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.

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 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 fundamental theorems

The fundamental theorems of welfare economics define properties of an intensely hypothetical economy in which there are markets 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, 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, and every wage rate is equal to its wage-earner's marginal product. The definition of perfect competition employed implies that consumers are perfectly informed about all products and are not 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 practical significance of the first theorem is limited by the hypothetical nature of its assumptions and by the the "theorem of the second best", which states that an increase in the competitiveness of one market in an economy in which some other market is not perfectly competitive, does not necessarily increase economic efficiency. One implication of the second theorem is that it is theoretically possible for a government to alter the distribution of wealth without causing the 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.