Welfare economics

The term economic welfare denotes the well-being of the individual, and the subject matter of welfare economics is the influence of collective decisions upon the welfare of groups of individuals. At the theoretical level welfare economics has provided limited support for other economic theories, and has contributed to philosophical debates about the role of the state. In its applied form it has been widely used by economic advisers to estimate the effects of proposed policy changes upon the welfare of those who would be affected.

The terms shown in italics in this article are defined on related article the subpage.

Definition

The definition of the welfare of an individual is the same as the definition of utility that is presented in the article on that subject, but the problem of defining the "social welfare" of groups of people is greatly complicated by the logical impossibility of defining the total welfare of an individual or of making inter-personal comparisons of utility. The nature of that problem is discussed on the tutorials subpage, where it is noted that no completely satisfactory theoretical solution is available. Applied welfare economics can provide only approximate advice, which consequently has to be qualified for policy purposes by the embodiment of value judgments.

The fundamental theorems

The fundamental theorems of welfare economics define the properties of an intensely hypothetical economy in which there are markets for everything that is supplied and that supply every demand, each of which operates in conditions of perfect competition and flexible prices, and which together are in general equilibrium.

In such an economy there are no externalities, no spillovers, no external economies, and no public goods; every firm operates on its production possibility frontier, the price of every product is equal to its marginal cost of production, every wage rate is equal to its wage-earner's marginal product, all consumers are perfectly informed about all products and none are influenced by customs, fashions or advertising.

• The first theorem states that every complete economy that is entirely made up of perfectly competitive markets is Pareto-efficient when in general equilibrium.
• The second theorem states that other characteristics of such an economy can be changed without limit without departing from its Pareto-efficient condition, provided that all of its markets continue to be perfectly competitive.

The first theorem is a demonstration that an economy can operate to everyone's satisfaction when each of its members acts solely in his own interests, in the absence of any organised coordination. It can be regarded as highly restricted formal proof of Adam Smith's contention that the economy itself provides a "hidden hand" which coordinates all economic activity. There is no role for government in the first theorem, but one implication of the second theorem is that it is theoretically possible for a government to alter the distribution of wealth without causing an economy to depart from an initially Pareto-efficient condition, provided that it does so without creating departures from perfect competition and flexible pricing. The proviso excludes the use of instruments that alter consumer choice (such as sales taxes, that distort choices between products, and income tax, which distorts the choice between consumption and leisure) leaving only unconditional lump-sum taxes such as a poll tax or a tax on land values.

The fundamental theorems have no direct implications for the analysis of real economies because no real economy has the characteristics that they require. They have had some indirect influence, however, as the result of the work of theorists and philosophers who have experimented with the consequences of removing some of the theorems' more unrealistic assumptions. For example, William Baumol has contributed to the theory of the state by allowing for the existence of external economies and diseconomies of production and consumption, such as the possibility that, in the absence of collective restraints, individuals acting in pursuit of their own immediate interests might reduce social welfare by behaving in ways that are damaging to others. The findings that have been reached concerning the desirable role of the state have generally been controversial and inconclusive.

Applied welfare economics

Cost-benefit analysis

Welfare economics has long served as the principal tool of the economists who are employed to advise governmental policy-makers. It is not a tool of precision, however: to the practical problems measuring welfare changes are added the conceptual problems of making interpersonal comparisons of welfare. The conceptual problems are often not decisive, however. The cost-benefit analysis of a road improvement that would save an estimated twenty serious accidents a year is not seriously hampered by the consideration that it would also inconvenience a dozen householders. The fact that nearly every policy change from which some people benefit also harms someone else, is coped with by adopting the proposition that efficiency is nonetheless increased provided that the gainers can benefit after compensating the losers. For the road improvement analysis, it is the estimating of the welfare costs of road accidents that presents the more difficult problem, and the resulting uncertainties could render the analysis inconclusive. The only objective evidence that is available concerning the magnitudes of welfare losses and gains is evidence from market behaviour, enabling the value to the community of a policy change to be derived from the consumers' surplus that it generates. In the absence of such information the estimation of welfare changes falls outside the province of economics and becomes the sole responsibility of the decision-maker.