Welfare economics is a field of economics that applies microeconomic techniques to evaluate the overall well-being (welfare) of a society. The principles of welfare economics are often used to inform public economics, which focuses on the ways in which government intervention can improve social welfare. Additionally, welfare economics serves as the theoretical foundation for several instruments of public economics, such as cost–benefit analysis. The intersection of welfare economics and behavioral economics has given rise to the subfield of behavioral welfare economics. Two fundamental theorems are associated with welfare economics. The first states that competitive markets, under certain assumptions, lead to Pareto efficient outcomes. This idea is sometimes referred to as Adam Smith's invisible hand. The second theorem states that with further restrictions, any Pareto efficient outcome can be achieved through a competitive market equilibrium, provided that a social planner uses a social welfare function to choose the most equitable efficient outcome and then uses lump sum transfers followed by competitive trade to achieve it. Arrow's impossibility theorem which is closely related to social choice theory, is sometimes considered a third fundamental theorem of welfare economics.
History In 1951, Kenneth Arrow tested whether rational collective selection rules could derive social welfare functions from individuals in preference to social states. He argued that rational law satisfies four conditions: partial universality, the Pareto principle, totalitarianism, and free will. Arrow concluded that there is no rational way to articulate individual preferences forms together resulting in a harmonious social status of the various social societies. More recently, Amartya Sen later emphasized the nature of the sequential gain approach, and Arrow's theory emphasized it. Sen said collective action often arises in social decision-making, because Arrow's theory is delivered through the aggregate of individual preferences rather than the formation of government or income, especially those that exist because of neutrality, presented a challenge to reconcile conflicting interests in revenue sharing. The neutral results, avoiding special utility issues, restricted the social analysis to structural utility issues. This restriction did not exclude important information about an individual’s social status or position needed to make an income allocation decision. Sen recommended expanding the scope of data used in welfare research and emphasized the need for explicit discussion of ethics and morality in welfare economics.
Theoretical basis
Cardinal utility
The early Neoclassical approach was developed by Edgeworth, Sidgwick, Marshall, and Pigou. It assumes the following:
Utility is cardinal, that is, scale-measurable by observation or judgment, Preferences are exogenously given and stable, Additional consumption provides smaller and smaller increases in utility (diminishing marginal utility). 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.
Behavioralist approach
The ordinal-behaviorist approach, originally called the new welfare economics, is based on the work of Pareto, Kaldor, Hicks, and Scitovsky. 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 Kaldor–Hicks efficiency, while questions of income distribution are covered in the specification of the social welfare function 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). The consensus in favor of such approaches, pushed by behavioralists of the 1930s and 40s, has largely collapsed since the discovery of Arrow's impossibility theorem and utility representation theorems have shown them to be mathematically self-contradictory, violating the principle of transitive preferences. Austrian school economists critique the foundations of both cardinal and ordinal approaches to welfare economics for relying on interpersonal comparisons of utility or aggregated social welfare functions, which they argue are incompatible with methodological subjectivism. Murray Rothbard, in particular, proposed a reconstruction of welfare economics based solely on "demonstrated preference," under which only voluntary market exchanges can be judged unambiguously welfare-enhancing. Centralized attempts to maximize social welfare via planner interventions face insurmountable knowledge and economic calculation problems.
Criteria
Efficiency Situations are considered to have distributive efficiency when goods are distributed to the people who can gain the most utility from them. Pareto efficiency is an efficiency goal that is standard in economics. A situation is Pareto-efficient only if no individual can be made better off without making someone else worse off. An example of an inefficient situation would be if Smith owns an apple but would prefer to consume an orange, while Jones owns an orange but would prefer to consume an apple. Both could be made better off by trading. A Pareto-efficient state of affairs can only come about if four criteria are met:
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