Welfare EconomicsDefinition A branch of economics that focuses on the optimal allocation of resources and goods and how this affects social welfare. Welfare economics analyzes the total good or welfare that is achieve at a current state as well as how it is distributed. This relates to the study of income distribution and how it affects the common good.Other MeaningWelfare economics uses the perspective and techniques of microeconomics, but they can be aggregated to make macroeconomic conclusions. Because different "optimal" states may exist in an economy in terms of the allocation of resources, welfare economics seeks the state that will create the highest overall level of social welfare.

Some people object to the idea of wealth redistribution because it flies in the face of pure capitalist ideals, but economists suggest that greater states of overall social good might be achieved by redistributing incomes in the economy.

TWOFUNDAMENTALTHEOREMSOFWELFARE ECONOMICS1. The first states that anycompetitive equilibriumorWalrasian equilibriumleads to aPareto efficientallocation of resource (It captures the logic of Adam Smith'sinvisible hand) and2. The second states the converse, that any efficient allocation can be sustainable by a competitive equilibrium.Thus a social planner could use a social welfare function to pick the most equitable efficient outcome, then use lump sum transfers followed by competitive trade to bring it about. Because of welfare economics' close ties tosocial choice theory,theorem is sometimes listed as a third fundamental theorem.

RATIONALEThe first fundamental theorem of welfare economics states that any Walrasian equilibrium isPareto-efficient. This was first demonstrated graphically by economistAbba Lernerand mathematically by economistsHarold Hotelling,Oskar Lange,Maurice Allais,Kenneth ArrowandGrard Debreu. The theorem holds under general conditions.The theorem relies only on three assumptions: (1)complete markets(i.e., no transaction costs and where each actor has perfect information), (2)price-takingbehavior (i.e., no monopolists and easy entry and exit from a market), and (3) the relatively weak assumption oflocal nonsatiation of preferences(i.e., for every bundle of goods there is another similar bundle that would be preferred). However, noconvexityassumptions are needed.The formal statement of the theorem is as follows:If preferences are locally nonsatiated, and if (x*, y*, p) is a price equilibrium with transfers, then the allocation (x*, y*) is Pareto optimal.An equilibrium in this sense either relates to an exchange economy only or presupposes that firms are allocatively and productively efficient, which can be shown to follow from perfectly competitive factor and production market.The second fundamental theorem of welfare economics states that, under the assumptions that every production setisconvexand every preference relationis convex andlocally nonsatiated, any desired Pareto-efficient allocation can be supported as a pricequasi-equilibrium with transfers. Further assumptions are needed to prove this statement for price equilibriums with transfers.The proof proceeds in two steps: first, we prove that any Pareto-efficient allocation can be supported as a price quasi-equilibrium with transfers; then, we give conditions under which a price quasi-equilibrium is also a price equilibrium.MEASURING SOCIAL WELFARE*Cardinal utilityThe earlyNeoclassicalapproachwas developed byEdgeworth,Sidgwick,Marshall, andPigou. It assumes the following: Utility iscardinal, that is, scale-measurable by observation or judgment. Preferences are exogenously given and stable. Additional consumption provides smaller and smaller increases in utility (diminishingmarginal utility). All individuals have interpersonallycomparableutility functions (an assumption that Edgeworth avoided in hisMathematical Psychics).With these assumptions, it is possible to construct asocial welfare functionsimply 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 theBenthamitetradition.*Ordinal utilityTheNew Welfare Economicsapproach is based on the work ofPareto,Hicks, andKaldor. 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 asPareto efficiencyand theKaldor-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 withordinal utility, which merely ranks commodity bundles (with anindifference-curvemap, for example).CRITERIAUtility, welfare, and efficiencyOur first concern will be a question of definitions. What is the difference between, and the relationship of, welfare and utility? The two terms sound similar, and seem often to be used in similar ways. But the difference between them is stark and important.Utility is a construct of descriptive or positive economics. The classical tradition asserts that economic behavior can be usefully described and predicted by imagining economic agents who rank the consequences of possible actions and choose the action associated with the highest-ranking. Utility, strictly speaking,has nothing whatsoever to do with well-being. It is simply a modeling construct that (it is hoped) helps organize and describe observed behavior. To claim that people value utility is a claim very similar to nature abhors a vacuum. Its a useful way of putting things, but natures abhorrence is not meant to signal an actual discomfort demanding remedy in an ethical sense. Subjective well-being, of an individual human or of the universe at large, is simply not a topic amenable to empirical science. By hypothesis, human agents strive to maximize utility, just as molecules strive to find lower-energy states over the course of a chemical reaction. Utility is important not as a desideratum of scientifically inaccessible minds, but as a tool invented by economists, a technique for describing and modeling human behavior that may (or may not!) turn out to be useful.Welfare is a construct of normative economics. While utility is a thing we imagine economic agents maximize, welfare is what economistsseek to maximize when they offer policy advice. There is no such thing as, and can be no such thing as, a scientific welfare economics, although the discipline is still burdened by a failed and incoherent attempt to pretend to one. Whenever a claim about welfare is asserted, assumptions regarding ethical value are necessarily invoked as well. If you believe otherwise, you have been swindled.If claims about welfare cant be asserted in a value-neutral way, then neither can claims of efficiency. Greg Mankiwteachesthat [under] free market [transactors] are together led by an invisible hand to an equilibrium that maximizes total benefit to buyers and sellers. That assertion becomes completely insupportable. Even the narrow and technical notion of Pareto efficiency, often omitted from undergraduate treatments, is rendered problematic, as nonmarket allocations can also be Pareto efficient and value-neutral ranking of allocations becomes impossible. Welfare economics is the very heart of introductory economics. Market efficiency, deadweight loss, tax incidence, price discrimination, international trade all of these topics are diagrammed and understood in terms of what happens to the area between supply and demand curves. If we cannot redeem those diagrams, all of that becomes little more than propaganda.

This ideal state of affairs can only come about if four criteria are met: Themarginal rates of substitutionin consumption are identical for all consumers. This occurs when no consumer can be made better off without making others worse off. Themarginal rate of transformationin production is identical for all products. This occurs when it is impossible to increase the production of any good without reducing the production of other goods. The marginal resource cost is equal to the marginal revenue product for all production processes. This takes place whenmarginal physical productof a factor must be the same for all firms producing a good. The marginal rates of substitution in consumption are equal to the marginal rates of transformation in production, such as where production processes must match consumer wants.There are a number of conditions that, most economists agree, may lead to inefficiency. They include: Imperfect market structures, such as amonopoly,monopsony,oligopoly,oligopsony, andmonopolistic competition. Factor allocation inefficiencies inproduction theory basics. Market failures andexternalities; there is alsosocial cost. Price discriminationandprice skimming. Asymmetric information,principalagent problems. Long rundeclining average costs in anatural mo