Welfare economics

 Welfare is, the level of well-being of a group.

It is sometimes thought of as the aggregate
of utility (individual well-being).
Welfare Economics
 Welfare economics is concerned with how well an economy operates in
terms of efficiency and equity/social justice
 Efficiency - allocation of resources
 Equity - distribution of income.
 Welfare economics focuses on using resources optimally to achieve the
maximum well-being for the individuals in society. But, unfortunately,
agreement cannot always be reached on what is optimal.
 Economic efficiency has to do with producing and facilitating as much
consumption as possible with available resources, whereas equity has to do
with how equitably goods are distributed among individuals. Some
questions: Do competitive markets lead to the most preferable state of
society? What are the distributional effects of imperfect competition and
monopoly power? How can the effects of monopoly power be measured?
 These are some of the fundamental questions of efficiency and equity that
can be addressed with welfare economics
 Given an initial distribution of income and
resources, one can possibly improve market
efficiency and make society better off.
 However, a system may be very efficient but
not very equitable in how the output is
distributed.
Pareto Efficiency
Definition:
 This is optimal outcome in society under which it is impossible to
make one person better off without making another person worse
off.
 An efficient economy is one that has exhausted all means of mutual
gains (trade).
 Therefore, Pareto Efficiency indicates that resources can no longer
be allocated in a way that makes a party better off without harming
other parties. In Pareto Efficiency, resources are allocated in the
most efficient way possible.
 Pareto Improvement: A resource allocation is Pareto improved if
there exists another allocation in which one person is better off, and
no person is worse off.
 As an example, suppose a new technology is introduced that causes
lower food prices and, at the same time, does not harm anyone by
(for example) causing unemployment or reduced profits. The
introduction of such a technology would be a Pareto improvement
Three Conditions/types of Efficiency

 Exchange (Consumption) Efficiency

 “maximum” utility
 Input (Production) Efficiency
 “maximum” output
 Product-Mix (Substitution) Efficiency
 optimum mix of commodities
Exchange (Consumption) Efficiency

 An allocation of commodities is consumption

efficient if the only way to make one person
better off is to make another person worse
off.
 The MRS between each pair of goods must
be equal for all consumers.
Exchange Efficiency Condition
 The MRS between the two goods must be
equal for all people

MRS A
M ,F  MRS B
M ,F

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Input (Production) Efficiency

 An allocation of inputs is production efficient if

the only way to increase the output of one
commodity is to decrease the output of
another commodity
Production Efficiency Condition
 The MRTS between capital and labor must
be equal for all commodities

MRTS Medicine
K ,L  MRTS Food
K ,L

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Marginal Rate of Transformation
 The MRT is the rate at which the economy
can transform one output into another by
shifting its resources
 If it equals 2, to have one additional unit of
medicine, we need to give up two units of food

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Substitution (Allocation) Efficiency

 A mix of commodities is allocation efficient if the

MRT between any two goods is equal to
consumers‟ common MRS between the two
commodities. (the ratio in which goods are being
produced is the same as people want to consume).

MRT M ,F  MRS Amber , Brent

M ,F
First Fundamental Theorem
of Welfare Economics
 This theorem says:
That any competitive equilibrium is Pareto
efficient.
 ,so as long as we have a competitive market,
markets left all to themselves will be efficient –
Pareto efficient. The famous “invisible hand
solution”.
Second Fundamental Theorem
of Welfare Economics
 Theorem states that given an appropriate endowment/initial condition, any
Pareto efficient outcome can in be achieved.
 This means, that for any given endowment, we can redistribute the
endowment to get to the efficient outcome we want.
 Income transfers are a superior way to redistribute because it doesn„t
change prices.
 Some policy makers hesitate to make large-scale income
redistribution because of incentives.
 Transferring wealth away for one group may provide a disincentive
to work, and giving money to another group may provide a
disincentive to work.
 Assumes we are only excited by money