• Unit 1.

Welfare Economics 10 Hours

• Pigovian welfare economics; Criteria for social welfare: GNP growth,
cardinalists criterion, Bentham’s criterion; Kaldor-Hicks compensation
principle; Scitovsky paradox, Bergson criterion; Social welfare function
—properties and limitations; Pareto optimality; Theory of the second
best; Arrow’s impossibility theorem; Rawl’s theory of social justice
 WELFARE ECONOMICS
• Welfare economics is concerned with the evaluation of alternative
economic situations from the point of view if the society’s well-
being.
• The total welfare in a country is W, but given the factor endowment
(resources) and the state of technology, suppose that this welfare
could be larger, for example W*.
• the tasks of welfare economics are (a) to show that in the present
state W<W* and (b) to suggest ways of raising W to W*.
• To evaluate alternative economic situations we need some criterion
of social well-being or welfare. It requires some ethical standard and
interpersonal comparisons, both of which involves subjective value
judgement and objective measurement.
1. Pigovian welfare economics; Criteria for social welfare:

Arthur Cecil Pigou (18 November 1877 – 7 March 1959) an English

economist.
Pigovian lays down two conditions for maximizations of welfare:
1. Given the taste and income distribution, an increase in national
income represents an increase in welfare,
2. For welfare maximization, the distribution of national income is
equally important. (if national income remains constant, transfer of
income from rich to the poor would improve welfare).
• Cont..
• Pigou has made a distinction between private and social costs. The
private marginal cost of a commodity is the cost of producing an
additional unit. The social marginal cost is the expense or damage to
society as a consequence of producing that commodity.
• Private marginal benefit can be measured by the selling price of the
commodity. Social marginal benefits refers to the total benefit that
society gets from the production of an additional unit.
• Pave the way for the analysis of external effects or externalities in
social welfare economics.
• Assuptions
1. Each individuals tries to maximize his satisfaction
2. Satisfactions are comparable both interpersonally and intrapersonal
3. law of diminishing marginal utility of income applies.
4. There is equal capacity for satisfaction. It implies that different people
drive the same satisfaction out of the same real income.
Criticism
• Notion of maximization is not clear
• Pigou measure ‘welfare’ cardinally
• National income is not an accurate measure of welfare.
• Man’s equal capacity for satisfaction does not make his notion of
welfare positive study Robbins
2. GNP Growth Criteria:
• Adam smith accepted the gross national product, as a welfare criterion
indirectly.
• Economic growth resulted in the increase of social welfare because growth
increased employment and the goods available for the consumption to the
community. Economic growth meant bringing W to W*
• It implies acceptance of the status quo of income distribution as ethical or
just. Growth may lead to a reduction in social welfare depending on who
avails mostly from it.
• Economics efficiency is a necessary prerequisite for the maximization of the
level of welfare. It can be defined objectively, and the modern welfare
economics is mainly concerned with the examination (comparison) of
different economic situations.
• But efficiency is the necessary condition, is not sufficient to guarantee the
maximization of social welfare.
3 BENTHAM’S CRITERION
• Jeremy Bentham, as English economist, argued that welfare is improved
when ‘the greatest good (is secured) for the greatest number’.
• Total welfare is the sum of the utilities of the individuals of the society.
W= Ua + Ub + Uc OR
• ∆W>0 if ∆(Ua+Ub+Uc)>0
• The application of Bentham’s ethical system to economics has serious
short-coming.
• Assume that the change which resulted in the changes in the individual
utilities is such, that A’s and B’s utility increases, while C’s utility
decrease, but (∆Ua+∆Ub) < ∆Uc. the sum of the increases in utilities of A
and B is less than the decrease in utility of C. at that situation total
utility of the society may decrease.
• This criterion cannot be applied to compare situations where ‘the
greatest good’ and greatest numbers’ do not exist simultaneously.
• For eg.
• Assume that in a situation Ua=200, Ub=50, Uc= 30, so that the total
utility in the society is 280.
• In another situation assume that a change occurred and Ua=100,
Ub=80 and Uc=80 so that the total utility is 260.
• The first situation has the greatest good’ (280>260), but the second
involves a more even distribution (of a smaller ‘total good’) among
the greatest number.
4 CARDINALIST’ CRITERION
• Several economists proposed the use of the law of diminishing marginal
utility’ as a criterion of welfare.
• Cardinal welfare theorists would maintain that social welfare would be
maximized if income is equally distributed to all members of the society.
• E.g. a society consist of three individuals; A has an income of $1000,
while B and C have an income of $500 each. Consumer A can buy
double quantities of goods as compared to B and C. As application of
law of diminishing marginal utility, A’s total utility is less than double of
the total utility of B or C, because A’s marginal utility of money is less
than of B or C. thus W<W*
• To increase social welfare income should be redistributed among three
individuals.
• Cont..
• It has serious flaw: it assume that all individuals have identical utility
functions for money, so that with an equal income distribution all would
have the same marginal utility of money. This assumption is too strong.
• Individuals differ in their attitudes towards money. A rich may have a utility
for money function that lies far above the utility (for money) function of
poorer individuals. In this case redistribution of income (towards more
equality) might reduce total welfare.
• Another criticism is an equal distribution of income cannot be examined in
isolation from the effects on resource allocation (which would follow the
redistribution of income) and incentives for work of the various individuals.
An equal income distribution may reduce some people work less, thus
leading to a reduction of total GNP.
• In both the cases income equality results in (pareto) inefficiency in the use
of resources and a reduction in social welfare.
5. KALDOR-HICKS COMPENSATION PRINCIPLE
• They have made efforts to evaluated the changes in social welfare
resulting from any economic re-organization which harms somebody
and benefits the others. This principle sought to remove
indeterminacy of Pareto optimality.
• Assumptions:
1. An individual himself is the best judge of his satisfaction which is
independent of the satisfaction of other.
2. There is consistency of the tastes of the individuals.
3. There can be ordinal measurement of utility.
4. The inter-personal utilities comparisons are not possible.
5. There is an absence of externalities in production and consumption
COMPENSATION PRINCIPLE
• If a change in allocation or economic policy makes A better off, with
making B worse off, than social welfare (SW) will increase if A can
compensate (hypothetically) B for his loss and still be better off
leading to the Pareto improved outcome.
Example: if fishing is prohibited in a lake, but swimming and boating are allowed,
then fisherman are worse off, but tourists are better off, has social welfare
increased or decreased?
• If the latter pay compensation to the fisherman for the loss of income due to
new law, then social welfare can remain constant
STATE A compensation STATE B
Constant constant
Kaldor compensation criterion
• The project is desirable according to Kaldor compensation criterion if
gainers can compensate losers in state B in such a way that everyone
becomes better off compared to state A
Utility possibility curve. Ua

Let the initial position of the society is Q. if any policy

improve the welfare from Q to R or Q to S is the Pareto D T R
optimality. It increase the welfare of B without making worse B
off A while moving Q to R.
Some change in economic policy, the two individuals move
from point Q to T cannot be evaluated by the Pareto S
criterion. Q
Prof. Hichks has given criterion from the loser’s point of view,
whereas Kaldor had formulated this criterion from the point
of view of gainer. Though the two criterion are expressed 0 E Ub
differently, but they are really same. Thus this criterion is
known as Kaldor’s criterion.
• Criticism
• This criterion implicitly assume that marginal utility of money is the same for all
the individuals in the society.
• It suggested potential compensation rather than actual compensation, in case the
potential compensation is not paid the welfare would be measured only in terms
of utility and that would requires the inter personal comparison of utility and
value judgement.
• It evaluates the gain and losses due to an economic change in monetary terms,
overlooking and the real value of gains and losses.
• It ignores the existing distribution of income of the community.
• This theory isolated the production and exchange from distribution and this
ignores the distribution.
6. Scitovsky paradox
• Hungarian born American economist Tibor Scitovsky.
• He pointed out one of the important contradictions in the Hicks-
Kaldor criteria.
• He proved that in some cases, a situation A can be shown as Kaldor
improvement over the B, and at the same time, B can be shown as
the Kaldor’s improvement over A.
 • Scitovsky’s Paradox
• In this case, point C is a clear improvement over point B.
Ub
this is happens because Ub remains unchanged when
Ua increases.
• However, it is possible to move C to A by a mere
redistribution of income. Therefore, B is a Kaldor
improvement over A, this is called the Scitovsky’s UPC1
paradox, which will arise whenever UPC’s intersect.
• He says that a change is an improvement if the winners
can bribe (dishonestly persuade) off the losers to accept B C
the change. And at the same time, losers are not bribe D
off the winners to accept the change. A UPC2

0 Ua
• Bergson criterion; Social welfare function—properties and
limitations;
• He used an explicit set of value judgements in the form of a social welfare
function.
• A social welfare function is analogous to the individual consumer’s utility
function. It provides a ranking of alternatives states (situations, configurations) in
which different individuals enjoys different utility levels.
• Each curve is the locus of combinations of utilities lf A and B which yield the same
level of social welfare.
• The further to the right a social indifference contour is , the higher the level of
social welfare will be.
• The problem with the social welfare function is that there is no easy method of
constructing it.
• Bergson’s welfare contours
UB
• Its existence is axiomatically assumed in
welfare economic.
• Somebody in the economy must undertake
the task of comparing the various
individuals or groups and rank them
according to what he thinks their worthiness ●a
is.
• A democratically elected government could ●d
be assumed to make such value judgements ● c W4
which would be acceptable be the society as
a whole. W3
● b W2
W1

0 UA
• It is examine the conditions of social welfare maximization in the simple two-
factor, two-commodity, two-consumer model.
• Assumptions
1. There are two factors, labor and capital, whose quantities are given. These factors are
homogeneous and perfectly divisible.
2. Two products, X and Y are produced by two firms. Each firm produces only one
commodity. The production functions give rise to smooth isoquants, with constant
returns to scale.
3. There are two consumers whose preferences are represented by indifference curve.
4. The production functions are independent. This rule out joint products and external
economies and diseconomies in production.
5. The goal of the consumer is utility maximization and producer is profit maximization.
6. The utilities of consumers are independent.
7. The ownership of factors, that is the distribution of the given L and K between the two
consumers, is exogenously determined.
8. A social welfare function W=∫ (UA,UB) exists.
• The problem is to determine the welfare-maximizing values of the
following variables.
a. The welfare-maximizing commodity-mix, that is the total quantity of
X and Y (production problem)
b. The welfare-maximizing distribution of the commodities produced
between the two consumers, XA,XB,YA,YB (distribution problem)
c. the welfare-maximizing allocation of the given resources in the
production of X and Y, LX, LY, KX, KY (allocation problem)
• In the 2*2*2 model we have ten unknowns, and we have to find the
values of these unknowns which maximize the social welfare
• Grand utility possibility frontier
• This shows the maximum utility attainable by B, given the utility
enjoyed by A from any given product-mix.
• Let the combination X0,Y0 denoted by point a on the production
possibility curve FF’. Ecah point on the contract curve 0a implies a
different distribution of the two commodities between the two
consumers, and hence a different combination of utilities. For eg.
Point cdenotes the utilities combination ,A2 for consumer A and B8 for
consumer B. we can plot this utility combination in the utility space,
that is graph on whose axes we can measure the utility of the two
consumers. Point c’ figure 3 represents the ,A2,B8 utility combination, it
shows the maximum utility attainable by B (B8 ), given the utility
enjoyed by A(A2 ).
• Derivation of grand utility possibility frontier

Y UB
U
F S
Y1 b
R
B8 c’
A6
B3
h BT
Y0 a k’
B1
B2 g’ h’
B3

A2
g
BT A4
k d
c
A2
0 0 A6 S’ R’
X1 X0 F’ X A2 A4 U’ UA
B8
• Bergson’s welfare contours
UB
• Its existence is axiomatically assumed in
welfare economic.
• Somebody in the economy must undertake U
the task of comparing the various ●w
individuals or groups and rank them
according to what he thinks their worthiness
is.
• A democratically elected government could
be assumed to make such value judgements UB* ● W* W4
which would be acceptable be the society as
a whole. W3
L●
W2
W1

0 UA* U’ UA
Pareto optimality (Vilfredo Pareto 1848 – 1923)
• Any change that makes at least one individual better-off and no one worse-off is
an improvement in social welfare. Conversely a change that makes no one better-
off and at least one worse-off is a decrease in social welfare.
• In some different way: a situation in which it is impossible to make
anyone better-off without making someone worse-off is said to be
Pareto optimality.
• Three marginal conditions for Pareto optimality.
1. Efficiency of distribution of commodities among consumer
(efficiency in exchange)
2. Efficiency of the allocation of factors among firms (efficiency of
production)
3. Efficiency in allocation of factors among commodities (efficiency in
the composition of output)
a) Efficiency of distribution of commodities among consumers
B’s indifference
curve
Y 0
A5
YB
A4
A3
z b B1
Edgeworth
contract
A2 a curve of
B2
YA exchange
MRSAX,Y = MRSBX,Y A1
c
B3
B4
B5
0 X
XA XA
A’s indifference
curve
b) Efficiency of allocation of factors among firms
Y Isoquants
MRTSXK,L = MRTSYK,L K 0
X5
KY
X4
X3
H e Y1
Edgeworth
contract
d curve of
X2 Y2
KX production
X1
Y3
Y4
Y5
0 L
LX LV
X Isoquantz
c) Efficiency in the composition of output (product-mix)
• The marginal condition for a Pareto-optimal or efficiency composition of
output requires that the MRPT between any two commodities be equal
to the MRS between the same two goods:
• MRTSXK,L = MRSYK,L = MRSAX,Y = MRSBX,Y
• OR MRPTK,L = MRSAX,Y = MRSBX,Y
• Since the MRPT shows the rate at which a good can be transformed into
another (on the production side) and MRS shows the rate at which
consumers are willing to exchange a good for another, the rate must ne
equal for a Pareto-optimal situation to be attained.
• Suppose that these rates are unequal.
• MRPTK,L = and MRSX,Y =
• That is MRPTK,L > MRSX,Y
That is MRPTK,L > MRSX,Y
• The above inequality shows that the economy can produce two units of Y by
sacrificing one unit of X, while the consumers are willing to exchange one unit of
Y for one unit of X. clearly the economy produces too much of X and too little of Y
relatively to the tastes of consumers. Welfare therefore can be increased by
increasing the production of Y and decreasing the production of X.
Criticism
• It cannot evaluate a change that makes some individuals better-off
and others worse-off.
• Strict Pareto criterion is of limited applicability in the real-world
situation.
• It does not guarantee the maximization of the social welfare.
• Arrow’s impossibility theorem
• it is a social choice paradox illustrating the flaws of ranks voting system.
• A clear order of preferences cannot be determined while adhering to principle
of fair voting system.
• it states that when voters have three or more distinct alternatives (options), no
ranked voting electoral system can convert the ranked preferences of individuals
into a community-wide (complete and transitive) ranking while also meeting the
specified set of criteria: unrestricted domain, non-dictatorship, Pareto efficiency,
and independence of irrelevant alternatives. The theorem is often cited in
discussions of voting theory as it is further interpreted by the Gibbard
–Satterthwaite theorem. The theorem is named after economist and Nobel
laureate Kenneth Arrow, who demonstrated the theorem in his doctoral thesis
and popularized it in his 1951 book Social Choice and Individual Values. The
original paper was titled "A Difficulty in the Concept of Social Welfare".
• In short, the theorem states that no rank-order electoral system can
be designed that always satisfies these three "fairness" criteria:
• If every voter prefers alternative X over alternative Y, then the group
prefers X over Y.
• If every voter's preference between X and Y remains unchanged, then
the group's preference between X and Y will also remain unchanged
(even if voters' preferences between other pairs like X and Z, Y and Z,
or Z and W change).
• There is no "dictator": no single voter possesses the power to always
determine the group's preference.
• It is impossible to achieve social ordering without violating at least
one condition among five conditions
• Non-dictatorship: wishes of multiple voters to be taken into a/c
• Pareto efficiency; if all chose A over B, then A should win.
• Independence of irrelevant alternatives is chice is removed, rank
shouldn’t change.
• Social ordering: : each individuals should able to order the choice in
the way he want.
• Unrestricted domain universality: voting must a/c for all individuals
preference.
1. A>B>C 45 prefer A over B and B over C
2. B>C>A 40 prefer B over C and C over A
3. C>A>B 30 prefer C over A and A over B
A wins with 45 votes
But in absence of the B, A has 45 over C but C has (40 +30) 70 votes
over A so C wins which is completely the paradox in result. It is called
Arrow’s impossibility theory of social choice.
• Raw’s theory of social justice
• A Theory of Justice is a 1971 work of political philosophy and ethics by the philosopher
John Rawls (1921–2002) in which the author attempts to provide a moral theory
alternative to utilitarianism and that addresses the problem of distributive justice (the
socially just distribution of goods in a society). The theory uses an updated form of
Kantian philosophy and a variant form of conventional social contract theory. Rawls's
theory of justice is fully a political theory of justice as opposed to other forms of justice
discussed in other disciplines and contexts.
• The resultant theory was challenged and refined several times in the decades following its
original publication in 1971. A significant reappraisal was published in the 1985 essay "
Justice as Fairness" and the 2001 book Justice as Fairness: A Restatement in which Rawls
further developed his two central principles for his discussion of justice. Together, they
dictate that society should be structured so that the greatest possible amount of liberty is
given to its members, limited only by the notion that the liberty of any one member shall
not infringe upon that of any other member. Secondly, inequalities – either social or
economic – are only to be allowed if the worst off will be better off than they might be
under an equal distribution. Finally, if there is such a beneficial inequality, this inequality
should not make it harder for those without resources to occupy positions of power – for
instance, public office.[1]
• In A Theory of Justice, Rawls argues for a principled reconciliation of liberty
and equality that is meant to apply to the basic structure of a well-ordered
society.[2] Central to this effort is an account of the circumstances of justice,
inspired by David Hume, and a fair choice situation for parties facing such
circumstances, similar to some of Immanuel Kant's views. Principles of
justice are sought to guide the conduct of the parties. These parties are
recognized to face moderate scarcity, and they are neither naturally
altruistic nor purely egoistic. They have ends which they seek to advance
but prefer to advance them through cooperation with others on mutually
acceptable terms. Rawls offers a model of a fair choice situation (the
original position with its veil of ignorance) within which parties would
hypothetically choose mutually acceptable principles of justice. Under such
constraints, Rawls believes that parties would find his favoured principles
of justice to be especially attractive, winning out over varied alternatives,
including utilitarian and right-wing libertarian accounts.
Rawls belongs to the social contract tradition, although he takes a different view from that of
previous thinkers. Specifically, Rawls develops what he claims are principles of justice
through the use of an artificial device he calls the Original position; in which, everyone
decides principles of justice from behind a veil of ignorance. This "veil" is one that essentially
blinds people to all facts about themselves so they cannot tailor principles to their own
advantage:
[N]o one knows his place in society, his class position or social status, nor does anyone
know his fortune in the distribution of natural assets and abilities, his intelligence,
strength, and the like. I shall even assume that the parties do not know their
conceptions of the good or their special psychological propensities. The principles of
justice are chosen behind a veil of ignorance.
According to Rawls, ignorance of these details about oneself will lead to principles that are
fair to all. If an individual does not know how he will end up in his own conceived society, he
is likely not going to privilege any one class of people, but rather develop a scheme of
justice that treats all fairly. In particular, Rawls claims that those in the Original
Position would all adopt a maximin strategy which would maximize the prospects of the least
well-off:
They are the principles that rational and free persons concerned to further their own
interests would accept in an initial position of equality as defining the fundamentals of
the terms of
• Rawls bases his Original Position on a "thin theory of the good" which he says "explains the rationality
underlying choice of principles in the Original Position". A full theory of the good follows after we derive
principles from the original position. Rawls claims that the parties in the original position would adopt two
such principles, which would then govern the assignment of rights and duties and regulate the distribution
of social and economic advantages across society. The difference principle permits inequalities in the
distribution of goods only if those inequalities benefit the worst-off members of society. Rawls believes that
this principle would be a rational choice for the representatives in the original position for the following
reason: Each member of society has an equal claim on their society's goods. Natural attributes should not
affect this claim, so the basic right of any individual, before further considerations are taken into account,
must be to an equal share in material wealth. What, then, could justify unequal distribution? Rawls argues
that inequality is acceptable only if it is to the advantage of those who are worst-off.
• The agreement that stems from the original position is both hypothetical and ahistorical. It is hypothetical
in the sense that the principles to be derived are what the parties would, under certain legitimating
conditions, agree to, not what they have agreed to. Rawls seeks to use an argument that the principles of
justice are what would be agreed upon if people were in the hypothetical situation of the original position
and that those principles have moral weight as a result of that. It is ahistorical in the sense that it is not
supposed that the agreement has ever been, or indeed could ever have been, derived in the real world
outside of carefully limited experimental exercises.
• The principles of justice
Rawls modifies and develops the principles of justice throughout his book. In chapter forty-six, Rawls makes his final clarification on the two principles of justice:
1. Each person is to have an equal right to the most extensive total system of equal basic liberties
compatible with a similar system of liberty for all. [4]

2. Social and economic inequalities are to be arranged so that they are both:
(a) to the greatest benefit of the least advantaged, consistent with the just savings principle, and
(b) attached to offices and positions open to all under conditions of fair equality of opportunity. [4]

The first principle is often called the greatest equal liberty principle. Part (a) of the second principle is
referred to as the difference principle while part (b) is referred to as the equal opportunity principle.[1]
Rawls orders the principles of justice lexically, as follows: 1, 2b, 2a.[4] The greatest equal liberty
principle takes priority, followed by the equal opportunity principle and finally the difference principle.
The first principle must be satisfied before 2b, and 2b must be satisfied before 2a. As Rawls states:
"A principle does not come into play until those previous to it are either fully met or do not apply." [5]
Therefore, the equal basic liberties protected in the first principle cannot be traded or sacrificed for
greater social advantages (granted by 2(b)) or greater economic advantages (granted by 2a). [6]