium at output Q1, which shows thinning of the market
due to asymmetric information. This happens because of the problem of
adverse selection, that is, hidden incentives in the market where firms have
the opportunity to hide their quality and sell at a higher price.
Similar problems can be observed in the market for insurance if average
pricing technique is used to charge premium for any insurance policy. For
example, if the insurance company averages the risk of theft across the city
to fix premiums for all the residents then it will be very high for residents in
safer regions and result in adverse selection by attracting only residents from
theft prone regions. This will result in more compensation outflow than
revenue from premium.
Moral Hazard
In case of contract markets like insurance, labour market, sharecropping
market, market for services like healthcare, etc. there is a hidden action
problem or hidden observation problem such that it is not possible for the
agents to observe each other's actions at all points of time after the contract
has been finalised. For example, after selling fire insurance to a household,
it is possible that the household becomes careless about fire safety resulting
in higher risk of fire compared to the risk evaluation of insurance firms while
providing fire insurance. This is the problem of moral hazard. In this case one
set of agents in the market (household in the above example) can take
advantage by breaching the contract at the cost of other sets of agents
(insurance firm) such that the agents who are losing due to breach of
contract cannot take any action to prevent it. Problem of moral hazard
increases the cost of transaction, risk in contract enforcement and delays in
economic decisions.
The problems of asymmetric information can be solved by:
a. Signalling: If one of the agents can signal to the market their true
position then it is possible to have a more coordinated solution to
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 | Economics (Optional) Foundation Course for CSE 2023-24 by Vibhas Jha Sir

asymmetric information. For example, in the market of lemons and

plums, if plum sellers can provide an extended warranty offer then it
can incentivize lemon buyers to distinguish in quality and avoid adverse
selection. Similarly, in an insurance market people in safer regions can
signal to the insurance company by developing community certificates to
establish that they are safer than others.
b. Screening: Under screening agents are allowed how to do a detailed
evaluation of any contract before finalizing it. For example, actuarial
risk evaluation by insurance companies to fix premium, aptitude tests
conducted by employers, test drive offered by car dealers, etc.
c. Legal Contract Evaluation: In this case a legal contract is signed
between the agent with detailed clauses on default, penalties, other
punishment provision, etc. and all emoluments for the work. This assures
that any act of malpractice can be punished through legal mechanism.

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