welfare economics

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Welfare Economics

The study of how to distribute income in order to achieve social good. In other words, welfare economics takes the preferences of individuals at the microeconomic level and tries to apply them in macroeconomics. It attempts to discourage inequality to improve utility. Welfare economics is rather controversial, in part because there is no one way to measure social good; therefore, its study can be subjective.

welfare economics

A normative branch of economics that is concerned with the way economic activity ought to be arranged so as to maximize economic welfare. Welfare economics employs value judgements 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 judgements in advising policy makers about decisions that affect the allocation of resources (which involves making interpersonal comparisons of UTILITY).

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 (see CLASSICAL ECONOMICS) 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 judgements 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. 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.

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:

  1. efficiency gains/losses;
  2. 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. See also MARKET FAILURE, NORMATIVE ECONOMICS, RESOURCE ALLOCATION, UTILITY FUNCTION, CARDINAL UTILITY, ORDINAL UTILITY.

References in periodicals archive ?
It was out of the wreckage of the old utilitarian welfare economics that the phoenix of social cost-benefit analysis arose in the 1960s, epitomised by the manual produced for the OECD by Little and Mirrlees (1974), and urged on by Arnold Harberger (1971) who considered that theoretical nitpicking ought not to be allowed to hold up the progress of empirical work.
The principles of welfare economics require an economic evaluation to adopt a societal perspective that includes all the possible costs and benefits of an intervention to all sectors in society (Johannesson, 1995).
Compensating variation is the key concept in most applied welfare economic analysis; it provides both the economic and legal standard for damage assessment.
12) When the storm of criticism subsided, some economists declared that not only compensation tests, but all of welfare economics, was dead, a declaration that has been repeated many times since.
Positive Economics, Welfare Economics, and Political Economy.
While these are beautiful theorems with welfare economic implications, they do not serve development economics well because technological progress, evolving income distributions, and many market imperfections are typical features of the very process of development.
That most economists know little about welfare economics does not help them distinguish between positive analysis and value judgments.
This very language, which economists use, derives from modern welfare economics founded on Pigou's extension of marginal analysis to the utilitarian market-failure analysis of J.
Basu has published widely and his contributions to the field span development economics, welfare economics, industrial organization, and public economics.
The topics include the structure of random utility models, applied welfare economics with discrete choice models, the compatibility of nested logit models with utility maximization, forecasting new product penetration with flexible substitution patterns, and an econometric analysis of residential electric appliance holdings and consumption.
A change in the tax system to index against changes in inequality is motivated both by financial theory and by classical welfare economics.
Bergson's 1938 paper clarified for all time what, exactly, are the links and how they are connected in the chain of reasoning that lies behind all of applied welfare economics.