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{{short description|Use of microeconomic techniques to evaluate well-being at the aggregate level}}
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'''Welfare economics''' is a field of economics that applies [[microeconomics|microeconomic]] techniques to evaluate the overall [[well-being]] (welfare) of a society. This evaluation is typically done at the economy-wide level,<ref>{{harvnb|Deardorff|2014}}</ref> and attempts to assess the distribution of resources and opportunities among members of society.

The principles of welfare economics are often used to inform [[public economics]], which focuses on the ways in which government intervention can improve [[social welfare]]. Additionally, welfare economics serves as the theoretical foundation for several instruments of public economics, such as [[cost–benefit analysis]]. The intersection of welfare economics and [[behavioral economics]] has given rise to the subfield of behavioral welfare economics.<ref name="bwe">{{harvnb|Bernheim|2008}}</ref>

Two [[fundamental theorems of welfare economics|fundamental theorems]] are associated with welfare economics. The first states that competitive markets, under certain assumptions, lead to [[Pareto efficiency|Pareto]] efficient outcomes.<ref name="ipe">{{harvnb|Hindriks|Myles|2013|pp=33–43}}</ref> This idea is sometimes referred to as Adam Smith's [[invisible hand]].<ref name="mas549"/> The second theorem states that with further restrictions, any Pareto efficient outcome can be achieved through a competitive market equilibrium,<ref name="ipe"/> provided that a social planner uses a social welfare function to choose the most equitable efficient outcome and then uses lump sum transfers followed by competitive trade to achieve it.<ref name="ipe"/><ref name="mas552">{{harvnb|Mas-Colell|Whinston|Green|1995|pp=551–572}}</ref> [[Arrow's impossibility theorem]] which is closely related [[social choice theory]], is sometimes considered a third fundamental theorem of welfare economics.<ref name="Feldman 2008">{{harvnb|Feldman|2008}}</ref>

Welfare economics typically involves the derivation or assumption of a [[social welfare function]], which can then be used to rank economically feasible allocations of resources based on the social welfare they generate. Such functions often include measures of economic efficiency and equity, as well as other measures such as [[economic freedom]] as described in the [[capability approach]].

== Approaches ==
{{Main article|Social welfare function|welfare definition of economics}}

=== Cardinal utility ===
{{see also|cardinal utility}}
The early ''[[Neoclassical economics|Neoclassical]] approach'' was developed by [[Francis Ysidro Edgeworth|Edgeworth]], [[Henry Sidgwick|Sidgwick]], [[Alfred Marshall|Marshall]], and [[Arthur Cecil Pigou|Pigou]]. It assumes the following:
* Utility is [[cardinal utility|cardinal]], that is, scale-measurable by observation or judgment.
* Preferences are exogenously given and stable.
* Additional consumption provides smaller and smaller increases in utility (diminishing [[marginal utility]]).
* All individuals have interpersonally commensurable utility functions (an assumption that Edgeworth avoided in his ''Mathematical Psychics'').
With these assumptions, it is possible to construct a [[social welfare function]] simply by summing all the individual utility functions. Note that such a measure would still be concerned with the distribution of income ([[distributive efficiency]]) but not the distribution of final utilities. In normative terms, such authors were writing in the [[Jeremy Bentham|Benthamite]] tradition.

=== Ordinal utility ===
{{see also|ordinal utility}}
The ''New Welfare Economics'' approach is based on the work of [[Vilfredo Pareto|Pareto]], [[John Hicks|Hicks]], and [[Nicholas Kaldor|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 efficiency|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|indifference-curve]] map, for example).

== Criteria ==

=== Efficiency ===
Situations are considered to have [[distributive efficiency]] when goods are distributed to the people who can gain the most utility from them.

[[Pareto efficiency]] is an efficiency goal that is standard in economics. A situation is Pareto-efficient only if no individual can be made better off without making someone else worse off. An example of an inefficient situation would be if Smith owns an apple but would prefer to consume an orange while Jones owns an orange but would be prefer to consume an apple. Both could be made better off by trading.

A pareto-efficient state of affairs can only come about if four criteria are met:
* The [[marginal rate of substitution|marginal rates of substitution]] in consumption for any two goods are identical for all consumers. We cannot reallocate goods between two consumers and make both happier.
* The [[Production possibility frontier#Marginal rate of transformation|marginal rate of transformation]] in production for any two goods is identical for all producers of those two goods. We cannot reallocate production between two producers and increase total output.
* The [[production theory basics#Total, average, and marginal product|marginal physical product]] of a factor input (e.g. labor) must be the same for all producers of a good. We cannot reduce production cost by reallocating production between two producers.
* The marginal rates of substitution in consumption equal the marginal rates of transformation in production for any pair of goods. Producers cannot make consumers happier by producing more of one good and less of the other.

There are a number of conditions that lead to inefficiency. They include:
* Imperfect market structures such as monopoly, [[monopsony]], oligopoly, [[oligopsony]], and [[monopolistic competition]].
* Factor allocation inefficiencies in [[production theory basics]].
* [[Externality|Externalities]].
* Asymmetric information, including [[principal–agent problem]]s.
* [[Long run and short run|Long run]] declining average costs in a [[natural monopoly]].
* Taxes and tariffs.
* Government restrictions on prices and quantities sold and other regulation resulting from [[government failure]].

Note that if one of these conditions leads to inefficiency, another condition might help by counteracting it. For example, if a pollution externality leads to overproduction of tires, a tax on tires might restore the efficient level of production. A condition inefficient in the "first-best" might be desirable in the [[Theory of the second best|second-best]].

To determine whether an activity is moving the economy towards Pareto efficiency, two compensation tests have been developed. Policy changes usually help some people while hurting others, so these tests ask what would happen if the winners were to compensate the losers. Using the ''Kaldor criterion'', the change is desirable if the maximum amount the winners would be willing to pay is greater than the minimum the losers would accept. Under the ''Hicks criterion'', the change is desirable if the maximum the losers would be willing to offer the winners to prevent the change is less than the minimum the winners would accept as a bribe to give up the change. The Hicks compensation test is from the losers' point of view; the Kaldor compensation test is from the winners'. If both conditions are satisfied, the proposed change will move the economy toward Pareto optimality. This idea is known as [[Kaldor–Hicks efficiency]]. If the two conditions disagree, that yields the [[Scitovsky paradox]].

===Equity===
There are many combinations of consumer utility, production mixes, and factor input combinations consistent with efficiency. In fact, there are an infinity of consumption and production equilibria that yield Pareto optimal results. There are as many optima as there are points on the aggregate [[production–possibility frontier]]. Hence, Pareto efficiency is a necessary, but not a sufficient condition for social welfare. Each Pareto optimum corresponds to a different income distribution in the economy. Some may involve great inequalities of income. So how do we decide which Pareto optimum is most desirable? This decision is made, either tacitly or overtly, when we specify the [[social welfare function]]. This function embodies value judgements about interpersonal utility. The social welfare function shows the relative importance of the individuals that comprise society.{{citation needed|date=October 2020}}

A utilitarian welfare function (also called a [[Jeremy Bentham|Bentham]]ite welfare function) sums the utility of each individual in order to obtain society's overall welfare. All people are treated the same, regardless of their initial level of utility. One extra unit of utility for a starving person is not seen to be of any greater value than an extra unit of utility for a millionaire. At the other extreme is the Max-Min, or [[John Rawls|Rawlsian]] utility function.<ref>{{cite book |last1=Stiglitz |first1=Joseph E. |title=The Great Divide |date=2015 |publisher=Penguin Books Limited |location=London |isbn=9780241202913 |pages=464}}</ref> According to the Max-Min criterion, welfare is maximized when the utility of those society members that have the least is the greatest. No economic activity will increase social welfare unless it improves the position of the society member that is the worst off. Most economists specify social welfare functions that are intermediate between these two extremes.

The social welfare function is typically translated into social [[indifference curve]]s so that they can be used in the same graphic space as the other functions that they interact with. A utilitarian social indifference curve is linear and downward sloping to the right. The Max-Min social indifference curve takes the shape of two straight lines joined so as they form a 90-degree angle. A social indifference curve drawn from an intermediate social welfare function is a curve that slopes downward to the right.

<div style="float:center;">[[Image:social indifference curves small.png]]</div>

The intermediate form of social indifference curve can be interpreted as showing that as inequality increases, a larger improvement in the utility of relatively rich individuals is needed to compensate for the loss in utility of relatively poor individuals.

A crude social welfare function can be constructed by measuring the subjective dollar value of goods and services distributed to participants in the economy (''See also'' [[Consumer surplus]], [[Consumer welfare standard]]).

== Fundamental theorems ==
{{main article|Fundamental theorems of welfare economics}}
The field of welfare economics is associated with two fundamental theorems. The first states that given certain assumptions, competitive markets (price equilibria with transfers, e.g. [[Walrasian equilibrium|Walrasian equilibria]]<ref name="mas549">{{harvnb|Mas-Colell|Whinston|Green|1995|pp=549–50}}</ref>) produce [[Pareto efficiency|Pareto efficient]] outcomes.<ref name="ipe"/> The assumptions required are generally characterised as "very weak".<ref>{{harvnb|Mas-Colell|Whinston|Green|1995|p=545}}</ref> More specifically, the existence of competitive equilibrium implies both [[price-taking]] behaviour and [[complete market]]s, but the only additional assumption is the local non-satiation of agents' [[Preference (economics)|preferences]] – that consumers would like, at the margin, to have slightly more of any given good.<ref name="mas549"/> The first fundamental theorem is said to capture the logic of Adam Smith's [[invisible hand]], though in general there is no reason to suppose that the "best" Pareto efficient point (of which there are a set) will be selected by the market without intervention, only that some such point will be.<ref name="mas549"/>

The second fundamental theorem states that given further restrictions, any Pareto efficient outcome can be supported as a competitive market equilibrium.<ref name="ipe"/> These restrictions are stronger than for the first fundamental theorem, with [[convex function|convexity]] of preferences and production functions a sufficient but not necessary condition.<ref name="mas552"/><ref>{{harvnb|Varian|2006|p=600}}</ref> A direct consequence of the second theorem is that a benevolent [[social planner]] could use a system of lump sum transfers to ensure that the "best" Pareto efficient allocation was supported as a competitive equilibrium for some set of prices.<ref name="ipe"/><ref name="mas552"/> More generally, it suggests that redistribution should, if possible, be achieved without affecting prices (which should continue to reflect relative [[scarcity]]), thus ensuring that the final (post-trade) result is efficient.<ref>{{harvnb|Varian|2006|pp=586–89}}</ref> Put into practice, such a policy might resemble [[predistribution]].

Because of welfare economics' close ties to [[social choice theory]], [[Arrow's impossibility theorem]] is sometimes listed as a third fundamental theorem.<ref name="Feldman 2008"/>

==Social welfare maximization==
Utility functions can be derived from the points on a contract curve. Numerous utility functions can be derived, one for each point on the production possibility frontier (PQ in the diagram above). A social utility frontier (also called a [[Utility–possibility frontier|grand utility frontier]]) can be obtained from the outer envelope of all these utility functions. Each point on a social utility frontier represents an efficient allocation of an economy's resources; that is, it is a Pareto optimum in factor allocation, in production, in consumption, and in the interaction of production and consumption (supply and demand). In the diagram below, the curve MN is a social utility frontier. Point D corresponds with point C from the earlier diagram. Point D is on the social utility frontier because the marginal rate of substitution at point C is equal to the marginal rate of transformation at point A. Point E corresponds with point B in the previous diagram, and lies inside the social utility frontier (indicating inefficiency) because the MRS at point C is not equal to the MRT at point A.

<div style="float:center;">[[File:Social indifference curve diagram.svg]]</div>
Although all the points on the grand social utility frontier are Pareto efficient, only one point identifies where social welfare is maximized. Such point is called "the point of bliss". This point is Z where the social utility frontier MN is tangent to the highest possible social [[indifference curve]] labelled SI.

==Criticisms==

Some, such as economists in the tradition of the [[Austrian School]], doubt whether a [[Cardinal number|cardinal]] utility function, or cardinal social welfare function, is of any value. The reason given is that it is difficult to aggregate the utilities of various people that have differing marginal utility of money, such as the wealthy and the poor.

Also, the economists of the Austrian School question the relevance of Pareto optimal allocation considering situations where the framework of means and ends is not perfectly known, since neoclassical theory always assumes that the ends-means framework is perfectly defined.{{citation needed|date=October 2020}}

The value of [[ordinal utility]] functions has been questioned. Economists have proposed other means of [[measuring well-being]] as an alternative to price indices like [[willingness to pay]] using revealed or stated preference method. This includes
[[subjective well-being]] functions based on individuals' ratings of their happiness or life satisfaction rather than on their preferences.<ref name = Dolan_2008>{{cite book |last1=Dolan |first1=Paul |last2=Metcalfe |first2=Robert |title=Comparing willingness-to-pay and subjective well-being in the context of non-market goods |date=2008 |publisher=Centre for Economic Performance, London School of Economics and Political Science |location=London |isbn=978-0-85328-297-6 |pages=45 |url=http://cep.lse.ac.uk/pubs/download/dp0890.pdf}}</ref>

Price-based measures are seen as promoting [[consumerism]] and [[productivism]] by many. It is possible to do welfare economics without the use of prices; however, this is not always done. Value assumptions explicit in the social welfare function used and implicit in the efficiency criterion chosen tend to make welfare economics a [[normative economics|normative]] and perhaps subjective field. This can make it controversial. However, perhaps most significant of all are concerns about the limits of a utilitarian approach to welfare economics. According to this line of argument, utility is not the only thing that matters and so a comprehensive approach to welfare economics should include other factors.

The [[capability approach]] is a theoretical framework that entails two core normative claims: first, the claim that the freedom to achieve well-being is of primary moral importance, and second, that freedom to achieve well-being is to be understood in terms of people's capabilities, that is, their real opportunities to do and be what they have reason to value.<ref>{{cite web |last1=Robeyns |first1=Ingrid |title=The Capability Approach |url=https://plato.stanford.edu/archives/win2016/entries/capability-approach/ |website=Stanford Encyclopedia of Philosophy |publisher=Metaphysics Research Lab, Stanford University |access-date=18 October 2020 |date=14 April 2011}}</ref>

==See also==
{{Div col|colwidth=30em}}
* [[Arrow's impossibility theorem]]
* [[Compensation principle]]
* [[Consumer surplus]]
* [[Deadweight loss]]
* [[Distribution (economics)]]
* [[Economic surplus]]
* [[Equity (economics)]]
* [[Feminist economics]]
* [[Gini coefficient]]
* [[Happiness economics]]
* [[Humanistic economics]]
* [[Income inequality metrics]]
* [[Involuntary unemployment]]
* [[Justice (economics)]]
* [[Kaldor–Hicks efficiency]]
* [[Lorenz curve]]
* [[Non-wage labour costs]]
* [[Pareto efficiency]]
* [[Public interest]]
* [[Social safety net]]
* [[Social welfare function]]
* [[Universal basic income]]
* [[Welfare state]]
* [[World Happiness Report]]
{{colend}}

== Notes ==
{{Reflist}}

== References ==
* {{citation|last1=Bernheim|first1=B. Douglas|title=Behavioral Welfare Economics|date=December 2008|doi=10.3386/w14622|url=http://www.nber.org/papers/w14622|access-date=8 June 2014|publisher=NBER|doi-access=free}}
* {{citation|last=Deardorff|first=Alan V.|title=Welfare economics|work=Deardorffs' Glossary of International Economics|access-date=9 June 2014|url=http://www-personal.umich.edu/~alandear/glossary/w.html#WelfareEconomics|year=2014}}
* {{citation|last=Feldman|first=Allan M.|year=2008|title=Welfare Economics|work=The New Palgrave: A Dictionary of Economics|volume=4|pages=889–95|edition=online|url=http://www.dictionaryofeconomics.com/article?id=pde2008_W000050|access-date=9 June 2014}}
* {{citation|last1=Hindriks|first1=Jean|last2=Myles|first2=Gareth D.|author-link2=Gareth Myles|title=Intermediate Public Economics|year=2013|publisher=MIT Press|location=Cambridge, MA|isbn=978-0262018692|edition=2nd}}
* {{citation|author-link=Andreu Mas-Colell|last1=Mas-Colell|first1=Andreu|first2=Michael D.|last2=Whinston|first3=Jerry R.|last3=Green|year=1995|title=Microeconomic Theory|chapter=Chapter 16: Equilibrium and its Basic Welfare Properties|publisher=Oxford University Press|isbn=0-19-510268-1|url=https://archive.org/details/isbn_9780198089537}}
*{{citation|last=Varian|first=Hal R.|author-link=Hal Varian|title=Intermediate Microeconomics: A Modern Approach|url=https://books.google.com/books?id=4XvRngEACAAJ|edition=7th|year=2006|publisher=W.W. Norton & Company|isbn=978-0-393-92702-3}}

==Further reading==
* Arrow, Kenneth J. (1951, 2nd ed., 1963). ''[[Social Choice and Individual Values]]'', Yale University Press, New Haven.
* Arrow, Kenneth J., and [[Gérard Debreu]] ed., 2002. ''Landmark Papers in General Equilibrium Theory, Social Choice and Welfare''. Edward Elgar Publishing, {{ISBN|978-1-84064-569-9}}. Description and table of [http://www.e-elgar.co.uk/Bookentry_contents.lasso?id=2281 contents.]
* [[Anthony B. Atkinson|Atkinson, Anthony B.]] (1975). ''The Economics of Inequality'', [[Oxford University Press]], London.
* [[Anthony B. Atkinson|Atkinson, Anthony B.]] (2012). ''Optimum population, welfare economics, and inequality'', [[Oxford University Press]], London.
* Bator, Francis M. (1957). "The Simple Analytics of Welfare Maximization", ''American Economic Review'', 47(1), [https://www.jstor.org/pss/1812285 pp. 22–59]
* Calsamiglia, Xavier, and Alan Kirman (1993). "A Unique Informationally Efficient and Decentralized Mechanism with Fair Outcomes", ''Econometrica'', 61(5), [https://www.jstor.org/stable/2951496 pp. 1147–72]
* Chipman, John S., and James C. Moore (1978). "The New Welfare Economics 1939–1974," ''International Economic Review'', 19(3), [https://www.jstor.org/stable/2526326 pp. 547–84]
* [[E. J. Mishan|Mishan, E. J.]] (1980). "The New Welfare Economics: An Alternative View", ''International Economic Review'', 21(3), [https://www.jstor.org/pss/2526362 pp. 691–705]
* Feldman, Allan M. (1987). "equity," ''[[The New Palgrave: A Dictionary of Economics]]'', v. 2, pp. 183–84.
* Feldman, Allan M., and Roberto Serrano, [1980] 2006. ''Welfare Economics and Social Choice Theory'', 2nd ed. {{ISBN|0-387-29367-1}}, {{ISBN|978-0-387-29367-7}} [https://books.google.com/books?id=7pZV5O5n_WwC&q=%22arrow's+theorem%22 Arrow-searchable chapter previews.]
*[[Johannes de Villiers Graaff|Graaff, Johannes de Villiers]], (1957; rev. ed., 1968). ''Theoretical Welfare Economics'', {{ISBN|978-0-521-09446-7}} Cambridge, UK: Cambridge University Press.
* [[Arnold Harberger|Harberger, Arnold C.]] (1971) "Three Basic Postulates for Applied Welfare Economics: An Interpretive Essay", ''Journal of Economic Literature'', 9(3), [https://www.jstor.org/stable/2720975 pp. 785–97]
* Just, Richard et al. (2004), ''The Welfare Economics of Public Policy'', Edward Elgar Publishing, Cheltenham and Northampton.
* Kuenne, Robert E., ed. (2000), ''Readings in Social Welfare: Theory and Policy'', Wiley. Description and scroll to chapter-preview [https://books.google.com/books?id=KMIr7g8nJykC links.]
* [[Ian Little (economist)|Little, I. M. D.]] (1950; 2002). ''A Critique of Welfare Economics'', Oxford. Preview. {{ISBN|0-19-828119-6}}.
* [[Yew-Kwang Ng|Ng, Yew-Kwang]] (1979; rev. ed., 1983). ''Welfare economics''. London: Macmillan.
* O'Connell, John F. (1982) ''Welfare Economic Theory'', Auburn House Publishing, Boston.
* [[Paul Samuelson|Samuelson, Paul A.]] (1947, Enlarged ed. 1983). "Welfare Economics", ''[[Foundations of Economic Analysis]]'', Harvard University Press, Cambridge, MA, ch. VIII, pp. 203–53.
* _____ (1977). "Reaffirming the Existence of 'Reasonable' Bergson-Samuelson Social Welfare Functions," ''Economica'', N.S., 44(173), [https://www.jstor.org/pss/2553553 pp. 81–88]. Reprinted in (1986) ''The Collected Scientific Papers of Paul A. Samuelson'', pp. [https://books.google.com/books?id=UKeJEc46R9AC&pg=PA47=gbs_atb 47–54]
* _____ (1981). "Bergsonian Welfare Economics", in S. Rosefielde (ed.), ''Economic Welfare and the Economics of Soviet Socialism: Essays in Honor of Abram Bergson'', [[Cambridge University Press]], Cambridge, pp. 223–66. Reprinted in (1986) ''The Collected Scientific Papers of Paul A. Samuelson'', [https://books.google.com/books?id=UKeJEc46R9AC&pg=PA225=gbs_atb pp. 3–46]
* [[Amartya Sen|Sen, Amartya K.]] (1963). "Distribution, Transitivity and Little's Welfare Criteria", ''Economic Journal'', 73(292), [https://www.jstor.org/stable/2228209 pp. 771–78]
* _____ (1982). ''Choice, Welfare and Measurement'', MIT Press. Description and scroll to chapter-preview [https://books.google.com/books?id=u8GPYeT1qAUC&q=false links.]
* Suzumura, Kotaro (1980). "On Distributional Value Judgments and Piecemeal Welfare Criteria," ''Economica'', 47(186), [https://www.jstor.org/stable/2553231 pp. 125–39]

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Ajay Kumar: Created a new article