MODULE 5

WELFARE ECONOMICS AND EQUILIBRIUM

Structure:

5.1. Criteria of Social Welfare

5.2. Cardinalists Criterion and Bentham Criterion
5.3. Pareto Optimal Conditions, Kaldor Hicks Compensation Criterion, Bergsons’
Criterion
5.4 Derivation of Grand Utility Possibility Frontier Imperfections
5.5 Externalities and Market Failures
5.6 Arrows Impossibility Theorem
5.7 Summary
5.8 Self-Assessment Question

Introduction:

Welfare economics focuses on the optimal allocation of resources and goods and how the
allocation of these resources affects social welfare. Welfare economics is a subjective
study that may assign units of welfare or utility to create models that measure the
improvements to individuals based on their personal scales.
5.1 Criteria of Social Welfare:
To evaluate alternative economic situations we need some criterion of social well- being or
welfare.

The measurement of social welfare requires some ethical standard and interpersonal
comparisons, both of which involve subjective value judgements.

Objective comparisons and judgements of the deservingness or worthiness of differ_ent

individuals are virtually impossible. Various criteria of social welfare have been suggested
by economists at different times.

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Growth of GNP as A Criterion of Welfare:

Adam Smith implicitly accepted the growth of the wealth of a society, that is, the growth of
the gross national product, as a welfare criterion. He believed that economic growth
resulted in the increase of social welfare because growth increased employment and the
goods available for consumption to the community. To Adam Smith, economic growth
meant bringing W closer to W*.

The growth criterion implies acceptance of the status quo of income distribution as
‘ethical’ or ‘just’. Furthermore, growth may lead to a reduction in social welfare,
depending on who avails mostly from it. However the growth criterion highlights the
importance of efficiency in social welfare. Given that social welfare depends on the
amount of goods and services (as well as on their distribution) efficiency is a necessary
prerequisite for the maximization of the level of welfare.

We note here that economic efficiency can be defined objectively, and the modern welfare
economics is mainly concerned with the examination (comparison) of the
(Pareto)-efficiency of different economic situations. However, efficiency, although a
necessary condition, is not sufficient to guarantee the maximization of social welfare.
Efficiency does not dispose of the need of having an ethical standard of comparing
alternative economic states.

Bentham’s Criterion:

Jeremy Bentham, an English economist, argued that welfare is improved when ‘the
greatest good (is secured) for the greatest number’. Implicit in this dictum is the
assumption that the total welfare is the sum of the utilities of the individuals of the society.
The application of Bentham’s ethical system to economics has serious short comings. To
illustrate the pitfalls in Bentham’s criterion let us assume that the society consists of three
individuals, A, B, and C, so that

W = UA + UB + UC

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According to Bentham ΔW > 0 if (ΔUA + ΔUB + ΔUC) > 0. However, assume that the
change which resulted in the changes in the individual utilities is such, that A’s and B’s
utility increases, while Cs utility decreases, but (∆UA + ∆UB) > |∆UC|. In other words,
two individuals are better-off while the third is worse-off after the change has taken place,
but the sum of the increases in utilities of A and B is greater than the decrease in the utility
of C.

Bentham’s criterion, obviously, implies that A and B have a greater ‘worthiness’ than C.
That is, implicit in Bentham’s criterion is an interpersonal comparison of the deservingness
of the members of the society. There is another difficulty with the application of Bentham’s
criterion.

This criterion cannot be applied to compare situations where ‘the greatest good’ and the
‘greatest numbers’ do not exist simultaneously. For example assume that in a situation
UA = 200, UB = 50, UC = 30, so that the total utility in the society is 280. In another
situation assume that a change occurred and UA = 100, UB = 80, and UC = 80, so that the
total utility is 260. The first situation has ‘the greatest good’ (280 > 260), but the second
involves a more even distribution (of a smaller ‘total good’) among the ‘greatest number’.

A ‘Cardinalist’ Criterion:

Several economists proposed the use of the ‘law of diminishing marginal utility’ as a
criterion of welfare. Their argument can be illustrated by the following example. Assume
that the society consists of three individuals; A has an income of £1000, while B and C
have an income of £500 each. Consumer A can buy double quantities of goods as
compared to B and C.

However, given the law of diminishing marginal utility, A’s total utility is less than double
the total utility of either B or C, because A’s marginal utility of money is less than that of B
or C. Thus W < W*. To increase social welfare income should be redistributed among the

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three individuals. In fact cardinal welfare theorists would maintain that social welfare
would be maximized if income was equally distributed to all members of the society.

The cardinalist approach to welfare has a serious flaw: it assumes that all individuals have
identical utility functions for money, so that with an equal income distribution all would
have the same marginal utility of money. This assumption is too strong. Individuals differ
in their attitudes towards money. A rich person may have a utility for money function that
lies far above the utility (for money) function of poorer individuals.

In this case a redistribution of income (towards more equality) might reduce total welfare.
Opponents of the cardinalist approach pointed out also that welfare effects of an equal
distribution of income cannot be examined in isolation from the effects on resource
allocation (which would follow the redistribution of income) and the incentives for work of
the various individuals.

An equal income distribution may induce some people to work less, thus leading to a
reduction in total GNP. Similarly, equal incomes in all employments may lead to an
allocation of resources which produces a smaller total output. In both cases income
equality results in (Pareto) inefficiency in the use of resources and a reduction in social

The Pareto-Optimality Criterion:

This criterion refers to economic efficiency which can be objectively measured. It is called
Pareto criterion after the famous Italian economist Vilfredo Pareto (1848-1923).
According to this criterion any change that makes at least one individual better-off and no
one worse-off is an improvement in social welfare. Conversely, a change that makes no
one better-off and at least one worse-off is a decrease in social welfare. The criterion can be
stated in a somewhat different way: a situation in which it is impossible to make anyone
better-off without making someone worse-off is said to be Pareto-optimal or
Pareto-efficient.

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The Kaldor-Hicks ‘compensation criterion:

Nicholas Kaldor and John Hicks suggested the following approach to establishing a
welfare criterion.

Assume that a change in the economy is being considered, which will benefit some
(‘gainers’) and hurt others (‘losers’). One can ask the ‘gainers’ how much money they
would be prepared to pay in order to have the change, and the ‘losers’ how much money
they would be prepared to pay in order to prevent the change.

If the amount of money of the ‘gainers’ is greater than the amount of the ‘losers’, the
change constitutes an improvement in social welfare, because the ‘gainers’ could
compensate the ‘losers’ and still have some ‘net gain’. Thus, the Kaldor-Hicks
‘compensation criterion’ states that a change constitutes an improvement in social welfare
if those who benefit from it could compensate those who are hurt, and still be left with
some ‘net gain’.

The Kaldor-Hicks criterion evaluates alternative situations on the basis of monetary

valuations of different persons. Thus it implicitly assumes that the marginal utility of
money is the same for all the individuals in the society. Given that the income distribution
is unequal in the real world, this assumption is absurd.

Assume, for example, that the economy consists of two individuals, A, who is a millionaire,
and B, who has an income of £4000. Suppose that the change (being considered by the
government) will benefit A, who is willing to pay £2000 for this change to happen, while it
will hurt B, who is prepared to pay £1000 to prevent the change.

According to the Kaldor-Hicks criterion the change will increase the social welfare (since
the ‘net gain’ to A, after he compensates B, is £1000). However, the gain of £2000 gives
very little additional utility to millionaire A, while the ‘loss’ of £1000 will decrease a lot
the well-being of B, who has a much greater marginal utility of money than A.

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Thus the total welfare will be reduced if the change takes place. Only if the marginal utility
of money is equal for all the individuals would the Kaldor-Hicks criterion be a ‘correct’
welfare measure. This criterion ignores the existing income distribution. In fact this
criterion makes implicit interpersonal comparisons, since it assumes that the same amounts
of money have the same utility for individuals with different incomes.

The Bergson criterion: the social welfare function:

The various welfare criteria so far discussed show that when a change in the economy
benefits some individuals and hurts others it is impossible to evaluate it without making
some value judgement about the deservingness of the different individuals or groups.
Bergson suggested the use of an explicit set of value judgements in the form of a social
welfare function.

A social welfare function is analogous to the individual consumer’s utility function. It

provides a ranking of alternative states (situations, configurations) in which different
individuals enjoy different utility levels.

5.2. Cardinalists Criterion and Bentham Criterion:

Cardinalists Criterion-
Several economists proposed the use of the 'law of diminishing marginal utility' as a
criterion of welfare. Their argument can be illustrated by the following example. Assume
that the society consists of three individuals; A has an income of £1000, while B and C
have an income of £500 each. Consumer A can buy double quantities of goods as
compared to Band C. However, given the law of diminishing marginal utility, A's total
utility is less than double the total utility of either B or C, because A's marginal utility of
money is less than that of B or C. Thus W < W*. To increase social welfare income
should be redistributed among the three individuals. In fact cardinal welfare theorists
would maintain that social welfare would be maximized if income was equally
distributed to all members of the society. The cardinalist approach to welfare has a
serious flaw: it assumes that all individuals have identical utility functions for money, so

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that with an equal income distribution all would have the same marginal utility of money.
This assumption is too strong. Individuals differ in their attitudes towards money. A rich
person may have a utility for money function that lies far above the utility (for money)
function of poorer individuals. In this case a redistribution of income (towards more
equality) might reduce total welfare. Opponents of the cardinalist approach pointed out
also that welfare effects of an equal distribution of income cannot be examined in
isolation from the effects on resource allocation (which would follow the redistribution of
income) and the incentives for work of the various individuals. An equal income
distribution may induce some people to work less, thus leading to a reduction in total
GNP. Similarly, equal incomes in all employments may lead to an allocation of resources
which produces a smaller total output.

Bentham Criterion-

Jeremy Bentham, an English economist, argued that welfare is improved when 'the
greatest good (is secured) for the greatest number'. Implicit in this dictum is the
assumption that the total welfare is the sum of the utilities of the individuals of the
society. The application of Bentham's ethical system to economics has serious
shortcomings. To illustrate the pitfalls in Bentham's criterion let us assume that the
society consists of three individuals, A, B, and C, so that W=UA+U8 +Uc According to
Bentham L\W > 0 if (L\U A+ L\U 8 + L\Uc) > 0. However, assume that the change which
resulted in the changes in the individual utilities is such, that A's and B's utility increases,
while Cs utility decreases, but (L\U A+ L\U 8 ) > I L\U c j. In other words, two
individuals are better-off while the third is worse-off after the change has taken place, but
the sum of the increases in utilities of A and B is greater than the decrease in the utility of
C. Bentham's criterion, obviously, implies that A and B have a greater 'worthiness' than C.
That is, implicit in Bentham's criterion is an interpersonal comparison of the
deservingness of the members of the society. There is another difficulty with the
application of Bentham's criterion. This criterion cannot be applied to compare situations

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where 'the greatest good' and the 'greatest numbers' do not exist simultaneously. For
example assume that in a situation U A= 200, U 8 =50, Uc = 30, so that the total utility in
the society is 280. In another situation assume that a change occurred and U A = 100, U 8
= 80, and U c = 80, so that the total utility is 260. The first situation has 'the greatest
good' (280 > 260), but the second involves a more even distribution (of a smaller 'total
good') among the 'greatest number'.

5.3 Pareto Optimal Conditions, Kaldor Hicks Compensation Criterion, Bergsons’

Criterion

Pareto Optimal Conditions-

We now turn to the concept of Pareto Optimality, named after the economist Vilfredo
Pareto. It is a concept that you will find recurring frequently in the economics literature.
The main proposition of Pareto Optimality can be summed up as follows.

An economy is in a Pareto Optimal state when no further changes in the economy can make
one person better off without at the same time making another worse off.

You may immediately recognize that this is the socially optimal outcome achieved by a
perfectly competitive market referred to above. It can be shown that an economy will be
Pareto Optimal when the economy is perfectly competitive and in a state of static general
equilibrium. The intuitive case for this is based on the fact that prices reflect economic
values in a competitive market. If a unit of goods or services could produce more or bring
greater satisfaction in some activity other than its present use, someone would have been
willing to bid up its price, and it would have been attracted to the new use.

When this price system is in equilibrium, the marginal revenue product, the opportunity
cost, and the price of a resource or asset will all be equal. Each unit of every good and
service is in its most productive use or best consumption use. No transfer of resources
could result in greater output or satisfaction.

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This can be examined more formally in terms of three criteria that have to be met for a
market equilibrium to result in Pareto Optimality. These are that there should be: exchange
efficiency, production efficiency and output efficiency.

Exchange efficiency

Exchange efficiency occurs when, for any given bundle of goods, it is not possible to
redistribute them such that the utility (welfare) of one consumer is raised without reducing
the utility (welfare) of another consumer.

A simple example of this is where there are two individuals, one with a loaf of bread, the
other with a block of cheese. Both can be made better off by exchanging bread for cheese.
An efficient exchange system will allow exchange of bread and cheese to take place until
neither party can be made better off without one of them becoming worse off.

In a multi-product, multi-consumer economy, exchange is far more complex and involves

the use of money to facilitate exchange. However, the principle is the same. So long as
products can be reallocated to make one person better off without making another worse
off, the economy is operating sub-optimally from the point of view of exchange efficiency.
In a perfectly competitive market, exchange will occur until this criterion is met.

Exchange efficiency alone does not necessarily result in Pareto Optimality. This is because
it relates only to a specific bundle of goods. It may be possible to make one or more
individuals even better off - without making any one else worse off - by altering the bundle
of goods produced in the economy. This could involve raising the total volume of goods
produced, as well as altering the combination of goods produced.

Production efficiency

Production efficiency occurs when the available factors of production are allocated
between products in such a way that it is not possible to reallocate the production factors so
as to raise the output of one product without reducing the output of another product.

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This is analogous to technical or production efficiency at the level of the firm. What is
being said here is that there are many situations in which it is possible to raise the total
output in an economy by simply reallocating factors of production at no additional cost.
This is because factors of production are more productive in some uses than they are in
others. In a competitive economy, producers bid for factors of production until they are
reallocated to their most productive use.

For example, if there is a lot of unproductive, low-wage labour employed in the

agricultural sector and labour shortages in the industrial sector where labour productivity is
potentially high, factory owners will bid up the price of labour and draw labour from the
agricultural sector into the industrial sector. This could significantly raise output in the
industrial sector without having a negative impact on output in the agricultural sector. So
long as factors of production can be redistributed in a way that increases the output of one
product without reducing the output of others, the economy is operating sub-optimally in
terms of production efficiency.

Output efficiency

Output efficiency occurs where the combination of products actually produced is such that
there is no alternative combination of products that would raise the welfare of one
consumer without reducing the welfare of another.

Both the exchange efficiency and the production efficiency criteria must hold in order for
this criterion to be met. The combination of outputs produced according to this criterion is
distributed between consumers according to the exchange efficiency criterion, and the
economy is operating with production efficiency.

Pareto Optimality is the result of rational economic behaviour on the part of producers,
consumers and owners of factors of production in a perfectly competitive economy.
Although we don't have the scope to examine the underlying theory here it can be shown

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that Pareto Optimality will be achieved if all markets are perfectly competitive and in
equilibrium.

It is important to realize that, whilst Pareto Optimality is the outcome in an economy that
meets each of the three efficiency criteria listed earlier, this does not mean that there is only
one 'optimal' allocation of resources. A Pareto efficient economy results in the
maximization of aggregate economic welfare for a given distribution of income and a
specific set of consumer preferences. A shift in income distribution changes the incomes of
individual consumers. As their incomes change, so too will their preferences, as their
demand curves for various products shift to the left or right. This will result in a different
equilibrium point in the various markets that make up the economy. Every alternative
distribution of income or set of preferences is characterized by a different Pareto Optimum.
Thus, since there is an infinite number of different ways in which income can be
distributed, there is also an infinite number of different Pareto Optimal equilibrium.

Obviously, in practice, no economy can be expected to attain the Pareto Optimum position.
Moreover, the Pareto principle is of little practical use as a policy tool since it is rarely
possible to devise a policy that makes someone better off without making someone else
worse off. Nevertheless, it is an important concept in the neo-classical tradition of
economics and integrates much of the theory. It is also a standard against which economists
can explore the real world, where making one person better off almost invariably means
making someone else worse off.

Kaldor Hicks Compensation Criterion-

A Kaldor–Hicks improvement, named for Nicholas Kaldor and John Hicks, is an

economic re-allocation of resources among people that captures some of the intuitive
appeal of a Pareto improvement, but has less stringent criteria and is hence applicable to
more circumstances. A re-allocation is a Kaldor–Hicks improvement if those that are made
better off could hypothetically compensate those that are made worse off and lead to a
Pareto-improving outcome. The compensation does not actually have to occur (there is no

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presumption in favor of status-quo) and thus, a Kaldor–Hicks improvement can in fact
leave some people worse off.

A situation is said to be Kaldor–Hicks efficient, or equivalently is said to satisfy

the Kaldor–Hicks criterion, if no potential Kaldor–Hicks improvement from that
situation exists.

A reallocation is said to be a Pareto improvement if at least one person is made better off
and nobody is made worse off. However in practice, it is almost impossible to take any
social action, such as a change in economic policy, without making at least one person
worse off. Even voluntary exchanges may not be Pareto improving if they make third
parties worse off.

Using the criterion for Kaldor–Hicks improvement, an outcome is an improvement if those

that are made better off could in principle compensate those that are made worse off, so that
a Pareto improving outcome could (though does not have to) be achieved. For example, a
voluntary exchange that creates pollution would be a Kaldor–Hicks improvement if the
buyers and sellers are still willing to carry out the transaction even if they have to fully
compensate the victims of the pollution. Kaldor–Hicks does not require compensation
actually be paid, merely that the possibility for compensation exists, and thus need not
leave each at least as well off. Under Kaldor–Hicks efficiency, an improvement can in fact
leave some people worse off. Pareto-improvements require making every party involved
better off or at least none worse off.

While every Pareto improvement is a Kaldor–Hicks improvement, most Kaldor–Hicks

improvements are not Pareto improvements. This is because the set of Pareto
improvements is a proper subset of Kaldor–Hicks improvements. This reflects the greater
flexibility and applicability of the Kaldor–Hicks criterion relative to the Pareto criterion

The Kaldor–Hicks methods are typically used as tests of potential improvements rather
than as efficiency goals themselves. They are used to determine whether an activity moves
the economy toward Pareto efficiency. Any change usually makes some people better off

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and others worse off, so these tests consider what would happen if gainers were to
compensate losers.

The Kaldor criterion is that an activity moves the economy closer to Pareto optimality if the
maximum amount the gainers are prepared to pay to the losers to agree to the change is
greater than the minimum amount losers are prepared to accept; the Hicks criterion is that
an activity moves the economy toward Pareto optimality if the maximum amount the losers
would pay the gainers to forgo the change is less than the minimum amount the gainers
would accept to so agree. Thus, the Kaldor test supposes that losers could prevent the
arrangement and asks whether gainers value their gain so much they would and could pay
losers to accept the arrangement, whereas the Hicks test supposes that gainers are able to
proceed with the change and asks whether losers consider their loss to be worth less than
what it would cost them to pay gainers to agree not to proceed with the change. After
several technical problems with each separate criterion were discovered, they were
combined into the Scitovsky criterion, more commonly known as the "Kaldor–Hicks
criterion", which does not share the same flaws.

The Kaldor–Hicks criterion is widely applied in welfare economics and managerial

economics. For example, it forms an underlying rationale for cost–benefit analysis. In
cost–benefit analysis, a project (for example, a new airport) is evaluated by comparing the
total costs, such as building costs and environmental costs, with the total benefits, such as
airline profits and convenience for travelers. (However, as cost–benefit analysis may also
assign different social welfare weights to different individuals, e.g. more to the poor, the
compensation criterion is not always invoked by cost–benefit analysis.)

The project would typically be given the go-ahead if the benefits exceed the costs. This is
effectively an application of the Kaldor–Hicks criterion because it is equivalent to
requiring that the benefits be enough that those that benefit could in theory compensate
those that have lost out. The criterion is used because it is argued that it is justifiable for
society as a whole to make some worse off if this means a greater gain for others.

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At a more technical level, various versions of the Kaldor–Hicks criteria lack desirable
formal properties. For instance, Tibor Scitovsky demonstrated that the Kaldor criterion
alone is not antisymmetric: it's possible to have a situation where an outcome A is an
improvement (according to the Kaldor criterion) over outcome B, but B is also an
improvement over A. The combined Kaldor–Hicks criterion does not have this problem,
but it can be non-transitive (though A may be an improvement over B, and B over C, A is
not thereby an improvement over C)

Bergsons’ Criterion:
The concept of social welfare function was first introduced by Prof. Bergson and later on
developed by Samuelson, Tintner and Arrow. They are of the view that no meaningful
propositions can be made in welfare economics without introducing value judgments. The
concept of social welfare is an attempt at providing a scientifically normative study of
welfare economics.

A social welfare function shows the factors 011 which the welfare of a society is supposed
to depend. Bergson defines it “as a function either of the welfare of each member of the
community or of the quantities of products consumed and services rendered by each
member of the community.”

In its original form the Bergson social welfare function is formulated in a completely
general manner. It is a function which establishes a relation between social welfare and all
possible variables which affect each individual’s welfare, such as a services and
consumption of each individual. It is an ordinal index of society’s welfare and is a function
of individual utilities. It is expressed as

W = F (U1,.U2, Un)

where W is the social economic welfare, F is for function, and UrU2……………… UN is

the levels of utilities of 1, 2,…individuals. W is an increasing function of these utilities.

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The general properties of the social welfare function are similar to those of an individual
utility function. In particular, the value of the welfare index increases whenever the utility
level of one individual is increased without lowering that of the other individual. Thus the
social welfare function is consistent with the Pareto optimality criterion, but it goes much
further, since it assigns a value to every economic state, including those which according to
the Pareto criterion are regarded as non-comparable. The existence of a social welfare
function, therefore, implies a comparison of the welfare position of the individual members
of society.

The Bergson social welfare function is based on certain assumptions:

(a) It assumes that social welfare depends on each individual’s wealth and income and each
individual’s welfare depends, in turn, on his wealth and income and on the distribution of
welfare among the members of the society.

(h) It assumes the presence of external economies and diseconomies with their consequent
effects.

(c) It is based on ordinal ranking of combinations of those variables which influence

individual welfare.

(d) Interpersonal comparisons of utility involving value judgments are freely permissible.

5.4 Derivation of Grand Utility Possibility Frontier Imperfections:

The utility–possibility frontier is derived from the contract curve. The utility–possibility
frontier (UPF) is the upper frontier of the utility possibilities set, which is the set
of utility levels of agents possible for a given amount of output, and thus the utility levels
possible in a given consumer Edgeworth box.

In welfare economics, a utility–possibility frontier (or utility possibilities curve), is a

widely used concept analogous to the better-known production–possibility frontier. The
graph shows the maximum amount of one person's utility given each level of utility

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attained by all others in society.Points on the curve are, by definition, Pareto efficient,
while points off the curve are not. However, based on the extent of society’s preferences
for an equal distribution of real income, a point off the curve may be preferred. All points
on or below the utility–possibility frontier are attainable by society; all points above it are
not attainable. The utility–possibility frontier is derived from the contract curve.

The utility–possibility frontier (UPF) is the upper frontier of the utility possibilities set,
which is the set of utility levels of agents possible for a given amount of output, and thus
the utility levels possible in a given consumer Edgeworth box.

In a competitive economy, any allocation over the utility–possibility frontier is a Pareto

optimum, as the UPF is a representation of the Pareto contract curve in a different
dimension (utilities rather than goods). The UPF is the set of points which, for a given level
of utility of person 1, utility of person 2 is maximized (subject to resource
availability).Because all points along the UPF represent different real income distributions,
all being Pareto efficient, it is difficult to determine which utility combination is preferable
to society. Usually, the social welfare function, which incorporates the deservedness of the
two individuals and states how society’s well-being relates to that of the two individuals, is
required to maximize social welfare. It is assumed that the value of social welfare changes
as the individual utility of any member of society changes. To maximize social welfare, a
point on the UPF would be chosen that also falls on the highest indifference curve for
society.

5.5 Externalities and Market Failures:

Externalities, or consequences of an economic activity, lead to market failurebecause a

product or service's price equilibrium does not accurately reflect the true costs and benefits
of that product or service. Equilibrium, which represents the ideal balance between buyers'
benefits and producers' costs, is supposed to result in the optimal level of production.
However, the equilibrium level is flawed when there are significant externalities, creating
incentives that drive individual actors to make decisions which end up making the group
worse off. This is known as a market failure.

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When negative externalities are present, it means that the producer does not bear all costs,
resulting in excess production. With positive externalities, the buyer does not get all the
benefits of the good, resulting in decreased production. An example of a negative
externality is a factory that produces widgets but pollutes the environment in the process.
The cost of the pollution is not borne by the factory, but instead shared by society.

If the negative externality is taken into account, then the cost of the widget would be higher.
This would result in decreased production and a more efficient equilibrium. In this case,
the market failure would be too much production and a price that didn't match the true cost
of production, as well as high levels of pollution.

An example of a positive externality would be education. Obviously, the person being

educated benefits and pays for this cost. However, there are positive externalities beyond
the person being educated, such as a more intelligent and knowledgeable citizenry,
increased tax revenues (from better-paying jobs), less crime and more stability. All of
these factors positively correlate with education levels. These benefits to society are not
accounted for when the consumer is considering the benefits of education.

Therefore, education would be under consumed relative to its equilibrium level if these
benefits are taken into account. Clearly, public policymakers should look to subsidize
those markets with positive externalities and punish those with negative externalities.

One obstacle for policymakers, though, is the difficulty of quantifying externalities to

increase or decrease consumption or production. In the case of pollution, policymakers
have tried tools, including mandates, incentives, penalties and taxes, that would result in
increased costs of production for companies that pollute. For education, policymakers have
looked to increase consumption with subsidies, access to credit and public education.

In addition to positive and negative externalities, some other reasons for market failure
include a lack of public goods, under provision of goods, overly harsh penalties
and monopolies (see also "How Does a Monopoly Contribute to Market Failure?").

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Markets are the most efficient way to allocate resources with the assumption that all costs
and benefits are accounted into price. When this is not the case, significant costs are
inflicted upon society, as there will be underproduction or overproduction.

Being cognizant of externalities is one important step in combating market failure.

While price discovery and resource allocation mechanisms of markets need to be respected,
market equilibrium is a balance between costs and benefits to the producer and consumer.
It does not take third parties into effect. Thus, it is the policymakers' responsibility to
adjust costs and benefits in an optimal way.

5.6. Arrows Impossibility Theorem:

In social choice theory, Arrow's impossibility theorem, the general possibility
theorem or Arrow's paradox is an impossibility theorem stating that when voters have
three or more distinct alternatives (options), no ranked voting electoral system can convert
the ranked preferences of individuals into a community-wide (complete and transitive)
ranking while also meeting a specified set of criteria: unrestricted
domain, non-dictatorship, Pareto efficiency, and independence of irrelevant alternatives.
The theorem is often cited in discussions of voting theory as it is further interpreted by
the Gibbard–Satterthwaite theorem. The theorem is named after economist and Nobel
laureate Kenneth Arrow, who demonstrated the theorem in his doctoral thesis and
popularized it in his 1951 book Social Choice and Individual Values. The original paper
was titled "A Difficulty in the Concept of Social Welfare".

In short, the theorem states that no rank-order electoral system can be designed that always
satisfies these three "fairness" criteria:

If every voter prefers alternative X over alternative Y, then the group prefers X over Y.

If every voter's preference between X and Y remains unchanged, then the group's
preference between X and Y will also remain unchanged (even if voters' preferences
between other pairs like X and Z, Y and Z, or Z and W change).

141
There is no "dictator": no single voter possesses the power to always determine the
group's preference.

Cardinal voting electoral systems are not covered by the theorem, as they convey more
information than rank orders. However, Gibbard's theorem extends Arrows theorem for
that case. The theorem can also be sidestepped by weakening the notion of independence.

The axiomatic approach Arrow adopted can treat all conceivable rules (that are based on
preferences) within one unified framework. In that sense, the approach is qualitatively
different from the earlier one in voting theory, in which rules were investigated one by one.
One can therefore say that the contemporary paradigm of social choice theory started from
this theorem.

The practical consequences of the theorem are debatable: Arrow has said "Most systems
are not going to work badly all of the time. All I proved is that all can work badly at times.

5.7 Summary:

Market failure occurs when the price mechanism fails to account for all of the costs and
benefits necessary to provide and consume a good. The market will fail by not supplying
the socially optimal amount of the good.

Prior to market failure, the supply and demand within the market do not produce quantities
of the goods where the price reflects the marginal benefit of consumption. The imbalance
causes allocative inefficiency, which is the over- or under-consumption of the good.

The structure of market systems contributes to market failure. In the real world, it is not
possible for markets to be perfect due to inefficient producers, externalities, environmental
concerns, and lack of public goods. An externality is an effect on a third party which is
caused by the production or consumption of a good or service

5.7 Self-Assessment Question

1.Explain shortly Criteria of Social Welfare.
2. Describe Cardinalists Criterion and Bentham Criterion.

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3. What is Pareto Optimal Conditions explain it?
4. Briefly write Kaldor Hicks Compensation Criterion and Bergsons’ Criterion.
5. Explain Derivation of Grand Utility Possibility Frontier Imperfections.
6 Shortly describe .Externalities and Market Failures.
7 What is .Arrow’s Impossibility Theorem?

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