WELFARE ECONOMICS
Topic 1. An introduction to welfare
economics
Lecture slides, notes & topic handouts for this
module are available from:
http://www.staff.city.ac.uk/n.j.devlin
Note: the ‘numbering’ of each point on the following slides is different to that
on the ‘notes’ for topic 1, as the slides are a somewhat condensed version.
1. Scarcity
2. Positive economics cf. normative
economics
3. Welfare economics (& the economic
evaluation of health care programmes) is
concerned with obtaining a social ordering
(ranking)
of
different
social
states
(allocations of resources).
 Complete
 Transitive (A > B > C, then A > C)
→ involves making value judgements
→ no objective or unique way of ranking
→ welfare economics is based on a certain set
of value judgements.
4. Welfare economics is based on the
concept of economic efficiency
Two main value judgements are involved:
 Individualism: Social orderings ought
to be based on individual orderings of
alternative states.
 Pareto principle
5. Theories of individual behaviour:
rationality, utility & utility maximisation
A formal statement of the household’s utility
maximisation problem is given by: maximise U
= u(x1, x2, …., xn ) subject to  p x  y
n
i 1
i
i
The
solution
the
household’s
utility
maximisation problem is given by: MRS
= dxdx  pp
2
1
1
2
6. Economies
consist
of
millions
of
individuals/households, with different tastes
and different budget constraints.
 we need to distil welfare statements about
the desirability of a social state from its
effects on millions of different households.
 One option is to use the Pareto Principle.
 ‘aggregate’ individuals’ preferences using
the ‘dominance’ notions contained in the
PP.
Weak Pareto criterion: if the utility of every
household is higher in state x than state y then
state x yields a higher level of societal welfare
than state y and is preferred.
Strong Pareto criterion: if the utilities of
some households are higher in state x that in
state y and the utility of no household is lower
in state x than state y then state x yields a
higher level of societal welfare than state y
and is preferred.
7. Limitations:
 Only permits a partial ordering
 If state x is neither Pareto superior, nor
Pareto inferior, not Pareto indifferent to
state y then states x and y are Pareto
non-comparable (states in which some
households are made better off but others
are made worse off in moving from one
state to another).
 Is neutral to distributional concerns
8. Overcoming Pareto non-comparability:
the compensation principle.
 Kaldor: state a is preferred to state b if the
gainers from the move to state a can
hypothetically compensate the losers so
that everyone is better off.
 Hicks: state a is preferred to state b if the
losers from the proposed move cannot
hypothetically bribe the gainers not to
make the move.
9. Problems with the compensation
principle:
 the redistribution is hypothetical only
 redistribution is assumed to be costless
 the Pareto Principle is still unable to rank
different Pareto optimal allocations
relative to one another (there are still
Pareto non-comparable states)
 the compensation principle may lead to
contradictions ( the Scitovsky Paradox).
10. Pareto optimality and the general
equilibrium of a competitive economy.
 The first fundamental theorem of welfare
economics: under certain assumptions the
allocation of goods and factors resulting
from a competitive equilibrium is Pareto
optimal.
11. The first fundamental theorem of
welfare economics requires:
 efficient exchange of goods and services
 MRS  MRS  pp **
a
b
1
2
 efficient allocation of the
production  MRTS  MRTS  wr **
a
factors
of
b
 efficient output choice (overall efficiency)
 MRS = MRT
12. Going beyond Pareto:
 A complete and consistent ranking of
social states is called a social welfare
ordering (SWO).
 the SWO can be represented by a social
welfare function (SWF) that assigns a
number to each social state so that they
might be ranked.
 A SWF involves value judgements about
the desirability of different social states.
Value judgements are statements of ethics
that cannot be found to be true or false on
the basis of factual evidence. The value
judgements found in a SWO may be weak
(i.e. broadly accepted) or strong (i.e.
controversial).
13. SWO
possibilities
are
limited
by
informational requirements that pertain to
the measurability and comparability of
households’ utility.
14. In practice, markets ‘fail’, so that the
conditions for the first fundamental theorem
of welfare economics to hold are not met
 non-competitive behaviour
 externalities
 public goods
 informational asymmetries.
15. The role of Government
 to address market failures.
 to provide the institutional and legal
framework under which the market
operates
 to redistribute income
 to provide merit goods and limit/ban
provision of demerit goods.
16. Public choice is the study of the political
mechanisms and institutions that explain
government and individual behaviour. It can
be defined simply as the economic study of
non-market decision-making.
e.g. voting
17. Government intervention may not be
desirable:
 the government requires some means of
addressing the problem of preference
revelation and the problem of aggregating
preferences
 there may be government failures
18. Applied welfare economics: the
empirical application of welfare
economics
 measures of welfare change using a
money metric.
 In a social CBA the appropriate decision
rule is the net present value (NPV), given
by NPV   B(1 rC) , where r is the social time
T
t
t 0
t
t
preference rate.
19. Extra welfarism.
 The admission of non-utility information
into SWO.
 In CEA the desirability of a project is
described in terms of a ratio of incremental
costs to incremental benefits.
(ICER)
 The proposed project should be
implemented if the ICER is < critical costeffectiveness ratio.