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 the related article 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 summing increments of welfare to 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.

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 with the intention of deriving some general rules concerning the policies needed to maximise social welfare. Their findings 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. Unfortunately its usefulness is limited by the practical problems of measuring welfare changes and 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 principle, the estimation of welfare changes in the absence of such information falls outside the province of economics and becomes the sole responsibility of the decision-maker. In practice, however, commonsense requires economists to take for granted the universally - accepted norms of his community. Crime-prevention is taken as a benefit, for example, and the offsetting benefits to the successful criminal are not taken into account. Such norms often breach the principal that each individual is to be considered the sole judge of his own welfare, and borderline cases can pose controversy by raising such questions as whether to take account of the pleasure derived from the consumption of potentially harmful substances such as recreational drugs and tobacco.

Competition policy

The conduct of competition (antitrust) policy is complicated by the theorem of welfare economics termed the "theory of the second best" which states that, although perfect competition can be deemed Pareto-efficient, efficiency is not necessarily increased by the removal of anticompetitive practices in an economy which is not otherwise in a state of perfect competition. In principle that theorem undermines the rational of competition policy but its commonsense implication is the need to take account of the relevant interactions when they arise .