Wednesday, January 25, 2012

What is Economic Welfare?

1) Definition of Economic Welfare
Economic welfare is a general concept which doesn't lend to easy definition. Some says it is a branch of economics that focuses on the optimal allocation of resources and goods and how this affects social welfare. 
Basically, this relates to the study of income distribution and how it affects the common good.  
Economic welfare is also considered as the level of prosperity and quality of living standards in an economy by focusing on the optimal allocation of resources and goods and how this affects social welfare. It is based on that economy can be measured through a variety of factors such as GDP and other indicators which reflect welfare of the population such as literacy, number of doctors, levels of pollution, etc but it is usually measured in terms of Real Income, real GDP. An increase in Real Output and real incomes suggests people are better off and therefore there is an increase in economic welfare. 
However, economic welfare will be concerned with more than just levels of income. 
For example, people's living standards are also influenced by factors such as levels of congestion and pollution. These quality of life factors are important in determining economic welfare.

2) Two Approaches: The early Neoclassical approach, The New Welfare Economics approach 
There are two mainstream approaches to welfare economics: the early Neoclassical approach and the New welfare economics approach.  

   2-1) The early Neoclassical approach (the first approach)
‘The greatest meliorator of the world is selfish, huckstering trade.’(R.W. Emerson, Work and Days)
To establish the first approach, we need to sketch a general equilibrium model of an economy. 
Assume all individuals and firms in the economy are price takers: none is big enough, or motivated enough, to act like a monopolist. Assume each individual chooses his consumption bundle to maximize his utility subject to his budget constraint. Assume each firm chooses its production vector, or input–output vector, to maximize its profits subject to some production constraint. Note that we assume self-interest, or the absence of externalities: An individual cares only about his own utility, which depends only on his own consumption. A firm cares only about its own profits, which depend only on its own production vector. 
The invisible hand of competition acts through prices; they contain the information about desire and scarcity that coordinate actions of self-interested agents. In the general equilibrium model, prices adjust to bring about equilibrium in the market for each and every good. That is, prices adjust until supply equals demand. When that has occurred, and all individuals and firms are maximizing utilities and profits, respectively, we have a competitive equilibrium. 
The first approach establishes that a competitive equilibrium is for the common good. But how is the common good defined? The traditional definition looks to a measure of total value of goods and services produced in the economy. In Smith, the ‘annual revenue of the society’ is maximized. In Pigou (1920), following Smith, the ‘free play of self-interest’ leads to the greatest ‘national dividend’. The modern interpretation of ‘common good’ typically involves Pareto optimality, rather than maximized gross national product. 
This approach says that all perfectly competitive equilibria with complete markets to deal with externalities and uncertainty are Pareto efficient*. 

   2-2) The New Welfare Economics approach(the second approach)
The New Welfare Economics approach is based on the work of Pareto, Hicks, and Kaldor. It explicitly recognizes the differences between the efficiency aspect of the discipline and the distribution aspect and treats them differently. Questions of efficiency are assessed with criteria such as Pareto efficiency and the Kaldor-Hicks compensation tests, while questions of income distribution are covered in social welfare function specification. Further, efficiency dispenses with cardinal measures of utility, replacing it with ordinal utility, which merely ranks commodity bundles (with an indifference-curve map, for example). 
The second approach establishes that the market mechanism, modified by the addition of lump-sum transfers, can achieve virtually any desired optimal distribution. Under more stringent conditions than are necessary for the first approach, including assumptions regarding quasi-concavity of utility functions and convexity of production possibility sets, the second approach gives the following:

The second approach of Welfare Economics. Assumes that all individuals and producers are self-interested price takers. Then almost any Pareto optimal equilibrium can be achieved via the competitive mechanism, provided appropriate lump-sum taxes and transfers are imposed on individuals and firms.

Allan M. Feldman, Welfare Economics 2006,,,,

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