4501 Unit 3

Welfare Economics

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• We may wonder why governments keep on making policy changes. Students are happy with
fewer exams then why do authorities insist on more exams?
• Or do exams even do any good?
• Does education help in earning more? If the answer is not necessarily then why do we keep on
experimenting with education policy?
• Students may ask questions like; are we spending on education for the satisfaction of the
students, or for that of parents, or for employing the teachers, or for international comparisons
or for the industry and the government?
• There cannot be a straight positively measurable answer to these questions.
• OR we may ask; was it necessary to create a BRTS corridor in Ahmedabad? For whom is it good?
Private vehicle owners find it inconvenient. Commuters of long distances find it convenient.
• So was the decision of the authorities to spend crores of Rupees after the BRTS corridor worth?
• Certain answers are normative in nature.
• Welfare economics is essentially normative in nature.
• So we may further ask, what are the norms? Which norms or measures decide what welfare is?
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When GDP of a nation increases, we may say that the nation prospers. But does it
mean an increase in total welfare? What if pollution reaches deplorable levels with a
rise in GDP and human beings suffer?
Welfare economics is a branch of economics that uses microeconomic techniques to
evaluate well-being at the aggregate level. Attempting to apply the principles of
welfare economics gives rise to the field of public economics, the study of how
government might intervene to improve social welfare.
OR
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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Pareto’s Criterion:

• Pareto explains welfare in terms of an optimal situation.

• If we are in a given state of affairs/economy and if we make any
changes in this affair and it is not possible to make anyone better off
without making anyone worse off then the given state is an optimum
state. This means there is no reason to move from the given state and
if we move then we cannot make some people better off without
making anyone worse off.
• An economy is said to be in a Pareto optimum state when no
economic changes can make one individual better off without making
at least one other individual worse off. This is also called the
Pareto efficiency.
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• The Pareto Optimal Solution refers to a solution, around which there is
no way of improving any objective without degrading at least one other
objective.

• This means that a decision or resource allocation is in such an optimal

state of allocation that any deviation from this point will not improve any
one objective or preference without making at least one objective or one
person’s preference worse off.
• Thus Pareto efficiency implies that resources are allocated in the
most economically efficient manner, but does not imply equality or
fairness
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• E.g., Governments of all countries of the world and WHO came to a
common decision to lock down during COVID-19.
• This decision was not fair but it was Pareto optimal under the given
circumstances.
• Any deviation from this decision would not have made anyone better
off without increasing the number of cases (A deviation from lock
down would improve the condition of workers as they would get their
daily wages. But while the workers would be better off many other
people would contract the disease and some would even die.)

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Pigou’s Welfare Criterion

• Pigou gave dual criteria for welfare.

1) Welfare can be increased if the national output/national income
increases.
• National output can increase when factors of production are allocated
more efficiently-their productivity improves.
• National income can also improve when production in some sectors
increases without diminishing production in other essential sectors.
(Production of some unessential goods may be phased out though.
This does not mean that this particular sector’s production has gone
down. New goods may be produced by discarding obsolete goods).

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2) Welfare can be increased if the given NI is redistributed in such a way
that the share of poor people increases by transfers from rich to the
poor. Marginal utility of money for rich is lesser. So if rich lose some
money, they don’t lose much marginal utility. (Or for the rich loss of
marginal utility might be nil) But, when the same amount of money is
transferred to the poor, their welfare improves. The marginal utility of
money for them is much higher.

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Kaldor-Hicks Criterion

• The Kaldor-Hicks methods are usually used as tests of the Pareto criterion rather than seeking
efficiency goals themselves. They’re used to verify whether or not an activity is moving the
economy towards the Pareto criterion. Any change in the current situation typically makes some
individuals better off at the same time making others worse off, therefore these tests ask what
would happen if the gainer were to compensate the losers. (Suppose, when we move from
situation A to situation B, the gainers gain Rs. 7,000 and the losers lose Rs. 2,000. Now, if the
gainers fully transfer Rs. 2,000 to the losers and yet save Rs. 5,000 as additional gains for
themselves, what is wrong in moving from state A to state B?
• The Kaldor - Hicks criterion considers this movement from state A to state B as a welfare
movement as the economy is only moving towards higher total gains.
• According to Kaldor- Hicks welfare criterion, a change in policy or economic organization will make
some individuals better off and others individuals worse off. But if the gainers were to
compensate the losers and still save some gains for themselves then the total welfare has
increased. Therefore the new state is better than the previous state. (This compensation can be
theoretical and not necessarily real)

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• Pareto mentioned that if we alter the current optimum state then we
cannot make someone better off without making anyone worse off.
• Kaldor- Hicks extend Pareto’s criterion to test that if some are made better
off and some are made worse off but if the gainers compensate the losers
and still save some gains then the new condition achieves better welfare.
• If we decide to reduce some subsidies on college education and transfer the
amount to make a SEZ, how do we decide whether this decision will
improve or reduce welfare?
• Reduction in subsidies on college education will have some loss for the poor
students only. Now with the creation of SEZ the industrial sector gains so
much profit that these gainers can give freeships and scholarships to the
poor students and fully compensate them. And yet the traders in the SEZs
have ample of profits for themselves. Such a decision definitely is a welfare
decision.
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Scitovsky’s welfare criterion

• Scitovsky double tests the Kaldor-Hicks criterion.

• He said that suppose we move from state A to state B by taking a
decision and state B satisfies the Kaldor-Hicks criterion. But what if
the losers do not mind going back to condition A? They are indifferent
between condition A and B. Or the losers prefer situation A (even if
they are fully compensated for their loses in situation B) and so they
fight / bribe the gainers to go back to condition A. In such a situation,
the Kaldor-Hicks criterion may not necessarily prove that a movement
from state A to state B is a movement towards greater welfare.
• This means situation B is considered superior to situation A in the
Scitovsky condition if and only if neither party wants to move back to
situation A.
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• So, the initial test is that moving from A to B fulfils Kaldor-Hicks criterion.
• The reversal is that the losers fight/bribe to go back to situation A. (Sometimes
in some typical situations even the gainers may want to go back to state A)
• Scitovsky welfare criterion says that the reversal must not be fulfilled. So losers
(neither party) should not wish to go back to A.
• The Kaldor-Hicks criteria are met if in an economic change, “gainers can over-
compensate the losers.
• “The reversal test is satisfied” if losers are able to bribe the gainers to stay in
the old position”.
• The Scitovsky double test is satisfied “By the fulfillment of the Kaldor-Hicks
test plus the non-fulfillment of the reversal test”.
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Bergson-Samuelson social welfare function
• This criterion considers welfare for a given set of individual
preferences or welfare rankings. (like we give rankings in IC analysis)
The object was "to state in precise form the value judgments required
for the derivation of the conditions of maximum economic welfare"
set out by earlier writers,
including Marshall and Pigou, Pareto and Barone, and Lerner.
• A. Bergson in his article ‘A Re­formulation of Certain Aspects of
Welfare Economics’ in 1938. Prior to its various concepts of social
welfare had been given by different welfare theorists but they failed
to provide a satisfactory solu­tion to the problem of maximization of
social welfare and measurement.

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purpose. These notes may contain material compiled from
• The equation here shows two
bundles as X and Y and the utility
functions of individuals a, b, and
c is given.

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 • Assume that there are two individuals A
and B in the society
• Each curve in the figure here is the locus
of combinations of utilities of A and B
which yield the same level of social
welfare. The further to the right a social
indifference contour is, the higher the
level of social welfare will be. With such
a set of social indifference contours
alternative states in the economy can be
unambiguously evaluated.
• For example a change which would
move the society from point b to point c
(or d) increases the social welfare. A
change moving the society from a to b
leaves the level of social welfare
unaltered.
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Social – welfare utility map compared with the IC map

• The Bergson-Samuelson welfare model looks like the map of indifference

curve and the equilibrium with the price line.
• The respective hypothetical utilities of the two persons in a two-dimensional
utility space is analogous to the respective quantities of the two commodities
for the two-dimensional commodity space of the indifference-curve surface
• The Welfare function is analogous to the indifference-curve map
• The Possibility function is analogous to the budget constraint
• Two-person welfare maximization point is at the tangency of the highest
possible Welfare function curve with the Possibility function and this is
analogous to tangency of the highest possible indifference curve with the
budget constraint in the IC analysis.
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• Necessary general conditions are that at
the maximum value of the function:
1) The marginal “Rupee's worth" of
welfare is equal for each individual and
for each commodity
2) The marginal "dis-welfare" of each
“Rupee worth" of labor is equal for each
commodity produced of each labor
supplier
3) The marginal “Rupee" cost of each unit
of resources is equal to the marginal
value productivity for each commodity.

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• Samuelson further sharpened the social welfare function by
introducing the Possibility function.
• Combining the welfare function and the grand possibility function, the
THE 'POINT OF BLISS‘ is derived where the welfare function is tangent
to the grand utility function.

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DETERMINATION OF THE WELFARE-MAXIMISING STATE:
• In figure the grand utility possibility
frontier is combined with the social
welfare function shown by the set of
social indifference contours. Social
welfare is maximised at the point of
tangency of the 'envelope' utility
possibility frontier with the highest
possible social indifference contour.
This point is called 'the point of bliss'.
It is denoted by w• in figure. The
maximum social welfare attainable in
our example is the level implied by
the indifference contour W3 . The
two consumers will enjoy the levels
of utility U• A and U • B.
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Extra understanding:
How is the grand
possibility frontier
derived?
In this figure consider ‘ps’ as the relative
prices if the two goods for which the
individual ICs are drawn.
The line that connects the tangency points of
the utility curves of individuals A and B is
called the utility possibility frontier or the
contract curve.
It is called the contract curve as it shows that
individuals A and B seek their own welfare
and in the process there is a bargaining
(invisible market kind of situation) which
creates a tangency of their respective ICs.
The tangency shows that they are in
equilibrium settlement at that point.

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Extra reading
• The problem with the social welfare function is that there is no easy method
of constructing it. Its existence is axiomatically assumed in welfare
economics. Somebody in the economy must undertake the task of
comparing the various individuals or groups and rank them according to
what he thinks their worthiness is. A democratically elected government
could be assumed to make such value judgements which would be
acceptable by the society as a whole. This is implicitly or explicitly assumed
when use is made of the apparatus of the social welfare function. It should
be noted that the social welfare function cannot be used to derive social (or
community) indifference curves in output space (analogous to the
indifference curves of a single individual) without taking into account the
distribution of income among the various individuals in the economy.
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Extra Slide : Only for extra reading
• The utilitarian’s were the first to talk of welfare in terms of the formula, ‘the greatest happiness of the greatest number’-
Bentham.
• Neo-Classical welfare theorists dis­cussed the problem of social welfare on the basis of cardinal measurability of utility and
interper­sonal comparison of utility. Analysis of Pareto optimality maximises social welfare by satisfying various marginal
conditions of production, distribution and allocation of resources among products. But unfortunately they are not fulfilled
due to the existence of various externalities and imperfec­tions in the market. Moreover, Pareto optimality analysis fails to
measure the changes in welfare resulting from any change which benefits one section of society and harms the other.
• Compensation principle as given by Kaldor-Hicks-Scitovsky attempts to measure the changes in social welfare resulting
from such economic changes which harm some and benefit others through hypothetical compensating payments.
• Compensation theorists claimed to give a value-free objective criterion based on ordinal concept of utility but, this is
based upon implicit value judgements and does not evaluate changes in social welfare satisfactorily.
• By providing the concept of social welfare function Bergson and Samuelson have attempted to provide a new approach to
welfare economics and have succeeded in rehabilitating welfare econom­ics. They have put forward the concept of social
welfare function that considers only the ordinal preferences of individuals.
• They agree to Robbins’ view that interpersonal comparison of utility involves value judgements but they assert that
without making some value judgements, economists cannot evaluate the impact of changes in economic policy on social
welfare.
• Thus, according to them, welfare economics cannot be separated from value judgements. According to them, welfare
economics is essentially a normative study. But the approach to study it must be scientific despite the fact that the use of
value judgements in it is unavoidable.

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