Prerequisites

Prerequisites

Almost
Almostessential
essential
Welfare: Basics
Welfare: Basics
Welfare:
Welfare:Efficiency
Efficiency

WELFARE: THE SOCIAL-

WELFARE FUNCTION
MICROECONOMICS
Principles and Analysis
Frank Cowell

July 2015 Frank Cowell: Welfare - Social Welfare function 1

 Social Welfare Function
Limitations of the welfare analysis so far:
Constitution approach
Arrow theorem is the approach overambitious?
General welfare criteria
efficiency nice but indecisive
extensions contradictory?
SWF is our third attempt
Something like a simple utility function?

Requirements
Requirements

July 2015 Frank Cowell: Welfare - Social Welfare function 2

 Overview
Welfare: SWF

The Approach

What is special about

a social-welfare SWF: basics
function?

SWF: national
income

SWF: income
distribution
July 2015 Frank Cowell: Welfare - Social Welfare function 3
 The SWF approach
Restriction of relevant aspects of social state to each person
(household)
Knowledge of preferences of each person (household)
Comparability of individual utilities
utility levels
utility scales
An aggregation function W for utilities
contrast with constitution approach
there we were trying to aggregate orderings

AAsketch
sketchofofthe
the
approach
approach

July 2015 Frank Cowell: Welfare - Social Welfare function 4

 Using a SWF
b
Take the utility-possibility set
Social welfare contours
A social-welfare optimum?
W(a,,b,...
W( ,... ))
a b

W defined on utility levels

Not on orderings

Imposes several restrictions

..and raises several questions

July 2015 Frank Cowell: Welfare - Social Welfare function 5

 Issues in SWF analysis
What is the ethical basis of the SWF?
What should be its characteristics?
What is its relation to utility?
What is its relation to income?

July 2015 Frank Cowell: Welfare - Social Welfare function 6

 Overview
Welfare: SWF

The Approach

Where does the

social-welfare SWF: basics
function come from?

SWF: national
income

SWF: income
distribution
July 2015 Frank Cowell: Welfare - Social Welfare function 7
 An individualistic SWF
The standard form expressed thus
W(1, 2, 3, ...)
an ordinal function
defined on space of individual utility levels
not on profiles of orderings
But where does W come from...?
We'll check out two approaches:
The equal-ignorance assumption
The PLUM principle

July 2015 Frank Cowell: Welfare - Social Welfare function 8

 1: The equal ignorance approach
Suppose the SWF is based on individual preferences.
Preferences are expressed behind a veil of ignorance
It works like a choice amongst lotteries
don't confuse and !
Each individual has partial knowledge:
knows the distribution of allocations in the population
knows the utility implications of the allocations
knows the alternatives in the Great Lottery of Life
does not know which lottery ticket he/she will receive

July 2015 Frank Cowell: Welfare - Social Welfare function 9

 Equal ignorance: formalisation
payoffs
payoffs ifif assigned
assigned
identity
identity 1,2,3,...
1,2,3,... in
in
Individualistic welfare:
the
the Lottery
Lottery of of Life
Life usetheoryofchoiceunder
uncertaintytofindshapeofW
W(1,2, 3,...)
vN-M form of utility function:
probabilityassignedto
u(x)
u : cardinalutilityfunction,
Equivalently:
independentof
utilitypayoffinstate
Replace by set of identities
{1,2,...nh}: welfareisexpectedutility
froma"lotteryonidentity
h hh
A suitable assumption about
probabilities? Anadditiveformofthe
1
nh welfarefunction
W= nh=1
h
h

July 2015 Frank Cowell: Welfare - Social Welfare function 10

 Questions about equal ignorance
Construct a lottery on identity
The equal ignorance assumption...
Where people know their identity with
certainty
h Intermediate case

The equal ignorance

assumption: h = 1/nh
But is this appropriate?

Or should we assume that

| | | | | people know their identities
1 2 3 identity h nh with certainty?

Or is the "truth" somewhere

between...?

July 2015 Frank Cowell: Welfare - Social Welfare function 11

 2: The PLUM principle
Now for the second rather cynical approach
Acronym stands for People Like Us Matter
Whoever is in power may impute:
...either their own views,
... or what they think societys views are,
... or what they think societys views ought to be,
...probably based on the views of those in power
Theres a whole branch of modern microeconomics that is a
reinvention of classical Political Economy
Concerned with the interaction of political decision-making and
economic outcomes.
But beyond the scope of this course

July 2015 Frank Cowell: Welfare - Social Welfare function 12

 Overview
Welfare: SWF

The Approach

Conditions for a welfare

maximum SWF: basics

SWF: national
income

SWF: income
distribution
July 2015 Frank Cowell: Welfare - Social Welfare function 13
 The SWF maximum problem
Take the individualistic welfare model Standard
W(1, 2, 3, ...) assumption

Assume everyone is selfish: myutilitydepends

h = Uh(xh) , h = 1,2, ..., nh onlyonmybundle

Substitute in the above: GivesSWFinterms

W(U1(x1), U2(x2), U3(x3), ...) oftheallocation

aaquick
quicksketch
sketch

July 2015 Frank Cowell: Welfare - Social Welfare function 14

 From an allocation to social welfare

(x
(x11aa,, xx22aa)) From the attainable set...
(x
(x11bb,, xx22bb)) ...take an allocation
Evaluate utility for each agent

A A Plug into W to get social welfare

aa=U
=Uaa(x
(x11aa,, xx22aa))
bb=U
=Ubb(x
(x11bb,, xx22bb))
But what happens to
welfare if we vary the
allocation in A?
W(aa,, bb))
W(

July 2015 Frank Cowell: Welfare - Social Welfare function 15

 Varying the allocation
Differentiate w.r.t. xih :
Theeffectonhif
dh = Uih(xh) dxih commodityi ischanged
marginal
marginalutility
utilityderived
derived
Sum over i: by h from good
by h from good ii
n Theeffectonhifall
dh = Uih(xh) dxih commoditiesarechanged
i=1

Differentiate W with respect to h: Changesinutilitychange

nh socialwelfare.
dW = Wh dhmarginal
marginalimpact
impacton
onsocial
social
h=1 welfare
welfareofofhs
hsutility
utility

Substitute nfor dn h in the above: Sochangesinallocation

h
changewelfare.
dW = Wh Uih(xh) dxih
Weights from
Weights from h=1 i=1 utility function
the SWF
July 2015 Frank Cowell: Welfare - Social Welfare function 16
 Use this to characterise a welfare optimum
Write down SWF, defined on individual utilities
Introduce feasibility constraints on overall consumptions
Set up the Lagrangian
Solve in the usual way

Now
Nowfor
forthe
the
maths
maths

July 2015 Frank Cowell: Welfare - Social Welfare function 17

 The SWF maximum problem
First component of the problem: Theobjectivefunction
W(U1(x1), U2(x2), U3(x3), ...)
Individualistic Utility
Utility depends
depends on
on
Individualistic welfare
welfare
own
own consumption
consumption
Second component of the problem:
n Feasibilityconstraint
(x) 0, xi = xih h

h=1
All
All goods
goods are
are
private
private
The Social-welfare Lagrangian: nh
Constraintsubsumes
W(U1(x1), U2(x2),...) - ( x ) h=1
h technologicalfeasibilityand
materialsbalance
FOCs for an interior maximum: Fromdifferentiating
Wh (...) Uih(xh) i(x) = 0 Lagrangeanwithrespecttoxih

And if xih = 0 at the optimum: Usualmodificationfora

cornersolution
Wh (...) Uih(xh) i(x) 0
July 2015 Frank Cowell: Welfare - Social Welfare function 18
 Solution to SWF maximum problem
Any
Anypair
pairofofgoods,
goods,i,ji,j
Any
Anypair
pairofofhouseholds
householdsh,h,
From FOCs:
MRSequatedacrossallh
Uih(xh) Ui(x)
= Wevemetthiscondition
Ujh(xh) Uj(x) before-Paretoefficiency
Also from the FOCs: socialmarginalutilityof
toothpasteequatedacrossallh
Wh Uih(xh) = W Ui(x)

Relate marginal utility to prices:

Thisisvalidifallconsumers
U (x ) = Vy pi
i
h h h
optimise
Marginal
Marginalutility
utilityofofmoney
money
Substituting into the above: Atoptimumthewelfarevalueof
Wh Vyh = W Vy $1isequatedacrossallh. Call
Social
Socialmarginal
marginal thiscommonvalueM
utility
utility ofincome
of income

July 2015 Frank Cowell: Welfare - Social Welfare function 19

 To focus on main result...
Look what happens in neighbourhood of optimum
Assume that everyone is acting as a maximiser
firms
households
Check what happens to the optimum if we alter incomes or
prices a little
Similar to looking at comparative statics for a single agent

July 2015 Frank Cowell: Welfare - Social Welfare function 20

 Changes in income, social welfare
Social welfare can be expressed as:
W(U1(x1), U2(x2),...) SWFintermsofdirectutility.
Usingindirectutilityfunction
= W(V1(p,y1), V2(p,y2),...)
Differentiate the SWF w.r.t. {yh}: Changesinutilityandchange
nh socialwelfare
nh
dW = Wh d = W V h dyh h
h=1 h y
h=1
nh
...relatedtoincome
dW = Mdy h
change
change in
in national
national income
income
h=1
Differentiate the SWF w.r.t. pi : Changesinutilityandchange
nh nh socialwelfare
dW = WhVihdpi = WhVyh xihdpi
from
from Roys
Roys
h=1 h=1 identity
identity
nh
Change
Change in
in total
total
dW = M xi dpi h expenditure
expenditure ...relatedtoprices
.
.

July 2015 h=1 Frank Cowell: Welfare - Social Welfare function 21

 An attractive result?
Summarising the results of the previous slide we
have:

THEOREM: in the neighbourhood of a welfare

optimum welfare changes are measured by changes
in national income / national expenditure

But what if we are not in an ideal world?

July 2015 Frank Cowell: Welfare - Social Welfare function 22

 Overview
Welfare: SWF

The Approach

A lesson from risk

and uncertainty SWF: basics

SWF: national
income

SWF: income
distribution
July 2015 Frank Cowell: Welfare - Social Welfare function 23
 Derive a SWF in terms of incomes
What happens if the distribution of income is not ideal?
M is no longer equal for all h
Useful to express social welfare in terms of incomes
Do this by using indirect utility function V
Express utility in terms of prices p and income y
Assume prices p are given
Equivalise (i.e. rescale) each income y
allow for differences in peoples needs
allow for differences in household size
Then you can write welfare as
W(ya, yb, yc, )

July 2015 Frank Cowell: Welfare - Social Welfare function 24

 Income-distribution space: nh=2

The income space: 2 persons

income
Bill's

y An income distribution
alit
u
t eq
c
rfe
f pe
o Note the similarity with a
n e
li diagram used in the analysis
of uncertainty

45
O Alf's Alf's
income income

July 2015 Frank Cowell: Welfare - Social Welfare function 25

 Extension to nh=3
income
Charlie's
Here we have 3 persons
An income distribution.

fe ct
per e
e of y in com
lin ualit Bil l's
eq

Alf's inco
me

July 2015 Frank Cowell: Welfare - Social Welfare function 26

 Welfare contours
An arbitrary income distribution
yb Contours of W
Swap identities
Distributions with the same mean
Equally-distributed-equivalent income
equivalent
equivalent in
in
welfare
welfare terms
terms
Anonymity implies symmetry of W

E y is mean income

E Richer-to-poorer income
higher
higher transfers increase welfare
y welfare
welfare
is income that, if received
y uniformly by all, would yield same
level of social welfare as y
E y is income that society would
ya give up to eliminate inequality
Ey
July 2015 Frank Cowell: Welfare - Social Welfare function 27
 A result on inequality aversion
Principle of Transfers : a mean-preserving redistribution from
richer to poorer should increase social welfare

THEOREM: Quasi-concavity of W implies that social welfare

respects the Transfer Principle

July 2015 Frank Cowell: Welfare - Social Welfare function 28

 Special form of the SWF
It can make sense to write W in the additive form
nh
1
W= yh
nh h=1

where the function is the social evaluation function

(the 1/nh term is unnecessary arbitrary normalisation)
Counterpart of u-function in choice under uncertainty
Can be expressed equivalently as an expectation:
W = E yh
where the expectation is over all identities
probability of identity h is the same, 1/nh , for all h
Constant relative-inequality aversion:
1
y =
1
y 1

where is the index of inequality aversion

works just like ,the index of relative risk aversion

July 2015 Frank Cowell: Welfare - Social Welfare function 29

 Concavity and inequality aversion

W The social evaluation function

Let values change: is a concave
transformation.

lower
lower inequality
inequality (y)
aversion
aversion
More concave ()implies higher
(y) inequality aversion

...and lower equally-distributed-

higher
= () equivalent income
higher inequality
inequality
aversion
aversion
and more sharply curved contours

y
income

July 2015 Frank Cowell: Welfare - Social Welfare function 30

 Social views: inequality aversion
yb yb Indifference to inequality
Mild inequality aversion

Strong inequality aversion
Priority to poorest

Benthamite case (= 0):

O ya O ya nh

W= yh
y b
y b

h=1 ():
General case

nh

W = [yh]1-/ [1-i]
h=1
Rawlsian case():
O ya
O ya

W = min yh
h
July 2015 Frank Cowell: Welfare - Social Welfare function 31
 Inequality, welfare, risk and uncertainty
There is a similarity of form between
personal judgments under uncertainty
social judgments about income distributions.
Likewise a logical link between risk and inequality
This could be seen as just a curiosity
Or as an essential component of welfare economics
Uses the equal ignorance argument
In the latter case the functions u and should be taken as
identical
Optimal social state depends crucially on shape of W
In other words the shape of
Or the value of
Three
Threeexamples
examples

July 2015 Frank Cowell: Welfare - Social Welfare function 32

 Social values and welfare optimum
yb The income-possibility set Y
Welfare contours ( = 0)
Welfare contours ( = )
Welfare contours ( = )

Y derived from set A

Nonconvexity, asymmetry come
from heterogeneity of households

y* maximises total income

Y y*** irrespective of distribution

y** trades off some income for
y
**
greater equality

y* y*** gives priority to equality; then

ya maximises income subject to that

July 2015 Frank Cowell: Welfare - Social Welfare function 33

 Summary
The standard SWF is an ordering on utility levels
Analogous to an individual's ordering over lotteries
Inequality- and risk-aversion are similar concepts
In ideal conditions SWF is proxied by national income
But for realistic cases two things are crucial:
1. Information on social values
2. Determining the income frontier
Item 1 might be considered as beyond the scope of simple
microeconomics
Item 2 requires modelling of what is possible in the
underlying structure of the economy...
...which is what microeconomics is all about

July 2015 Frank Cowell: Welfare - Social Welfare function 34