CHAPTER SIX

Fundamental Theories and Theorems

of Welfare Economics
Definition and Main Concepts of Welfare Economics
 Welfare economics refers to the allocation of
goods and resources for promoting social
welfare.
 It deals with an economically efficient
distribution of resources for the well being of the
people.
 Welfare economists seek to guide the public
policy such that the distribution is economically
and socially beneficial for all sections of the
society.
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 Meaning of Welfare Economics
The aim of welfare economics is the overall well-
being of society.

Welfare economics involves an evaluation of the

economic policies, guiding the public policies for
the greater good of society.

The study of welfare economics uses the tools of

cost-benefit analysis and social welfare functions.
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 Meaning of Economic Welfare cont’ned……
 The level of prosperity and quality of living standards in
an economy.
 Economic welfare can be measured through a variety of
factors such as GDP and other indicators which reflect the
welfare of the population (such as literacy, number of
doctors, levels of pollution, number of teachers, etc.)
Basically, it refers to how well people are doing.
 Economic welfare is usually measured in terms of real
income/real GDP.

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 Positive vs Normative Economics

 Positive economic and normative economic are two

standard branches of modern economics.

 Positive economics is objective and fact-based where the

statements are precise, descriptive, and clearly
measurable.

 Positive economics can be measured against tangible

evidence or historical instances.
 Positive economics can be approve/disproof
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 Positive vs Normative Economics cont…..
Normative economics is prospective on
economics that reflects normative or ideologically
prescriptive judgments toward economic
development investment projects ,statements, and
scenarios.
Normative economics expresses ideological
judgments about what may result in economic
activity if public policy change are made.
Public policy is based on a combination of both
positive and normative economics.
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 Positive vs Normative economics
Positive vs Normative Economics
Positive
 Statements can be tested using
scientific methods
 Explain various economics
phenomena
 Focus on description quantification
and Explanation of economics
It is relevant and fact
It is tangible and positive
economics
Investigation on positive economic
Normative
Statements cannot be tested
Judgment and ideological
perspective
 Public policy changed and
made
Behavioral economics
It is prescribe solution
economics

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 Compensating and Equivalent Variations
Compensating Variation
 It is the adjustment in income that returns the consumer to
the original utility after an economic change has occurred.
 In the case of a positive economic change (such as a fall
in price of a good), CV is often referred to as the
maximum a consumer is willing to pay in order to have
the economic change happen.
 When there is a negative economic change, CV is the
minimum the consumer needs in order to accept the
economic change.
 CV: Original Utility and new prices

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 Equivalent Variation (EV)
 It is the adjustment in income that changes the consumer’s utility
equal to the level that would occur if the event had happened.

 In the case of a positive economic change, such as a fall in price,

EV would be the increase in income that would give the consumer
the same additional utility that would happen if a price did fall.

 In the case of a negative economic change, EV would be the

amount of income that would be taken away to lower the
consumer’s utility to the level that would happen if the change had
occurred.

 CV: deals with Original Utility and new prices

 EV: deals with Final Utility and old prices

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 The Concepts of efficiency and Equity

 Efficiency describes a situation where a certain level of

utility is reached by maximizing resources in the least
expensive way possible.

 Efficiency means that all goods or services are allocated to

someone (there’s none left over).

 In essence, efficiency indicates how well an organization

uses its resources to produce goods and services.

 Thus, it focuses on resources (inputs), goods and services

(outputs), and the rate (productivity) at which inputs are
used to produce or deliver the outputs.

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 The Concepts of efficiency and Equity Cont’ed….
 Equity concerns the distribution of resources and is
inevitably linked with concepts of fairness and social
justice

 Equity, or economic equality, is the concept or idea of

fairness in economics, particularly in regard to taxation or
welfare economics.

 Efficiency means that society is getting the maximum

benefits from its scarce resources.

 Equality means that those benefits are distributed

uniformly among society's members

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 Pareto principle
 Vilfredo Federico Pareto was born in Italy in 1848.
 The generalization became: 80% of results will come
from just 20% of the action.
Pareto’s 80/20 rule
This “universal truth” about the imbalance of inputs and
outputs is what became known as the Pareto principle, or
the 80/20 rule.

 This imbalance is often seen in various business cases:

 20% of the sales agents generate 80% of total sales.

 20% of customers account for 80% of total profits.

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 Advantages of the Pareto Principle
 It can give you a window into who to reward or what to fix.
 The Principle helps you realize that the majority of results come from a minority
of inputs
 If 20% of workers contribute 80% of results: Focus on rewarding these
employees.

Disadvantages of the Pareto Principle

 While the 80/20 split is true for Pareto's observation, that doesn't necessarily
mean that it is always true.

For instance,
 30% of the workforce (or 30 out of 100 workers) may only complete 60% of the
output.

 The remaining workers may not be as productive or may just be slowing off on
the job.

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 Pareto optimality
 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.

 Optimality is the result of rational economic behavior on the part

of producers, consumers and owners of factors of production in a
perfectly competitive economy.

 Pareto Optimality examined more formally in terms of

three(exchange efficiency, production efficiency and output
efficiency) criteria that have to be met for a market equilibrium.

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 Fundamental theorems of welfare economics
There are two basic Theorems in Welfare Economics
The first welfare economics fundamental theorem stated that,
Theorem stating that no further exchange would make
one person better off without making another worse
off
Any competitive equilibrium in a market must be
Pareto optimal
Markets are a basic tool for the allocation of goods in
a society.
 Competitive markets and competitive equilibrium
result in Pareto efficiency.
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 The second welfare economics fundamental theorem
 It states that any Pareto optimum can be supported as a
competitive equilibrium.
 This theorem is significant because it permits efficiency and
distribution concerns to be separated.
 Society can attain any Pareto Efficient outcome with removal
of initial legacies and free trade
 This means, that for any given grant, we can redistribute the
grant to get to the efficient outcome we want equals to
subsidize certain services
 It should be highlighted that a Pareto efficient distribution
occurs when someone has all of the goods and the rest of the
population has none.
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Compensating Variation and Equivalent Variation
COMPENSATING VARIATION (CV): The
minimum amount of money a consumer must be
compensated after a price increase to maintain the
original utility.
The consumer’s ORIGINAL Utility is important.
EQUIVALENT VARIATION (EV): The change
in money to give a equivalent utility to a price
change.
The consumer’s FINAL Utility is important.
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 THE END!

January 20, 2023

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