Welfare Economics

Welfare economics is a very important branch of economic theory. It serves as a foundation for many applied (relatively speaking) branches of economics, such as public finance, cost—benefit analysis and the economics of government policy in many areas, including international trade, industry and welfare (social security and so on). The importance of welfare economics is scarcely in any doubt.

The concept of Pareto optimality plays a major part in welfare economics. Many theorems and optimality conditions are formulated with reference to Pareto optimality because the Pareto principle is widely accepted as a value judgment, while judgments that involve interpersonal comparisons of utility are more controversial. However this does not mean that welfare economics has to be based only on the Pareto principle. Indeed theorems and analysis based on ‘extra-Paretian’ principles have been developed. Nevertheless Pareto optimality will continue to be one of the most important concepts in welfare economics, and hence it warrants careful study.

In the previous chapter we noted that the Pareto principle is a sufficient condition for social improvement. However most policy changes make some individuals better off and some worse off, so can we still have a sufficient condition for social improvement? This brings us to the issue of welfare criteria, which has been the subject of considerable debate in the literature on welfare economics.

The discussion of the magnitude of welfare change in this chapter centres on the concept of consumer surplus associated with a price change. But some of the measures of consumer surplus - such as compensating variation, equivalent variation and our proposed measure, marginal-dollar equivalent (see the appendix to this chapter) — can also be used to measure welfare changes that are associated with other changes.

What is the optimal distribution of income? As with any constrained optimisation problem, this depends on the form of the objective function and of the constraint. Since we are interested in optimality from the social point of view, the relevant objective function is the SWF. Since a reasonable SWF does not exist without an interpersonal comparison of cardinal utility (Chapter 5), the interpersonal cardinal utility approach is used in this chapter. The relevant constraint can be expressed as a utility possibility frontier if we agree that social welfare is a function of individual utilities (or individual welfares — abstracting away the differences between preference and welfare, the two are equivalent; see Section 1.3). Factors other than individual utilities are either regarded as not relevant to social welfare or are held constant. In Section 2.2.1 we derived a utility possibility frontier by taking the outer envelope of the numerous utility possibility curves, each corresponding to a specific collection of goods. This could be regarded as rather restrictive or purely economic, since by varying only the collection of goods other factors (social and so on) must be held constant. By changing these other factors, a different utility possibility frontier may emerge. Conceptually this generalisation can easily be taken into account by taking the outer envelope of the various utility possibility frontiers and calling it the grand utility possibility frontier.

It was noted in Chapter 2 that an equilibrium situation of a perfectly competitive market economy is Pareto optimal under certain conditions. One of these conditions is the absence of (unaccounted for) external effects. However external effects are pervasive. External effects in the form of environmental disruption have attracted both academic and public attention for decades (see for example Papandreou, 1994; Stavins, 2000). This chapter considers how external effects can cause non-optimality, and how this can be alleviated. But first we shall discuss the concept and classification of external effects.

In Chapter 2 we discussed the necessary conditions for Pareto optimality and how these conditions could be fulfilled. A factor that makes fulfilment of the necessary conditions difficult in a market economy is monopolistic power, which is quite impossible to eliminate in the presence of the increasing returns to scale and product differentiation that are characteristic of many sectors of the economy. The presence of external effects (Chapter 7) makes things even more complicated. In principle there may exist a tax/ subsidy system that enables all the necessary conditions to be fulfilled and a first-best Pareto optimum achieved. But this may not be politically or institutionally feasible. (In the presence of ‘non-amenable’ externalities, the first best is inherently impossible to achieve, even abstracting from the problems of political feasibility, costs and information. Non-amenable externalities include those external effects, such as social interaction, which change their character once tax/subsidy, regulation, bargaining and so on are introduced to internalise the effects. See Ng, 1975d.) If the necessary conditions cannot be satisfied for some sectors of the economy for one reason or another, what is the best we can do for the rest of the economy? This is the problem of second best.

Traditional welfare economics is incomplete in at least two important respects. First, it is based on an orthodox economic analysis that is largely neoclassical in nature. Neoclassical economics concentrates on resource allocation and largely ignores the important classical economic problems associated with divisions of labour to take advantage of economies of specialisation and the associated evolution of economic organisations. This deficiency is discussed in the present chapter. While attention has recently been paid to the classical problems of specialisation (see for example Yang and Ng, 1993), the related welfare economic issues raised by this new classical framework are only just beginning to be addressed and there is considerable scope for further research.

Welfare economics has achieved much, although it still has long-standing weaknesses, such as the inability to make non-Pareto comparisons due to the difficulty of making interpersonal comparisons of cardinal utilities. Ways of overcoming this weakness have been discussed in Chapter 5 and in Ng (1996a, 2000a), but the use of interpersonally comparable cardinal utilities has not been widely accepted by economists. In this chapter it is argued that welfare economics is too narrow in focus and should be expanded to make the analysis more complete, and hence more useful. Important reformulations of welfare economics and cost—benefit analysis are needed. Some of the points discussed below have long been known about but have largely been ignored in welfare economic analysis. Some are less well known or are controversial, but are nevertheless important for welfare.

We started off by defining welfare economics as a branch of study that endeavours to formulate propositions that enable us to state that social welfare in one economic situation is greater or lesser than in another. Is the welfare economics presented in this book useful in this respect?