Welfare economics

The concept of welfare is concerned with 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. The theorems of welfare economics provide the theoretical basis for the benefits of market competition, the determinants of economic efficiency, the practice of cost-benefit analysis and many other aspects of economic theory.

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 collective or "social" welfare is greatly complicated by the logical impossibility, noted in that article, 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 consequently provides only partial ad-hoc solutions, qualified by the need to embody value judgments without totally abandoning the presumption that every individual is the sole judge of his own welfare. In many cases, however, the judgments required are so widely accepted as to present no practical difficulty. There is general acceptance, for example, that gains in individual welfare arising from psychotic satisfactions are not admissible components of social welfare.

The Pareto criterion

The aggregate increase in welfare resulting from an action cannot be quantified because interpersonal comparisons of welfare are conceptually impossible. However, it is possible to determine whether an activity increases or decreases an individual's economic welfare. One way of overcoming the conceptual barrier is to deem that an activity will increase efficiency only if it makes somebody better off without making anybody worse off. Efficiency so defined is termed Pareto efficiency in honour of the economist, Vilfredo Pareto, who first put that definition forward. The terms Pareto efficient and Pareto optimum are used to describe an ideal state of affairs from which it is impossible to make a change which would make anybody better off without making somebody else worse off. (The Pareto criterion is often modified for general use by the introduction of the compensation principle, according to which efficiency is increased if those who gain as the result of an action could benefit from it after compensating those who lose from it, but it is the unmodified formulation that is referred to below).

The benefits of competition

The propositions that are termed the fundamental theorems of welfare economics define the properties of a market that is in equilibrium and has the hypothetical characteristic of perfect competition .

The first fundamental theorem of welfare economics

The first theorem states that every perfectly competitive market is Pareto-efficient when in equilibrium.

The second fundamental theorem of welfare economics

The second theorem states that the characteristics of a perfectly competitive market can be changed without limit while retaining its Pareto-efficiency, provided that it continues to be perfectly competitive.

The theorem of the second-best

The practical significance of the fundamental theorems is further limited by the the theorem of the second best, which states that an increase in the competitiveness of a market is nor perfectly competitive, does not necessarily increase efficiency.