Definition of welfare economics


What is the welfare economy?

Well-being economics is the study of how the allocation of resources and goods affects social well-being. This is directly related to the study of economic efficiency and income distribution, as well as how these two factors affect the general well-being of people in the economy. Concretely, well-being economists seek to provide tools to guide public policies in order to obtain social and economic results beneficial for the whole of society. However, the economics of well-being is a subjective study that depends heavily on the assumptions chosen about how well-being can be defined, measured and compared for individuals and for society as a whole.

Key points to remember

  • Welfare economics is the study of how the structure of markets and the distribution of goods and economic resources determine the general welfare of society.
  • Welfare economics seeks to assess the costs and benefits of changes in the economy and to orient public policies towards increasing the total good of society, using tools such as analysis cost-benefit and social welfare functions.
  • The economics of well-being depends heavily on assumptions about the measurability and comparability of human well-being between individuals, and the value of other ethical and philosophical ideas about well-being.

Understanding the economics of well-being

Welfare economics begins with the application of utility theory in microeconomics. Utility refers to the perceived value associated with a particular good or service. In dominant microeconomic theory, individuals seek to maximize their utility through their actions and consumption choices, and the interactions of buyers and sellers through the laws of supply and demand in competitive markets generate surplus for consumers and producers.

The microeconomic comparison of consumer and producer surpluses in markets under different market structures and conditions provides a basic version of welfare economics. The simplest version of welfare economics can be thought of as the following question: “What market structures and what arrangements of economic resources between individuals and production processes will maximize the total sum of utility received by all individuals or will maximize the total consumer and producer surplus in all markets? ? “The welfare economy seeks the economic state that will create the highest overall level of social satisfaction among its members.

Pareto efficiency

This microeconomic analysis leads to the condition of Pareto efficiency as an ideal in welfare economics. When the economy is in a state of Pareto efficiency, social welfare is maximized in the sense that no resources can be reallocated to improve an individual’s situation without harming at least one individual. One of the goals of economic policy might be to try to move the economy to an efficient Pareto state.

To assess whether a proposed change in market conditions or in public policy will advance the economy towards Pareto efficiency, economists have developed various criteria, which estimate whether the welfare gains from a change in the economy economy outweigh the losses. These include the Hicks Criterion, Kaldor’s Criterion, Scitovsky’s Criterion (also known as the Kaldor-Hicks Criterion), and Buchanan’s Unanimity Principle. In general, this type of cost-benefit analysis assumes that the gains and losses of public services can be expressed in monetary terms. It also treats issues of equity (such as human rights, private property, justice and fairness) as out of the question or assumes that the status quo represents some sort of ideal over these types. of questions.

Maximization of social welfare

However, Pareto efficiency does not provide a one-size-fits-all solution to how the economy should be organized. Multiple Pareto efficient arrangements of the distributions of wealth, income and production are possible. Shifting the economy towards Pareto efficiency might be an overall improvement in social welfare, but it does not provide a specific goal as to the arrangement of economic resources between individuals and markets that will actually maximize the good. -be social. To do this, welfare economists have designed various types of welfare functions. Maximizing the value of these functions then becomes the objective of the economic analysis of the well-being of markets and public policies.

The results of this type of social welfare analysis depend heavily on assumptions about the possibility and how utility can be added or compared between individuals, as well as on philosophical and ethical assumptions about the value to be placed on the good. -being of different individuals. These allow for the introduction of ideas about equity, justice and rights to be incorporated into the analysis of social welfare, but make the exercise of welfare economics an inherently subjective area. and possibly contentious.

How is economic well-being determined?

Under the prism of Pareto efficiency, optimal welfare, or utility, is achieved when the market is allowed to reach an equilibrium price for a given good or service – it is at this point that consumer and producer surpluses are maximized.

However, the goal of most modern welfare economists is to apply notions of justice, rights and equality to the machinations of the market. In this sense, markets that are “efficient” do not necessarily achieve the greatest social good.

One of the reasons for this disconnection: the relative usefulness of different individuals and producers when evaluating an optimal outcome.Welfare economists could theoretically argue, for example, for a higher minimum wage – even if this reduces producer surplus – if they believe that the economic loss to employers would be felt less acutely than. the increased utility experienced by low-wage workers.

Practitioners of normative economics, based on value judgments, may also try to measure the desirability of “public goods” that consumers do not pay for in the free market.

The opportunity to improve air quality through government regulations is one example of what standards economy practitioners might measure.

Measuring the social utility of various outcomes is an inherently imprecise endeavor, which has long been a critique of welfare economics. However, economists have a number of tools at their disposal to assess the preferences of individuals for certain public goods.

They can conduct surveys, for example, asking how much consumers would be willing to spend on a new highway project. And as economist Per-Olov Johansson points out, researchers could estimate the value of a public park, for example, by analyzing the costs people are willing to incur to visit it.

Another example of applied welfare economics is the use of cost-benefit analyzes to determine the social impact of specific projects.In the case of a town planning commission trying to assess the creation of a new sports arena, the commissioners would likely balance the benefits for fans and team owners with those of businesses or owners displaced by new ones. infrastructure.

Critique of the welfare economy

In order for economists to arrive at a set of policies or economic conditions that maximize social utility, they must engage in interpersonal comparisons of utility. To build on a previous example, one would have to infer that minimum wage laws would help low-skilled workers more than they hurt employers (and, potentially, some workers who might lose their jobs).

Critics of welfare economics argue that making such comparisons accurately is an unrealistic goal. It is possible to understand the relative impact on utility, for example, of price changes to the individual. But, from the 1930s, British economist Lionel Robbins argued that comparing the value that different consumers place on a set of goods is less practical. Robbins also disparaged the lack of objective measurement units to compare utility between different market players.

Perhaps the most powerful attack on welfare economics is that of Kenneth Arrow, who in the early 1950s introduced the ‘impossibility theorem’, which suggests that the inference of social preferences in aggregating individual rankings is inherently flawed. It is rare that all the conditions combined make it possible to arrive at a true social order of the results available.

If, for example, you have three people and they are asked to rank different possible outcomes (X, Y, and Z), you might get these three orders:

  1. Y, Z, X
  2. X Y Z
  3. Z, X, Y

You might conclude that the group prefers X over Y because two people ranked the first over the second. Similarly, we can conclude that the group prefers Y to Z, since two of the participants put them in that order. But if we therefore expected X to rank above Z, we would be wrong – in fact, the majority of subjects put Z before of X. As a result, the desired social order is not achieved – we are simply stuck in a cycle of preferences.

Such attacks have dealt a serious blow to the welfare economy, whose popularity has declined in popularity since its heyday in the mid-20th century. However, it continues to attract followers who believe, despite these difficulties, that economics is, in the words of John Maynard Keynes, “a moral science.”


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