MODULE 6 - WELFARE ECONOMICS

WELFARE ECONOMICS

INTRODUCTION:

Ø Positive microeconomics attempts to explain determination of product & factor prices & on this basis resources allocation being made in a private sector economy.

Ø Welfare Economics brings in Economic Efficiency into this process.

Ø An attempt to establish criteria to evaluate alternative economic states and help policy formulation to achieve economic efficiency i.e. maximize social welfare.

Ø Establishes criteria to meet the social rationality of economic activity.

Ø Social rationality: activity ensuring optimum allocation of resources and therefore guaranteeing maximum social welfare.

Ø Welfare economics considers interrelationship or interdependence between various parts of the economy such that changes in resource allocation in one part of the economy affect all other parts of it.

Ø Greatest challenge is to objectively measure social welfare because interpersonal comparison of utilities or welfare is very subjective.


OVERVIEW OF THEORIES OF WELFARE ECONOMICS

PARETO OPTIMALITY:

Ø Any change that makes at least on individual better off without making any other worse off is an improvement of social welfare.

Ø Increase in social welfare: changes that make everyone in the society better.

Ø Decrease in social welfare: changes that make no individual better off while it makes at least one individual worse off.

Ø Pareto optimal economic state: resource allocation wherein a rearrangement to make one better off is impossible without making another worse off.

Ø The basis of welfare economics.


NEW WELFARE ECONOMICS:

Ø Pareto optimality excludes interpersonal comparison of utility.

Ø Does not include changes in economic state where some persons are better off and other worse off.

Ø Compensation principle tries to judge such situations.

SOCIAL WELFARE FUNCTION:

Ø Propositions of welfare economics need to have explicit value judgements.

Ø Otherwise useless.


CONDITIONS OF PARETO OPTIMALITY

ECONOMIC EFFICIENCY:

Ø Neoclassical & earlier versions: social welfare a sum total of cardinally measurable utilities of different members of society.

Ø Pareto’s objections: (a) cardinal utility & its independent additive nature; (b) need to take away welfare economics from interpersonal comparisons of utilities to impute objectivity into it.

Ø Pareto’s maximum social welfare: (a) based on ordinal utility; (b) keep it free from value judgements.

Ø Pareto optimum, merely a necessary condition of maximum social welfare not a sufficient condition.

PARETO CRITERION:

Ø Any reorganization of economic resources that does not harm anybody and makes someone better off, indicates an increase in social welfare.

Ø Can be explained and illustrated using Edgeworth Box and Utility Possibility curve. Explain diagrams 57.1 & 57.2 on page 1074.

Ø Edgeworth box: tangency points of various indifference curves of two individuals of the society are Pareto Optimum points and locus of these points is called, “Contract Curve” or “Conflict Curve”.

Ø Utility possibility curve: locus of various combinations of utilities obtained by two persons from the consumption of a particular bundle of goods. Movements: Q to R – B’s welfare increases, A’s remains same; Q to S – A’s welfare increases, B’s remains same; Q to D – welfare of both increase. Fails to explain movement beyond RS range like from Q to E: B’s welfare increasing & A’s welfare decreasing.

MARGINAL CONDITIONS OF PARETO OPTIMUM

Ø Competition leads society to an optimum position. Has not given mathematical proof or derived marginal conditions to establish it.

Ø Lerner & Hicks derive marginal conditions to attain Pareto Optimum.

Ø Assumptions: see page 1075.

Ø Derived seven marginal conditions. Also can be called necessary conditions of Pareto Optimum.

Condition – 1: Optimum distribution of products among consumers: efficiency of exchange -

Ø MRS between any two goods must be the same for every individual who consumes them both.

Ø MRS: amount of one good necessary to compensate for the loss of a marginal unit of another to maintain a constant level of satisfaction.

Ø Unequal MRS of two goods between two individuals: better to have exchange between them of the goods so that satisfaction of both or one increases without decreasing satisfaction of the other.

Ø Explained use Edgeworth Box in diagram 57.3 on page 1076.

Ø Movement from a point off the contract curve to a point on the relevant segment of it increases social welfare.

Ø All IC tangency points on the contract curve are Pareto optimum points but movement along it increases one person’s welfare at the cost of decreasing the others.

Ø Pareto criterion does not identify the best of the optimum on the contract curve.

Condition – 2: Optimum allocation of factors – efficiency in production –

Ø MRTS between any pair of factors must be the same for any two firms producing two different products and using both the factors to produce the products.

Ø Using factors of production such that it is impossible to increase output of one good without decreasing the output of the other or of increase the output of both by any reallocation of factors of production.

Ø Explain diagram 57.4 on page 1077.

Condition – 3: Optimum direction of production – efficiency in product mix –

Ø Relates technical production conditions and state of consumer’s preferences. Also called overall condition of Pareto Optimality or overall condition of Economic Efficiency.

Ø MRS between any pair of products for any person consuming both must be the same as the marginal rate of transformation (for the community) between them.

Ø Social welfare is maximized when in the product mix produced in society matches what consumers would like to have (consumer preferences as shown in the indifference curve).

Ø Can be explained and illustrated in two ways: (1) match between consumer’s indifference and society’s transformation curve; (2) drawing the Edgeworth Box within the space underneath the chosen point on the transformation curve.

Ø Explain diagrams 57.5, 57.6 & 57.7 on pages 1078 & 1079.

Condition – 4: Optimum degree of specialization –

Ø To determine optimum level of output of every product by every firm.

Ø The Marginal rate of transformation between any two products must be same for any two firms that produce both the products.

Ø Similar MRTXY between goods in two firms implies any reallocation of resources between the two goods would not lead to increase in the combined output of either goods or lead to the increase in the output only with output loss of the other.

Ø Transformation curve: locus of various combinations of two goods which a firm can produce by fully utilizing its given resources. Slope of the curve measures MRT between the two goods.

Condition – 5: Optimum factor product relationship –

Ø The marginal rate of transformation between any facto and any product must be the same for any pair of firms using the factor and producing the product.

Ø MRT of factor into a product: how many units of a product are produced by an additional unit of a factor – it marginal product.

Ø Marginal product of producing a product to be same for all firms producing the product.

Ø Unequal marginal product means transferring inputs across the outputs would increase output of both products and one of it without increase in the quantity of input used.

Ø Explain diagrams 57.9(a) & 57.9(b) on page 1087.

Condition – 6: Optimum allocation of a factor’s time

Ø The marginal rate of substitution between ‘leisure and work for money income’ by the factor should be equal to the marginal rate of transformation between factor’s time and the product.

Ø Greater MRS between leisure and income of the factor compared to MRT between factor’s time and product, increase in individual satisfaction by transferring a factor unit’s time from work to leisure.

Ø Greater rate of exchange between leisure and income vs. lesser rate of exchange between factor’s time and producing output – better to move away from work to leisure.

Ø Greater value attached to leisure than productive work.

Ø Explain diagram 57.10 on page 1083.

Condition – 7: Inter temporal optimum allocation of money assets –

Ø Relates to lender and borrowers of capital or money assets.

Ø Rate of interest at which lender is willing to lend should be equal to the marginal productivity of the financial to the borrowers.

Ø Technically stated it is equality of the marginal rate of substitution between money funds at any pair of times (present vs. future income and consumption) must be the same for any two individuals (one maybe the lending firm and the other maybe the individual borrower).

Ø The comparative value of present income or consumption to future income or consumption must be the same for both the individuals – both borrower and lender.

Ø Explain diagram 57.11 on page 1084.

Second order & total conditions

Ø All indifference curves are convex to the origin.
Ø All transformation curves are concave where the marginal conditions are satisfied.

Conclusion:

Ø Pareto optimality assumes given income distribution.

Ø Change in income distribution leads to change in product mix in the production process and change in factor allocation between products.

Ø No criteria by Pareto to judge whether new optimum better or worse than previous optimum.

Note: Critical evaluation of Pareto criterion and Pareto optimality to be independent self study.


NEW WELFARE ECONOMICS: COMPENSATION PRINCIPLE

INTRODUCTION:

Ø Although Pareto laid the foundation of modern welfare economics through optimality concept, he tried to keep it free from a comparison of welfare between individuals and from value judgements.

Ø In terms of the Edgeworth Box technique all points of equal substitutions between individuals are optimum even though one would have an absolutely higher level of welfare by being on a higher indifference curve and the others have an absolutely lower share of welfare by being on a lower indifference curve. (See again the Edgeworth Box diagram 57.1 on page 1074).

Ø Putting in another way Pareto could not explain economic changes specially those resulting from policy which makes some better off and others worse off.

Ø Problem due to his unquestioned acceptance of a given socio-economic structure of income distribution.

Ø Kaldor, Hicks and Scitovsky tried to address this Pareto Indeterminacy by evolving welfare criteria to address economic reorganization which benefits some and harms others.

Ø The criterion is called “Compensation Principle”, as it involves socio-economic bribery of the loser by the beneficiary not to stall the economic reorganization process or the socio-economic bribery of the beneficiary by the losers to stall the economic reorganization that accentuates unequal distribution of welfare changes.

Ø Assumptions: independent individual satisfaction, no externalities from consumption & production, constant individual tastes, production & exchange issues separate from distribution issues & ordinal utility ranking.


KALDOR – HICKS WELFARE CRITERION: COMPENSATION PRINCIPLE


v An economic reorganization or policy change that makes some people better off and others worse off, can increase social welfare if those who gain from the change could compensate the losers and still be better off than before. (Kaldor’s Version)

v Putting it in another way if the losers cannot successfully bribe the gainers not to change from the original situation.

v Explained and illustrated by the ‘Utility Possibility Curve’, diagram 58.1 on page 1097.

v Movement from point Q to T makes B better off and A worse off. It involves interpersonal comparison or difference in the distribution of welfare between A and B. So it cannot be explained by Pareto Optimality Criterion as to whether there is increase or decrease in overall social welfare.

v Compensation Principle: B can compensate A by moving from point T to R, result being A’s utility same as in Q but B’s utility still greater than A’s utility.

v Meaning: Economic reorganization benefits B and harms A. B compensates A and puts him back to original welfare and still gets a bigger share of welfare consequent to the economic or policy reorganization. So the sequence is: policy change – gainers & losers – gainers compensate losers through subsequent income redistribution – losers back to status quo and gainers still gainers.

v Existence of the possibility of compensation is enough. Need not be necessarily be made. Merely a shift to a more efficient position and not necessarily involves overall or absolute increase in output or real income. Only an act of efficient redistribution.

v Illustration: Both A & B could move to a superior position G benefiting both – overall economic development & increase in overall welfare. Then mere redistribution can take B to point T and again through compensation down to point R with A in original welfare position. (Diagram 58.1 on page 1097).

v Compensation principle can also increase social welfare when individuals move from a point on a lower utility possibility curve to a point on a higher utility possibility curve due to economic change.

v Explain diagram 58.2 on page 1098. Movement from point Q to R: B loses & A gains. On compensation A moves to point R which puts B in old utility position as in point Q and still A is still better off.


SCITOVSKY PARADOX:

v Statement: If according to a welfare criterion position B is shown to be revealed preferred to position A, then by the same prince it should also be ensured that position A must never be preferred to position B.

v Explain diagram 58.3 on page 1099. Movement from point C to D and to point F through compensation satisfied Kaldor-Hicks criterion. Also movement from point D to C and to point E through compensation also satisfies Kaldor-Hicks criterion. Since to and fro movements in welfare positions satisfies Kaldor-Hicks criterion, it is a paradox, named as ‘Scitovsly Paradox’.

v Scitovsky paradox occurs when two utility (higher & lower) possibility curves intersect.

SCITOVSKY’S DOUBLE CRITERION OF WELFARE:

v Rules out the possibility of contradictory results in Kaldor-Hicks criterion.

v The double criterions are: (a) gainers of an economic reorganization through compensation persuade losers to accept the change; (b) economic reorganization policy simultaneously does not allow opportunity for losers to persuade gainers to remain in the original situation.

v Explain diagram 58.4 on page 1100.

v Putting it another way in the compensation principle gainers bribe the losers to accept the change and along the policy should not provide an opportunity for the losers do be able to reverse bribe gainers to accept status quo.

v Ideologically ‘Scitovsky’s Double Criterion’ appears dogmatic (dictatorial) with all possibilities for a reversal or review closed. It also assumes that policy makers and policy lobbyist are always committed to some equity in welfare distribution.

v Double criterion fulfilled only when the two utility possibility curves are one above the other and do not intersect each other.

v Critical analysis of compensation principle: self – independent study by students.

SOCIAL WELFARE FUNCTION AND THEORY OF SOCIAL CHOICE


INTRODUCTION

Different welfare theorists have failed to provide a satisfactory solution to the problem of maximization of social welfare. Externalities and market imperfections impede achieving Pareto criterion. Also Pareto Optimality does not explain unequal share of welfare benefits and so actually is not able to address the issue of benefit to one social section along with loss to another. Even the compensation principle addressing this lacuna in Pareto Optimality and simultaneously claiming to be value judgement free could not be amenable to implementation. In fact Kaldor and Hicks did not consider it necessary to actually execute the redistribution but claimed fulfillment of their criterion just by its presence.

Addressing the preceding issues Samuelson and Bergson evolved the Social Welfare Principle of Welfare Economics. They brought out their reasoning by first accepting Lionnel Robbins’ (a staunch positive economist) criticism of the subjectivity of welfare economics because of the need to make interpersonal comparison of utilities (or welfare) which depends on value judgements. But at the same they also asserted that without such value judgements impact of economic policy cannot be evaluated. So Samuelson and Bergson posited welfare economics as a normative study of economics, which can be scientific despite inevitable value judgements.

BERGSON – SAMUELSON SOCIAL WELFARE FUNCTION:

Social Welfare is an ordinal ranking of society’s welfare. It is a function of the utility level of all individuals in society. Its general and basic form is as follows:

W = W (U1, U2, U3, ………… UN) - where W = Social Welfare and U1, U2, U3 ……. UN = ordinal utility indices of different individuals of the society.

Social welfare functions and value judgements: In the social welfare there are explicit value judgements which are actually ethical notions. The form of the social welfare function is decided by the value judgements on which it is based. So when value judgements change social welfare functions also change. There is no standardized or unique welfare function in this model. Further the ethical framework could be obtained outside of economics either through democratic process or dictatorship. Welfare economics has now allowed normative value judgements to be imputed into economic analysis through the back door by both accepting its inevitability for understanding desirableness of welfare distribution of policy and by proposing that these value judgements need not necessarily made by economists. While in a positive sense this makes economic science more interdisciplinary it could free ride on the knowledge accretion of other academic disciplines of knowledge. The convenience available in economics to do this is just to take ethical notions given outside the so called boundaries of economics as given and simply convert them into assumptions.

Social welfare function is individualistic: The Social Welfare function takes evaluation of welfare as dependant on the individual who would be judging it using economic variables. An individual’s ordinal utility level depends on his own consumption of goods and services based on his tastes but not on others. However any value judgement used to build the social welfare function must be consistent and transitive i.e. if situation A > situation B and situation B > situation C, then situation A > situation C.

Explanation & illustration of social welfare function:

Refer figure 61.1 on page 1123. The social welfare function is explained and illustrated using social indifference curves also called welfare frontiers. A social indifference curve or welfare frontier is a collection of combinations of utilities of say two individuals A and B, which give equal level of overall social welfare. Each individual will have different specific levels of utility or welfare but on the whole it sums up to a given level of welfare. The properties of the social indifference curve are similar to indifference curves. So the slope of the slope of the social indifference is the sacrifice of one individual’s utility for a given increase in the other’s utility. Similarly economic progress (growth or development) would push both the individuals to a higher curve resulting in an overall increase of social welfare.

Fairness and equity which are value judgements are seen in the shape of the social indifference curves. For example in the diagram movement from point R to Q means B’s utility increases and A’s utility decreases but the social welfare remains the same because both the points are on the social indifference curve W1. Given that W1 was in the very instance constructed upon a normative model of values, it follows that A’s loss of utility is equal to B’s gain in utility. By being able to make such an interpretation of the points in the curve, social welfare function has now incorporated interpersonal comparison of utility and also value judgements. In the same even movements between the curves can also be normatively rationalized. For example movement from point Q on W1 to point S on W2, means A’s gain in utility is greater than B’s loss of utility and still overall social welfare has moved to a higher level.

Maximum Social Welfare: Point of Constrained Bliss:

On the basis of the social welfare concept, social indifference map and grand utility possibility frontier, a unique point of maximum social welfare can be identified. This ultimately solves the indeterminacy of the Pareto criterion. (The Grand Utility Possibility Frontier is defined as a locus of various physically attainable utility combinations of say two persons when the factor endowment, state of technology and preference of individuals are given). The social indifference map shows the individuals utility combinations society would like to attain while the grand utility possibility curve shows the individuals utility combinations society can attain. When the two are superimposed a unique social welfare point is attained at the point of tangency between the social indifference and the grand utility possibility frontier. Refer diagram 61.2 on page 1125.

· W1, W2, W3 and W4 = social indifference map.
· V V’’ = grand utility possibility frontier.
· Q = point of tangency between W3 & V V ‘. Point of constrained bliss, as it is the optimum welfare attained within factor & technology constraints.
· W4 = social indifference curve unattainable given the present facto and technology constraints.
· R = being on the grand utility possibility is economically efficient when compared to point S which is within O V V ‘space, even though the latter is on a higher individual social indifference curve. This means what socially acceptable is not necessarily economically efficient. It brings out the conflict between efficiency and equity. Sometimes it is in social interest to choose inefficient allocation of resources, if the optimum option is unattainable. That is to say to achieve equitable distribution of welfare i.e. to satisfy the objective of social equity, some inefficiency in resource allocation is accepted.

The following features of Bergson-Samuelson’s social welfare function are to noted:

1) It is based on explicit value judgements and involves interpersonal comparisons of utility in ordinal terms.
2) The maximum social welfare position is completely determined as a result of the introduction of value judgements regarding distribution of welfare among individuals.
3) There is no unique value judgement basis for the function.
4) Once the social welfare function has been decided upon by value judgements, the maximization technique used to obtain the maximum social welfare position at which allocation of resources is Pareto optimum and also the distribution of goods and services is equitable. Thus, both efficiency and equity are achieved so that social welfare may be maximized.
5) Used along with the Pareto optimality analysis the concept of social welfare function enables us to find a unique solution generally called the point of bliss and which combines economic efficiency with distributive justice.

Note: The critical evaluation of the function is independent study by the students.


ARROW’S THEORY OF SOCIAL CHOICE

1) Sources of and method of inducting value judgements into the social welfare function is unclear.

2) Through reasonable democratic procedures it is difficult to add up each individual’s preference into a social preference. (Arrow).

3) Social ordering does not reflect every individual members ordering. (Arrow).

4) An individual’s preference for a social state depends on: (a) commodities – including those of other; (b) collectives – municipal services, parks etc.

5) So there could be a difference between an individual’s values (value judgements) and his / her tastes.

6) Therefore Arrow claimed that there is a difference between what an individual likes to have and what an individual should have.

7) So every individual’s values itself could have a deep private motive to be accomplished.

Arrow’s condition of Social Choice (Arrow’s Theory of Social Choice):

1) They are reasonably necessary conditions of a social state that reflects and represents preferences of all individuals in society.

2) Sources of Social Choice: (a) Dictator: compulsion (easiest); (b) Traditional Society: custom & tradition; (c) Democracy: voting (most difficult).

3) In a democracy it is very difficult to have social choice that exactly tallies with individual preference ordering of social conditions because: (a) no two individuals are the same; (b) every individual is free to choose his preferred social state.

4) Such an ideal condition could come about only if five necessary conditions are satisfied. (Arrow’s Theory of Social Choice).

5) Such an ideal condition does not get fulfilled in real life. At least one of the five conditions is not fulfilled or is violated. This claim and the validation of this claim is called “Arrow’s Impossibility Theorem”.

Arrow’s Theory of Social Choice:

1) Condition 1 – Transitivity (or) Consistency: Social state A > Social State B; Social State B > Social State C; then Social State A > Social State C; provided Social States A, B & C can be related to each other in terms of preference or indifference (Principle of Connexity).

2) Condition 2 – Responsiveness to individual’s preferences: Social ranking of choices must respond positively to individuals’ ranking of choices including changes taking place in it. A sub-group’s choice of alternative A more intense than before compared to alternative B and no one’s preference for A has diminished, then it should remain that A > B. Discrimination deliberately reduces the social desirability of a social sate even if some individuals’ preference for it increases. Putting it in layman’s terms what the group likes must be similar or representative of what the individual likes. This view implies the idea of consensus (or) popular acceptance, fundamental to a free market economy.

3) Condition 3 – Non imposition: If B is not better than A for no one, and A > B for even a minority, then social choice should be A > B. Choice of A makes some better off but no one worse off. But rejection of A will make some worse off without making anyone better off (Pareto Criterion). Also social choice should not be externally decided.

4) Condition 4 – Non Dictatorship: Social choice to be determined democratically by voting.

5) Condition 5 – Independence of irrelevant alternatives: Social preference between two alternatives determined exclusively by individual’s preference for the alternatives and not affected by alternatives that are not available. If A, B & C are available at one time and A > B > C, so A > C. If C by is unavailable then it should not be B > A. This follows from the consistency (or) transitivity condition by which individuals do not violate or reverse preferences or choices due to an alternative becoming immediately irrelevant.

Note: Arrow's Impossibility Theory is also taught in Public Economics. Hence for this semester it will not repeated as lecture in the Micro Economics course (November 1st, 2007).