Welfare Economics
Welfare Economics
Microeconomic
Indira Gandhi Analysis
National Open University
School of Social Sciences
Block
5
WELFARE ECONOMICS
UNIT 13
Pigovian vs Paretian Approach 5
UNIT 14
Social Welfare Function 26
UNIT 15
Imperfect Market Externality and Public Goods 42
UNIT 16
Social Choice and Welfare 62
Expert Committee
Prof. Bhaswar Moitra Prof. Gopinath Pradhan
Department of Economics School of Social Sciences
Jadavpur University Indira Gandhi National Open University
Kolkata New Delhi
Dr. Naresh Kumar Sharma Prof. Narayan Prasad
University of Hyderabad School of Social Sciences
School of Economics, Hyderabad Indira Gandhi National Open University
New Delhi
Dr. Anirban Kar
Deptt. of Economics Prof. Kaustuva Barik
Delhi School of Economics School of Social Sciences
University of Delhi Indira Gandhi National Open University
New Delhi
Dr. Indrani Roy Chowdhury
Economics Faculty, Jamia Millia Islamia Prof. B.S. Prakash
New Delhi School of Social Sciences
Indira Gandhi National Open University
Prof. Sudhir Shah
New Delhi
Deptt. of Economics, Delhi School of Economics
University of Delhi Mr. Saugato Sen
School of Social Sciences
Dr. Manish Gupta
Indira Gandhi National Open University
NIPFP, New Delhi
New Delhi
Material Production
Mr. Manjit Singh
Section Officer (Pub.)
SOSS, IGNOU, New Delhi
September, 2016
Indira Gandhi National Open University, 2016
ISBN-81-266
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BLOCK 5 WELFARE ECONOMICS
Introduction
APPROACH
Structure
13.0 Objectives
13.1 Introduction
13.2 Pigovian Approach
13.2.1 Pigovian Analysis
13.2.2 Case for the Market
13.2.3 Case for Improving upon the Market System
13.3 Pareto Optimal Conditions
13.3.1 Pareto-Optimality
13.4 Two Fundamental Welfare Theorems
13.5 Let Us Sum Up
13.6 Key Words
13.7 Some Useful Books
13.8 Answer or Hints to Check Your Progress
13.9 Exercises
13.0 OBJECTIVES
After going through this unit, you will be able to:
• understand two major approaches, Pigovian and Paretian, adopted in
analyzing economic welfare;
• assess the role of market in the attainment of welfare;
• examine the Pareto optimality condition; and
• evaluate the two fundamental welfare theorems.
13.1 INTRODUCTION
In the ambit of welfare economics, there are two clear trends, Pigouvian and
Paretian, which have influenced the analytical content. While the former is
considered as ‘cardinalist’, the latter is termed ‘ordinalist’ from the
methodology point of view. In this unit we shall explain both these
approaches including the requirement of value judgment that helps develop
the analysis.
For Pigou, a situation ‘in which each several sort of resource is allocated in
such a way that the last unit of it in any one use yields a physical product of
the same money value as the last unit of it in any other use’ is one of ideal
allocation, irrespective of the distribution of money incomes. If it is a
community comprising rich and poor people, then ‘though it is true that
aggregate satisfaction can be increased by departures from this type of
allocation in ways deliberately designed to benefit poor people, it is probable
that departures taken at random, e.g., through the operation of monopoly
power, would diminish aggregate satisfaction’. Therefore, according to Pigou,
such an allocation is properly called the ideal allocation with respect to the
existing distribution of money income.
After setting the main problem of inquiry as ‘the allocation of real factors of
production to maximise the total value of output’, Pigou tried to describe
some characteristics indicative of an optimal configuration and define
deviations from this optimal solution as inefficient. A crucial part of the
analysis was the concept of changes in output resulting from a movement of
resources from one use to another. Pigou defined marginal net product as ‘the
difference between the aggregate flow of product for which flow of resources,
when appropriately organised, is responsible and the aggregate flow of
product for which a flow of resources differing from that flow by a small
(marginal) increment, when appropriately organised, would be responsible’.
Pigou then drew a distinction between social and private marginal net
product. The marginal social net product is the ‘total net product of physical
things or objective services due to the marginal increment of resources in any
given use or place, no matter to whom any part of this product may accrue’. It
might happen, for example, that costs are thrown upon people not directly
concerned, through, say, uncompensated damage done to surrounding woods
by sparks from railway engines. All such effects must be included-some of
them positive, others negative elements in reckoning up the social net product
of the marginal increment of any volume of resources turned into any use or
6
place. The marginal private net product is that ‘part of the total net product of
physical things or objective services due to the marginal increment of Pigovian vs Paretian
resources in any given use or place which accrues in the first instance i.e., Approach
prior to sale to the person responsible for investing resources there’. In some
conditions this is equal to, in some it is greater than, in others it is less than the
marginal social net product.
Pigou also discussed second order conditions and considered the implications
of several local maxima. He offered the possibility that State action might be
“justified” if it could “jerk the industrial system out of its present poise at a
position of relative maximum, and induce it to settle down again at the
position of absolute maximum-the highest hill-top of all. Later, however, he
adds that worries about relative versus global maxima are a “secondary
matter” (see Hla Myint, “Theories of Welfare Economics”, Harvard
University Press, 1948, p. 128).
For Pigou, the problem facing society is one of allocating resources so that the
total value of output is maximised. He makes extensive use of the “flowing
resources” metaphor: A flowing stream of resources is continually coming
into being and struggling, so far as unavoidable costs of movement allow of
this, to distribute itself away from points of relatively low returns towards
points of relatively high returns. A clear signal of the performance of any
observed configuration of resources is the marginal social net product of each
resource. There is an answer to society's resource allocation problem and,
thus, deviation from optimality cannot only be judged inadequate, it can be
improved1.
Pigou thought it a settled matter that the market system often generated an
optimal solution and, thus, did not spend much time or effort explaining this
result. Self-interested resource owners, unhampered by ignorance, seeking to
maximise their private returns, will allocate resources so that marginal private
net products will everywhere deviate by less than the costs of movement and,
thus, the sum total of returns will attain a maximum. If private and social
products are equivalent, the free play of self-interest yields a socially optimal
allocation.
For Pigou, Government sets the rules to which the agents respond. He
advocated State action in selective and studied ways and did not propose
direct government control of individual agents; instead, he saw government
1
M. W. Reder, Studies in the Theory of Welfare Economics, Columbia University Press, New
8 York, 1947, p. 34.
providing the necessary incentives, carrots or sticks that would improve upon Pigovian vs Paretian
the current allocation of resources. This implies Pigou's continued reliance on Approach
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2) What is ideal output or ideal allocation as mentioned by Pigou? Pigovian vs Paretian
Approach
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3) What are obstacles to free movement? Explain how they affect welfare
situations?
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The term is named after Vilfredo Pareto, an Italian economist who used the
concept in his studies of economic efficiency and income distribution. If an
economic system is not Pareto efficient, then it is the case that some
individual can be made better off without anyone being made worse off. It is
commonly accepted that such inefficient outcomes are to be avoided, and
therefore Pareto efficiency is an important criterion for evaluating economic
systems and political policies.
11
Welfare Economics In particular, it can be shown that, under certain idealised conditions, a system
of free markets will lead to a Pareto efficient outcome. This was first
demonstrated mathematically by economists Kenneth Arrow and Gerald
Debreu, although the restrictive assumptions necessary for the proof mean
that the result may not necessarily reflect the workings of real economies.
The original constructors of the Paretian system were satisfied with the
equality of the number of equations and unknowns to establish the existence
of equilibrium. Instead of pursuing this question more vigorously, their
attention was turned onto something else: supposing such a set of prices did
exist, is the resulting equilibrium allocation an “efficient” one? By
“efficiency” they referred to the concept of “Pareto optimality”: i.e., a
situation is Pareto-optimal if by reallocation you cannot make someone better
off without making someone else worse off.
There is often more than one Pareto efficient outcome for a given amount of
resources. For example with a dictatorship, both with dictator X or with
dictator Y, the outcome will be Pareto efficient because in the first instance it
will be impossible to raise the well-being of anyone without reducing X’s
benefit and similarly for Y.
13.3.1 Pareto-Optimality
On the basis of the definition given by Pareto, three important sets of
efficiency conditions are to be considered. They are (a) production efficiency
or optimal allocation of factors; (b) consumption efficiency, or (c) product
mix efficiency or Optimum Direction of Production. The three sets of
efficiency conditions can be expressed through equality conditions as follows:
c) Product Mix Efficiency: MRSAXY = MRPTXY for any household A and any
pair of outputs, X, Y.
• Each individual has his/her own ordinal utility function and possesses a
definite amount of each product and factor.
12
• Production function of every firm and the state of technology is given and Pigovian vs Paretian
Approach
remains constant.
Consider the case of a two sector model: there are two firms producing two
goods in the economy, X and Y, using two factors of production, say, labour
and capital. At point G, the two firms are producing output levels X and Y
through allocation of resources. Although existing factors are fully utilised,
yet, this allocation is “Pareto-inefficient”. This implies that, we can reallocate
factors between firms such that firm Y increases output from Y to Y0 and firm
X stays at the same level of output as before. Thus, moving from allocation G
to allocation F is a Pareto-improving movement. In contrast, this new
allocation, point F, is obviously a Pareto-efficient situation, as any attempt to
reallocate resources in order to increase output of one firm inevitably requires
a reduction in output of the other.
Further, it can be seen that, from the isoquants formed at any possible
allocation, if there is “lens” between the two isoquants; then we can undertake
a Pareto-improving reallocation. As evident from the above figure, an
allocation such as G will yield output levels that will lie in the interior of the
production possibilities set (the area below the Production Possibility
Frontier). Thus, one of the first conditions for Pareto-efficiency is that the
marginal rates of technical substitution between any two factors must be the
same among all firms. In this case, MRTSXKL = MRTSYKL, which, in turn,
implies that output combinations will belie on the PPF.
13
Welfare Economics
Φf (xf) = 0,
Where xf = [x1f, x2, .., xnf] and an xif can be either an input or an output.
Lerner's Rule, therefore, is that for any two firms, f, g = 1, 2,..., F such that
14
If xi is an output and xj is an input, then this equation states that the marginal Pigovian vs Paretian
product of xi should be the same for both firms. If both xi and xj are input, Approach
then this states that the marginal rates of technical substitution between the
inputs are the same for both firms (MRTSfij = MRTSgij). Finally, if xi and xj
are both outputs, then this states that the marginal rate of product
transformation are the same for both firms (MRPTfij = MRTSgij).
We know that the contract curve that connects origins OA and OB represent the
set of Pareto-optimal allocations. It can be seen that, unlike the case of 15
Welfare Economics production efficiency, the shape of the contract curve for consumers is not
clearing comparison to that for the producers. However, it is to be noted that
the condition for consumption efficiency requires that an allocation between A
and B has to be Pareto-optimal and it must lie on the contract curve.
Moreover, the second order condition is that the marginal rate of substitution
between two goods be the same among all consumers. In other words, for
consumption efficiency of A and B, MRSAXY = MRSBXY.
To derive the CIC, we have to change the outputs X and Y such that the
consumers remain at their same utility levels they had at C (and thus retain the
same “aggregate” utility, U(C)). However, changing outputs X and Y changes
the dimensions of the Edgeworth-Bowley Box. Clearly, if we see F as the
origin of agent B, then changing output levels from F = (XF, YF) to G = (XG,
YG) we are changing the agents B's origin from F to G. Consequently, the
whole indifference map of agent B changes. Of course, the indifference map
of A does not change as it starts from the bottom left origin, OA. Nonetheless,
if the change in output is done carefully enough so that the utilities of A and B
do not change, we need to somehow remain on A's indifference curve UA(C)
and the tangency of that curve with the indifference map of agent B (at point
CG) will yield an indifference curve for B that has exactly the same utility
level as it had before (i.e., UB(C)). Thus, at output levels (XF, YF) and (XG,
YG), both A and B have the same utility levels, UA(C) and UB(C) that they had
before. In this case, aggregate utility, U(C), remain the same as a result of the
movement from F to G and thus we can say that F and G lie on the same
"community indifference curve", U(C). It is to be noted that the slope of the
CIC curve at point F is the same as the slope of the individual indifference
curves at point CF. Similarly, the slope of the CIC at point G is the same as the
slope of the individual indifference curves at point, CG.
16
Pigovian vs Paretian
Approach
The CIC curve that is constructed for a particular level of utility U(C),
however, is not the only CIC curve that can be constructed that passes through
point F. In the same Edgeworth-Bowley box - and thus at the same levels of X
and Y - we can construct a different CIC curve by considering a different level
of aggregate utility. This is shown below in Figure 13.4.
17
Welfare Economics
There is no reason to assume that CICC and CICD have the same slope.
Indeed, as long as the indifference curves of both agents within the
Edgeworth-Bowley box have different MRSs at points C and D, CICC and
CICD will necessarily have different slopes at point F and intersect each other.
These different slopes of the CICC and CICD curves at point F, are captured by
examining the price lines tangent to CICC (with slope -(pX/pY)C - which is also
tangent to the MRSs of the agents at point C) and CICD (with slope -(pX/pY)D -
which is also tangent to the MRSs at point D).
In the figure, CICC is tangent to the PPF while CICD is not. Now, both CICC
and CICD represent different aggregate utility levels and, it cannot be said as
to which one is superior because of their intersecting properties. However, it is
to be noted that CICc represents a Pareto-optimal allocation whereas CICD
does not. This is explained in Figure 13.5.
2
Amartya Sen, On Ethics and Economies, Welfare and Measurement, Harvard University
Press, 1990, p. 34. 19
Welfare Economics propositions about the desirability of such allocations inherent within that
notion. Thus, there is nothing inherent in Pareto-optimality that implies the
maximisation of social welfare.
A second important note to recall is that Pareto-optimality is a general
equilibrium notion and thus quite dependent on what we wish to include. For
instance, two particular countries may have Pareto-optimal allocations within
themselves, but when allocation is made for the trading opportunities that
exist between both countries, the general allocation is no longer Pareto-
optimal.
In the literature of welfare economics, quite often, the terms Pareto-optimality
and Pareto-efficiency are interchangeably used. Nonetheless, the term Pareto-
efficiency is somewhat inadequate as some people naturally think of efficiency
as a “technological” feature; but efficiency in production is only one part of
what we mean. By “efficiency”, in a Paretian context, we are also required to
take into consideration “consumer efficiency”. Thus, an economic situation
can be “efficient” in a production sense, yet “inefficient” in a general Paretian
sense.
Moreover, Pareto’s own term, “maximum ophelimity”, may not be a much
better way of conveying the purely descriptive (and ethically neutral) meaning
of the concept of Pareto-optimality. Perhaps the best description of Pareto-
optimality is the underutilized concept, coined by Maurice Allais: “an
allocation is “Pareto-optimal” if there is an “absence of distributable
surplus”3. This is an excellent term as it conveys the true meaning of Pareto-
optimality and suboptimality. One can think of a “distributable surplus” as the
set of mutually beneficial (or at least not harmful) trades between parties
(firms, agents, countries, etc.) that have not been undertaken (e.g., the “lens”
between indifference curves or isoquants in an Edgeworth-Bowley box
constitutes a “distributable surplus”). By Allais's definition, if there is no
distributable surplus, the situation is clearly Pareto-optimal.
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3
Anthony Barnes Atkinson, “The Economics of the Welfare State”, American Economist,
20 Vol. 40, 1996.
3) Are all Pareto efficient situations optimal? Pigovian vs Paretian
Approach
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4) What are the conditions of Pareto optimality?
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5) What is community indifference curve?
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6) What is Scitovsky Set?
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Welfare Economics • First Fundamental Welfare Theorem: every competitive equilibrium is
Pareto-optimal.
• Second Fundamental Welfare Theorem: every Pareto-optimal allocation
can be achieved as a competitive equilibrium after a suitable redistribution
of initial endowments.
The First and Second Welfare Theorems were proved graphically by Abba
Lerner (1934) and mathematically by Harold Hotelling (1938), Oskar Lange
(1942) and Maurice Allais.
Pareto on the other hand based his welfare economics on ordinal principles
and emphasised on the concept of Pareto optimality. We saw how the
condition of Pareto optimality is obtained through production efficiency,
consumption efficiency and product-mix efficiency. We also explained how
consumer indifference curve play a role in establishing pareto optimal
conditions. At last we analysed the two fundamental welfare theorems that
link the competitive equilibrium conditions with the Pareto optimal allocation.
We found that Pareto optimal and Pareto efficient are different concepts. The
allocation, which is Pareto efficient from the point of view of production, is
not optimal from the point of view of consumption.
Contract Curve: A contract curve is the set of all points in an Edgeworth box
that are Pareto efficient.
Marginal Private Net Product: It is that part of the total net product of
physical things or objective services due to the marginal increment of
resources in any given use or place which accrues in the first instance, i.e.,
prior to sale to the person responsible for investing resources there.
23
Welfare Economics Marginal Rate of Substitution: The marginal rate of substitution is the rate
at which consumers are willing to give up one good in exchange for more
units of another good. Numerically, this is the negative slope or derivative
(evaluated at a point) of the indifference curve. The marginal rate of
substitution is also the negative marginal utility of X over the marginal utility
of Y. The two relationships are mathematically equivalent.
Marginal Social Net Product: It is the total net product of physical things or
objective services due to the marginal increment of resources in any given use
or place, no matter to whom any part of this product may accrue.
4) No. All Pareto efficient solutions or outcomes are not optimal in the
sense that viewing from ethical sense, Pareto optimality is adequate as a
concept of efficiency, but not optimal.
13.9 EXERCISES
1) Explain Pigovian Welfare economics. Show how Pigou attempted the
maximisation of social welfare.
2) What are the conditions of Pareto optimality? Point out the main
weakness of Paretian analysis.
25
Welfare Economics
UNIT 14 SOCIAL WELFARE FUNCTION
Structure
14.0 Objectives
14.1 Introduction
14.2 Value Judgment
14.3 Social Welfare Function
14.4 Compensation Principle
14.4.1 Kaldor-Hicks Criteria
14.4.2 Scitovsky Reversals and the Double Criteria
14.4.3 William Gorman’s Intransitivity Problem
14.4.4 Samuelson’s Criteria
14.5 An Appraisal
14.6 Let Us Sum Up
14.7 Key Words
14.8 Some Useful Books
14.9 Answer or Hints to Check Your Progress
14.10 Exercises
14.0 OBJECTIVES
After going through this unit, you will be able to:
• identify the themes used as value judgment in welfare formulation;
• understand the process of constructing the social welfare function and its
analytical significance;
• assess the new welfare economics approach through compensation
principle;
• explain various criteria of the compensation principle; and
• understand the intransitivity problem and its significance.
14.1 INTRODUCTION
In the previous unit we have seen two approaches, neo-classical and new
welfare economics, dealing with the norms of efficient resource allocation.
We extend the discussion presently to see the appropriateness of value
judgement in analysing the welfare issues and search for the areas of
development and refinement. In the process, we will discuss the ethical social
basis of welfare function and of compensation principle. We will discuss how
through compensation principle optimum welfare is achieved. We shall also
be able to decipher whether the compensation principle is an improvement
over the earlier attempts or not.
28
Bergson first introduced the idea of a social welfare function in his article ‘A Social Welfare Function
Reformulation of Certain Aspects of Welfare Economics’ in 1938. By
introducing the concept of ‘social welfare function’, Bergson and Samuelson
approached welfare analysis in a different way. They based the concept of
SWF on ordinal preferences of individuals and argued that welfare economics
is essentially a normative study, but the approach should be scientific despite
the fact that the incorporation of value judgments in it is simply unavoidable.
It would be prudent to have a brief overview of some alternative welfare
functions, which will be helpful in bringing out some embedded ethical
judgments. The classical welfare function was put forward by Bentham, Pigou
and Marshall, popularly known as ‘Benthamite welfare function’. According
to them, social welfare is the sum of cardinal utilities obtained by all members
of a society. In algebraic form, this can be denoted as:
W=U1+U2+…………+Un
where W denotes social welfare, U1, U2, etc.; represent the cardinal utilities of
the individual members of the society. The goal of a society is to maximise
social welfare, that is, the aggregate of the utilities of the individual members
of society. Given this, maximum social welfare will be achieved if income is
so distributed that marginal utility of income is equal for all individuals in a
society. Moreover, the classical viewpoint is that maximisation of social
welfare is achieved only with equal distribution of income.
Another important social welfare function has been propounded by the noted
philosopher John Rawls. Rawls analysed welfare economics by posing a
problem: “what type of welfare criterion would be adopted by the society
when it is in such an initial position where everybody has to behave under
uncertainty about how the welfare criterion chosen will ultimately affect his
utility or welfare”. Assuming that individuals are risk averse, he asserts that
such a welfare criterion will be chosen that deviations from perfect equality
would be made only when with unequal distribution of utilities, the worst off
individual is better off actually than under equality conditions. This can be
stated algebraically as follows:
W (U1, U2, U3,………….Un) = min (U1, U2, U3,……………Un)
This implies that social welfare of resource allocation depends only on the
worst off individual, that is, the person with minimum utility.
Social welfare function is an ordinal index of society’s welfare and is a
function of the utility level of all individuals comprising the society. The
“Bergson-Samuelson” social welfare function (SWF) can be expressed in the
following general form:
W = W (U1, U2,.., UH),
where “society’s” welfare denoted by W, is merely a function of the utilities
of its constituent members, Uh, h = 1, 2, …...., H, where H are the number of
households in the society. In other words, U1, U2,.., UH represents the ordinal
utility indices of different individuals or households in the society. The ordinal
utility index of an individual depends upon the goods and services she
consumes and the magnitude and kind of work she does and the amount of
leisure she enjoys.
The Bergson-Samuelson SWF can be explained with the help of the grand
utility possibilities frontier (GUPF). We know that every point on the GUPF is
a Pareto-optimal allocation, and thus it seems that no point is necessarily
preferable to another. The Bergson-Samuelson SWF shows that, given the set 29
Welfare Economics of Pareto-optimal points, which is more desirable from “society’s” point of
view, where the notion of social desirability was subsumed in a social welfare
function.
Heuristically, we can envisage the upper contour set of the SWF as a set of
“social indifference curves” in utilities space, as shown in Figure 14.1.
According to Bergson, there are some desirable properties of a society which
are captured by the SWF: for instance, social welfare increases if the utility of
any of its members increase and none decrease (the “Pareto principle”) that
yields northeasterly ascendance of the social indifference curves. It is worth
mentioning that the consideration of fairness and equity are incorporated into
the SWF and are reflected in the shapes of social indifference curves. In other
words, it can be argued that equity is socially desirable; consequently, extreme
distributions of utility ought to be given less weight. Thus, the convexity of
the social indifference curve needs to be accepted and like the usual
indifference curves they are also non-intersecting.
35
Welfare Economics UB
UPFD
G K
U B (G )
H
U B (H )
UPFF
U B (E ) E
W'
U A (G ) U A (K ) U A (E ) UA
36
Social Welfare Function
14.5 AN APPRAISAL
In sum, disregarding the problems inherent in the Kaldor, Hicks and Scitovsky
criteria, the question must be raised again: are these objective criteria make
any sense? Ethically, of course, the Kaldor criteria is easily disputed as it is
only a “could” and not a “would” or even a “should”. As In M.D. Little
writes, in his famous critique:
“It seems improbable that so many people would, in England now, be
prepared to say that a change, which, for instance, made the rich so much
richer that they could (but would not) overcompensate the poor, who were
made poorer, would necessarily increase the wealth of the community.”
A point that has been reiterated by many contemporaries’ economists such as,
Baumol, Reder and Samuelson.
However, there were three lines of defense followed by the advocates of the
compensation principle. The first was to agree and make the “could” into a
“would”, i.e; to have the winners actually compensate the losers. This, of
course, leads to an improvement of sorts; the practical objection that arises is
that once we are at a new allocation, winners are unlikely to surrender any of
their gains.
The second defense, pursued by Hicks (1941), was that even if the losers do
not get compensated in the move, they might still benefit in the “long-run” if
the criteria were followed consistently by the society. This argument is similar
to that of “trickle-down” theory and that support for free trade. Some people
may be worse off in the short-run, but in the long run, everyone will be better
off. The underlying assumption, of course, is that at some point, those who
lost utility initially will come across a possible move in which they benefit and 39
Welfare Economics a society which follows the Kaldorian rule will move to it and thus they will
gain in the end. Of course, as Little notes, this is completely hypothetical.
There is nothing to guarantee that there will eventually be a move in which the
initial losers will be the ultimate winners.
The third (and perhaps considered better) line of defense is that the Kaldor-
Hicks criteria merely lay out what is economically possible and that it is up to
policy-makers, on the basis of their own value judgments, to choose which
move to make and whether compensation of the losers should be forced. Thus,
they argue, they are merely underlining that certain options may be more
economically possible than others, but they are still only options. The final
decision will require more philosophical, ethical and political considerations
to be brought into the story.
40
Max-min Criterion: ‘Welfare is maximised when the utility of those society Social Welfare Function
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.
Social Welfare Function (SWF): A function that measures the material
welfare of a society using a number of economic variables.
Value Judgment: Ethical beliefs of people about what is good or bad, not
based on scientific logic or law.
14.10 EXERCISES
1) Write short note on value judgments and their role in welfare analysis.
2) What do you mean by social welfare function? Explain different
approaches to it.
3) Critically evaluate compensation criteria. Do they serve any purpose in
welfare analysis? Explain.
41
Welfare Economics
UNIT 15 IMPERFECT MARKET
EXTERNALITY AND PUBLIC GOODS
Structure
15.0 Objectives
15.1 Introduction
15.2 Inability to Obtain Optimum Welfare
15.2.1 Market Failure
15.2.2 Imperfect Competition
15.2 3 Natural Monopoly
15.2.4 Imperfect Knowledge, Uncertainty, Non-existent and Incomplete Market
15.3 Externality
15.3.1 Types of Externalities
15.3.2 Externalities in Supply and Demand
15.3.3 Negative Externalities
15.3.4 Beneficial Externalities
15.3.5 Externality and Coase Theorem
15.4 Public Goods and Market Failure
15.4.1 Scitovsky Contour for Public Goods
15.4.2 Inefficient Provision of Public Goods
15.4.3 The Lindahl Formula
15.5 Let Us Sum Up
15.6 Key Words
15.7 Some Useful Books
15.8 Answer or Hints to Check Your Progress
15.9 Exercises
15.0 OBJECTIVES
After going through this unit, you will be able to:
• understand the reasons for the inability to obtain optimum welfare;
• explain the phenomenon of externality and its significance; and
• able to realise the problems inherent in the consumption of public goods.
15.1 INTRODUCTION
In the last unit, we discussed how through different compensating criteria, we
will be able to obtain optimum welfare in competitive market conditions
through economic reorganisation. But the real life conditions do not always
exhibit the competitive features of the market owing to some constraints.
Therefore, we are unable to attain optimum welfare. In this unit, we will
examine these conditions, which lead to market failure and inability to obtain
optimum welfare in the society. We shall also discuss the phenomenon of
externality, which is peculiar to the consumption of public goods.
43
Welfare Economics • Monopolistic competition, in which there are many sellers producing
highly, differentiated goods.
• Monopsony, in which there is only one buyer of a good.
• Oligopsony, in which there is a small number of buyers.
There may also be imperfect competition in markets due to buyers or sellers
who lack information about prices and the goods being traded. There may also
be imperfect competition due to a time lag in a market. For example, in the
1990s, there was a shortage of computer programmers as becoming a skilled
programmer requires several years of experience the shortage of such skilled
personnel continued. Another example is the "jobless recovery". There are
many growth opportunities available after a recession, but it takes time for
employers to react, which would result in gainful employment. Hence high
unemployment persists.
To demonstrate that imperfect competition fails to generate a Pareto optimum,
it is necessary to provide a suitable characterisation of Pareto optimality.
There are several ways in which this can be done. First, by consideration of
the competitive equilibrium it can be appreciated that competitive firms price
at marginal cost which is one of the conditions for Pareto optimality. In
contrast, price will not be equal to marginal cost in the imperfectly
competitive industry.
A second method of comparison is that at a Pareto optimum, the ratio of
shadow prices for any pair of goods is equal to the ratio of market prices. But
for the economy with imperfect competition, assuming that there is a single
firm in each imperfectly competitive industry, prices are not proportional to
the marginal rates of transformation, which captures the social cost of
producing each good. In addition, the imperfectly competitive firms take the
effects of their actions upon prices into account, which eliminates the direct
proportionality.
The imperfectly competitive equilibrium cannot maximise the value of any
social welfare function that satisfies the Pareto criterion. This observation
then makes it natural to consider what the degree of welfare loss may actually
be, either for a real economy or for simulated examples. The assessment of
monopoly welfare loss has been a subject of some dispute in which
calculations have provided a range of estimates from the effectively
insignificant to considerable percentage of potential welfare.
That monopoly causes loss of welfare and misallocation of resources will
become clear by considering the following Figure 15.1.
It will be seen from the figure that the transformation curve of the community
AB is tangent to the community indifference curve IC3 at point E. Therefore,
at point E MRTxy of the community is equal to the MRSxy. Thus, E represents
maximum possible level of social welfare and the combination of two
commodities being produced represents optimum allocation of resources. But
when the commodity X is being produced under conditions of monopoly, the
equilibrium will be at H, not at E
44
Y
Imperfect Market Externality
l and Public Goods
A
k
R k'
H
P
l
Comm odity Y
IC4
E
N
IC3
P' IC2
IC1
O Q M B X
Commodity X
Fig. 15.1: Monopoly as an Obstacle to Attain Pareto Optimum
This is because, under monopoly, producers would be equating MRT or the
ratio of marginal costs with the ratio of marginal revenues and not with the
ratio of prices of two goods. Since consumers would be equating MRS with
the price ratio of two goods, the MRT in the equilibrium position at point H
will not be equal to the MRS. This is quite obvious from the figure where at
point H transformation curve AB and consumers indifference curve IC1 are
intersecting. This implies that the slopes of transformation curve at point H,
which indicates MRT and the slopes of consumer’s indifference curve IC2,
which indicates MRSxy will not be the same. It will be observed from the
figure that at point H, MRS is greater than MRTxy, as tangent ll’ drawn to
point H on IC1 is steeper than the tangent kk’ drawn to point H on the
transformation curve AB. This means that consumers’ preference is that good
X should be produced more but because of the existence of monopoly in the
production of commodity X, it is not being produced to the desired quantity.
As a result, the level of satisfaction or welfare of the consuming community is
at a lower level than possible under the given production conditions. Thus,
monopoly has caused misallocation of resources.
15.2.3 Natural Monopoly
A natural monopoly is referred to a market structure, where a single firm is
the only supplier of a particular kind of product or service due to the
fundamental cost structure of the industry that precludes another entry.
Natural monopolies are often contrasted with coercive monopolies, in which
competition would be economically viable if allowed but potential
competitors are barred from entering the market by law or by force.
Natural monopolies arise where the largest supplier of an industry, or the first
supplier to a local area, has an overwhelming cost advantage over other actual
or potential competitors. This tends to be the case in industries where capital
costs predominate creating economies of scale, which can be reaped at an
output level large enough in relation to the size of the market. Such high costs 45
Welfare Economics create barriers to entry. Examples of these types of industries include water
services and electricity. It may also depend on control of a particular natural
resource. Companies that grow to take advantage of economies of scale often
run into problems of bureaucracy; these factors interact to produce an “ideal”
size for a firm at which its average cost of production is minimised. If that
ideal size is large enough to supply the whole market, then that market is a
natural monopoly.
Fig. 15.2: Long Run Decreasing Average Cost in the case of Natural Monopoly
A natural monopoly occurs in a market where the average cost curve is
decreasing over the entire relevant range of outputs. In Figure 15.2, a typical
“U” shaped long-run average cost curve (LRAC) is shown. It reflects the
common tendency for average costs to first fall then rise as output increases.
In the case of a natural monopoly, the entire relevant part of the LRAC curve
(that is, the range of outputs where demand for the product exists) is
downward sloping.
If a single company supplies the entire market, the output it produces will
correspond approximately to the amount Q. If two firms supply the market,
each firm will produce approximately Q/2, and if there are three firms, each
will produce Q/3. The more firms in the industry, the less each firm will
produce, and the greater will be the cost structure for each firm.
15.3 EXTERNALITY
The existence of externality prevents the achievement of Pareto optimality
even when perfect competition prevails. An externality occurs in when a
decision (for example, to pollute the atmosphere) causes costs or benefits to
individuals or groups other than the person making the decision. In other
words, the decision-maker does not bear all of the costs or reap all of the gains
from her action. As a result, in a competitive market too much or too little of 49
Welfare Economics the good will be consumed from the point of view of society. If a company
making the decision benefits more than it does (education, safety), then the
good will be under-consumed by other. On the other hand, if the costs to the
world exceed the costs to the individual making the choice (pollution, crime),
then the good will be over-consumed from society's point of view.
15.3.1 Types of Externalities
Examples of externalities include:
• Pollution by a firm in the course of its production which causes nuisance
or harm to others. This is an example of a negative externality, external
cost, or external diseconomy.
• The harvesting by one fishing company in the open sea depletes the stock
of available fish for the other companies. Over-fishing may result. This is
an example of a common property resource, sometimes referred to as the
Tragedy of the commons.
• An individual planting an attractive garden in front of her house may
benefit others living in the area. This is an example of a positive
externality, beneficial externality, external benefit or external economy.
• An individual buying a picture-phone for the first time will increase the
usefulness of such phones to people who might want to call her. This may
lead to the general acceptance of these phones. This is an example of a
network externality.
In contrast; a property tycoon buying up a large number of houses in a town,
causing prices to rise and therefore making other people who want to buy the
houses worse off (perhaps by excluding them from the housing market), is not
causing an externality, because the effect is through prices, and is considered
part of the normal functioning of the market. Alternatively, these effects are
sometimes called “pecuniary externalities”, with externalities as defined
above called “technological externalities.”
Externalities are important in economics because they may lead to
inefficiency. Because the producers of externalities do not have an incentive
to take into account the effect of their actions on others, the outcome will be
inefficient. There will be too much activity that causes negative externalities
such as pollution, and not enough activity that creates positive externalities,
relative to an optimal outcome.
15.3.2 Externalities in Supply and Demand
The usual economic analysis of externalities can be illustrated using a
standard supply and demand diagram if these can be monetised (valued in
terms of money). An extra supply or demand curve is added, as in the
diagrams below. One of the curves is the private cost that consumers pay as
individuals for additional quantities of the good (in competitive markets, the
marginal private cost) and the other curve is the true cost that society as a
whole pays for production and consumption of increased production the good
(the marginal social cost).
Similarly, there might be two curves for the demand or benefit of the good.
The social demand curve would reflect the benefit to society as a whole, while
the normal demand curve reflects the benefit to consumers as individuals and
is reflected as effective demand in the market.
50
15.3.3 Negative Externalities Imperfect Market Externality
and Public Goods
Figure 15.4 below shows the effects of a negative externality. For example,
the steel industry is assumed to be selling in a competitive market – before
pollution-control laws were imposed and enforced. The marginal private cost
is less than the marginal social or public cost by the amount of the external
cost, i.e., the cost of the smoking stacks and water pollution. This is
represented by the vertical distance between the two supply curves. It is
assumed that there are no external benefits, so that social benefit equals
individual benefit.
Thus, a public good is difficult to produce for private profit, and it is difficult
to get people to pay for its beneficial externalities. By definition, a public
good possesses two properties:
• It is non-rivalrous, meaning that its benefits do not exhibit scarcity of
consumption; once it has been produced, each person can benefit from it
without diminishing anyone else's enjoyment.
• It is non-excludable, meaning that once it has been created, it is impossible
(or at least very difficult) to prevent people from gaining access to the
good.
Public goods are “pure” when they possess these properties absolutely. There
are impure public goods those confined to particular localities (for example,
‘A’ congested road). The problem with public good is that a free market is
unlikely to produce its optimum amount. Important public goods such as
national defense will be under-produced due to the free-rider problem. In
practice, this problem has been solved through government intervention and
the provision of public goods by the state. These solutions are not without
critics, however, since there are some who have argued that such interventions
can lead to too many resources being allocated to a public good's production.
In the case of national defense, this is the alleged problem of the military-
industrial complex. Also, the centralized governments are not the only
substitute for markets. In theory, tradition and decentralised democracy might
play a role of the government.
A public good is the opposite of a private good, i.e., a good that can be sold in
the market. A loaf of bread, for example, is a private good. Its owner can
exclude others from using it, and once it has been consumed, it cannot be used
again.
58
Imperfect Market Externality
and Public Goods
K=100%
DB
K=0%
M Qs
Amount of public good
Fig. 15.9: Lindahl Pricing for Public Goods
Check Your Progress 3
1) Which characteristic of public goods leads to inefficient resource
allocation? Explain its operation.
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
2) Describe the meaning of market failure in public goods.
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
3) Discuss the Lindahl Formula for efficient allocation of public goods.
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
15.9 EXERCISES
1) Explain the conditions of inability to obtain optimum welfare.
2) What is market failure? Account for its causes.
3) What is Externality? Explain different types and their causes.
4) Explain the difficulty in the provision of public goods.
61
Welfare Economics
UNIT 16 SOCIAL CHOICE AND WELFARE
Structure
16.0 Objectives
16.1 Introduction
16.2 Theory of Second Best
16.3 Arrow’s Impossibility Theorem
16.4 Rawls’ Theory of Justice
16.4.1 Original Position
16.4.2 Two Principles of Justice
16.4.3 An Appraisal
16.5 Equity-Efficiency Trade-off
16.6 Let Us Sum Up
16.7 Key Words
16.8 Some Useful Books
16.9 Answer or Hints to Check Your Progress
16.10 Exercises
16.0 OBJECTIVES
After going through this unit, you will be able to explain:
• choices available to a society when optimal welfare is not achievable;
• reason for not looking at second best options when first best is violated;
• Arrow’s impossibility theorem on social welfare;
• Rawl’s’ views on organising and governing a society; and
• equity-efficiency trade off as limits to redistribution.
16.1 INTRODUCTION
In the previous unit, we have seen the prevalence of imperfect asymmetric
information, transaction costs, presence of externalities and public good,
which prevent attainment of optimal social welfare conditions. The present
unit discusses the available choice. We start with the theory of second best
and proceed to look into the difficulties of constructing a social welfare
function. By bringing in the theory of justice, it is tried to assess the available
choice for imparting the social welfare. The unit concludes with the equity
efficiency trade off in distribution mechanism.
63
Welfare Economics some or other reasons, it may be better to violate other marginal conditions of
Pareto optimality to achieve maximum possible social welfare.
The theory of second best has been applied to question, the desirability of
advocating competitive pricing in some particular markets when it is known
that Pareto conditions do not hold in other markets. However, the advocates of
such policies in making some markets more competitive in achieving Pareto
optimality argue that as the markets in question are unrelated, it does not
matter for attaining maximum social welfare that in other market conditions
for Pareto efficiency are not fulfilled. Advocates of the latter policy argue that
when markets are relatively independent or unrelated, marginal cost pricing
increase social welfare. Thus, in the words of Prof. S. Charles Maurice and
Own. R. Phillips, “the theory of second best applies most strongly when
markets are closely related: that is, they either produce complementary goods
like bread and butter, or one market is an intermediate supplier of another as
in the case of tyre makers supplying automobile producers”.
64
preference order. This social choice function should have several desirable Social Choice and
(“fair”) properties: Welfare
X Y Z
A 3 2 1
B 1 3 2
C 2 1 3
In this table three individuals A, B and C who constitute the society have been
shown to have voted for three alternative social states, X, Y and Z by writing
3, against the most preferred alternative, 2 for the next preferred alternative
and 1 for the least preferred alternative. As shown in the table, individual A
prefers X to Y, Y to Z and therefore X to Z. Individual B prefers Y to Z, Z to
X and therefore Y to X. and individual C prefers Z to X, X to Y and therefore
Z to Y. It is clear that two individuals A and B prefer Y to Z and also two
individuals A and C prefer Z to X. Thus, the majority (two of the three
individuals) prefers X to Y and also Y to Z, and therefore, Z to X. But
majority also prefers Z to X. Thus, we see that majority rule leads to
inconsistent social choices because on the one hand, X has been preferred to Z
by the majority and on the other hand, Z has also been preferred to X by
majority, which is contradictory or inconsistent.
On the basis of five conditions as mentioned above, Arrow has derived three
consequences to explain his impossibility theorem. Let us analyze these
consequences in the case of three alternatives X, Y and Z available to the two
individuals, A and B. According to Consequence I, whenever the two
individuals prefer X to Y, then irrespective of the rank of the third alternative
Z, society will prefer X to Y. According to Consequence II, if in a given social
choice, the will of individual prevails against the opposition of individual B,
then the will of A will certainly prevail in case individual B is different or
agrees with A. According to Consequence III, if individuals A and B have
exactly conflicting interests in the choice between two alternatives X and Y,
then the society will be indifferent between X and Y. It is interesting to note
that the simple proof of the impossibility theorem follows from Consequence
III. For instance, if individual A prefers X to Y and individual B prefers Y to
Z and if society opts for X, then A will be a dictator inasmuch as her choice
will always be a social choice. Thus, Arrow’s theorem says that ‘if the
66
decision-making body has at least two members and at least three options to Social Choice and
decide among, then it is impossible to design a social choice function that Welfare
satisfies all these conditions at once’. Arrow, therefore concludes that it is
impossible to derive a social ordering of different conceivable alternative
social states on the basis of the individual ordering of those social states
without violating at least one of the value judgments as expressed in the five
conditions of social choices. This is in essence his impossibility theorem.
Check Your Progress 1
1) Point out the theory of second best with suitable present economy
examples.
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
2) How individual ordering of social states is made according to Arrow’s
impossibility theorem?
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
3) What do you mean by social choice function?
…………………………………………………………………………..
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…………………………………………………………………………..
…………………………………………………………………………..
67
Welfare Economics advantaged must compensate the disadvantaged with the goal of bringing
them up to an acceptable level of advantage.
Attempting to balance the demands posed by these rival theories, Rawls
maintained that inequalities in society can only be justified if they produce
increased benefits for the entire society and only if those previously the most
disadvantaged members of society are no worse off as a result of any
inequality. An inequality, then, is justified if it contributes to social utility, as
the merit theory asserts. But, at the same time, Rawls asserted, priority must
be given to the needs of the least advantaged, as the needs theory asserts.
Thus, differential rewards are allowed to the advantaged members of society
but not because of any merit on their part. These rewards are tolerated
because they provide an incentive for the advantaged, which ultimately will
prove beneficial to society (e.g., taxing the advantaged with the goal of
redistributing the wealth to provide for the least advantaged).
16.4.1 Original Position
Using a thought experiment Rawl’s called “the original position” from which
agents behind a “veil of ignorance” select principles of justice to govern the
society. Two principles serve to organise society, are the “liberty principle”
and the “difference principle.” He rooted the original position in and
extended the concept of “social contract” previously espoused by Hobbes,
Rousseau and Locke, which made the principles of justice the object of the
contract-binding members of society together.
According to Rawls, a society is a cooperative venture between free and equal
persons for the purpose of mutual advantage. Cooperation among members
makes life better because of the “primary goods” which include among others:
health, rights, income and the social bases of self-respect. All social primary
goods – liberty and opportunity, income and wealth, and the bases of self-
respect – are to be distributed equally unless an unequal distribution of any or
all of these goods is to the advantage of the least favored.
The problem every society must confront, Rawls noted, is that the members
will often disagree on what constitutes the good and how the benefits and
burdens within society will be distributed among its members. Some believe,
for example, that the good consists in virtuous conduct while others believe
that the good is discovered in the pursuit of individual happiness, at least in so
far as the members of society define these terms. Some members believe that
an individual’s merit should determine how one would participate in society’s
benefits while others believe that society must provide the least advantaged
extra assistance so that they will be able to share equally in society’s benefits.
If society is to exist and to endure despite these and other such differences, its
members must derive a consensus regarding what minimally constitutes the
good.
What consensus requires in actual practice is that the members agree upon the
rules which will govern them as a society and that these rules will be applied
consistently. But, Rawls asked, just how would a society and its members
know what constitutes a “fair” principle? And, how would it be possible to
determine what is “reasonable” for every member to agree with? Thompson
cites the example of welfare to make this point:
The growth of the welfare state has often been explained and defended as a
progressive recognition that government should provide certain benefits
(positive rights) in order to prevent certain harms to citizens (negative rights).
68
Yet, its opponents claim that the welfare state violates the negative rights of Social Choice and
other citizens (property owners, for example). Welfare
V T
Q
B’s Utility
E
UB
W3
D
W2
W1
450
O UA V'
A’s Utility
Fig. 16.2: Rawlsian Theory of Justice
73
Welfare Economics considerations may be applied across generations as well as across
individuals.
However, the issue before the practical policy is not so much on how to
establish a fair society and its de novo state of distribution, but to consider
whether and how to address the problem of redistribution. The question,
therefore, is to what extent and how the existing state of distribution, as
determined by the market and prevailing social institutions, needs to be
amended. To some extent, this may be accomplished by way of voluntary
actions of the members but such transfers carry minor weight as compared
with policies of redistribution decided upon by the process of budget. Such
policies will then be met by the responses of individuals who stand to lose or
gain in the process. This may in turn affects the size of the pie available for
redistribution and imposes costs, which must be allowed for. Here comes the
issue of efficiency-equity trade-off.
Redistribution involves costs as well as benefits, and both must be considered
in policy making. Policies to redistribute, to begin with, can shrink the size of
the pie available for distribution. This is shown here with regard to effects on
labor supply, but similar problems arise with regard to saving, investment and
economic growth.
Let us take up the analytical framework of efficiency-equity trade-off.
Consider two individuals, H with high and L with low earning capacity. To
simplify, suppose L’s earning capacity is, in fact zero. In the absence of
intervention, H has a substantial positive income and L has none. Now a tax is
imposed on H and the yield is transferred to L. As a result of the tax, the new
wage rate of H (the return in goods which H can obtain for selling leisure) is
reduced. Initially, H may respond by working more (H’s labour supply
schedule slopes backward over a range of high wage rates), but thereafter a
further increase in the tax rate will induce her to retain more leisure. As a
result, the revenue obtainable from a given tax is not unlimited. As the tax rate
is increased further, revenue will rise for some time until a point is reached
beyond which further increases in the tax rate will result in declining
revenues. Hence, a reduction in funds available for transfers to L becomes
inevitable. This relationship is illustrated in the following table, showing H’s
responses to rising rates of tax with a wage rate of Rs. 10.
Tax
Revenue
from H
H’s income Transferred H’s income
Tax Rate H’s Hours Before tax to L (Rs) After tax L’s income
(percentage) worked (Rs.)
(i) (ii) (iii) (iv) (v) (vi)
0 6.0 60.0 0 60.0 0
15 7.0 70.0 10.5 59.5 10.5
30 5.0 50.0 15.0 35.0 15.0
50 2.5 25.0 12.5 12.5 12.5
80 1.0 10.0 8.0 2.0 8.0
100 0 0 0 0 0
74
As the tax is introduced, H increases his working hours initially so as to Social Choice and
recoup some of her lost income. She does so until a tax rate of 15 percent is Welfare
reached, above which her working hours will be reduced. In moving from 15
percent to 30 percent, revenue still rises as the increase in tax rate more than
offsets the decline in the taxable base. However, as the tax rate is increased
further, revenue begins to fall. Whereas the goal of Max-Min would be served
by stopping at 30 percent, a 50 percent rate would be needed for full
equalisation.
The potential scope for redistribution may thus be limited because a further
increase in tax rates eventually hits a revenue ceiling. But this is not the entire
story. There is another and more subtle cost to redistribution, which becomes
effective from the outset. This arises because withdrawing one rupee of
income tax from H leaves her with a welfare loss in excess thereof, and
because receipt by L also imposes a deadweight loss that must be taken into
consideration. As noted below, this factor poses a major problem in the design
of welfare programs.
The fact that the donor loses more than the recipient gains, however, does not
mean that the transaction must involve a social loss. Much depends on the
weight to be attributed per Rupee of loss and gain, so that a low-income gain
of 90 paisa may, as placed under a social weight, more than outweigh a loss of
Rs.1.10 for the higher up.
The nature of efficiency-equity tradeoff is illustrated in the Figure 16.3 below
for an economy consisting of two persons, A and B. As shown, the vertical
and horizontal axes measure A’s and B’s utility levels, with utility rising when
moving from O to C or from O to D. CD is the utility frontier and is1, is2,
is3…are social indifference curves reflecting the distributive judgment of the
community. B* is the point of bliss, reflecting the best of all possible solutions.
Index of
A’s Utility
E G
Z
B*
is 5
is 4
is 3
is 2
is1
O D Index of
B’s Utility
Fig. 16.3: Equity-Efficiency Tradeoff
75
Welfare Economics If prevailing arrangements place the economy at E, movement to points below
F and G on the utility frontier is efficient (Pareto optimal), since at least one
gains and no one loses. But the Pareto criterion of efficiency does not tell us
how to choose among points between F and G. From the social point of view,
however, G is the best, since it reaches the highest possible social indifference
curve, is4. Now suppose that the functioning of the market leads to the point F.
Given the is curves in the figure, a social gain results by moving from F to B*,
raising social welfare from is2 to is5. This gain results even though A loses, so
that the move is not sanctioned by the criterion of Pareto efficiency.
Moreover, moving to a point off the utility frontier, such as K, may be
superior from the social point of view to remaining at F. Introduction of a
social welfare function, as reflected in is1, is2, is3 thus suggests a broadened
concept of efficiency, i.e., one by which the outcome is assessed and ranked in
terms of social welfare weights.
To see how this bears on the efficiency cost of redistribution, we might
imagine CBD to trace the utility frontier, as it would look if redistribution
could be achieved without an efficiency cost. But given this cost, and
beginning at F, the actually available frontier may be given by the dotted line
FKZ. By moving from F to K (but not further!), redistribution still pays in
social welfare terms, but the gain is less (involving a shift from is2 to is3 only)
than it would be without an efficiency cost of redistribution. Although society
may thus accept some efficiency loss to obtain an equity gain, distributional
adjustments should be made so as to minimise this cost.
Check Your Progress 2
1) What are the two principles of justice as mentioned by the philosopher
Rawls?
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
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2) What is equity-efficiency trade-off?
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Welfare Economics 2) The equity-efficiency trade-off which poses major problem in the design
of welfare programmes states that there is a limit to redistribution in an
economy. This means that there is a limit to amend the existing state of
distribution as determined by the market and prevailing social
institutions to establish fair society.
16.10 EXERCISES
1) Discuss the relevance of Rawls theory of Justice for third world
countries.
2) Briefly explain equity-efficiency tradeoff.
3) Critically examine Arrow’s Impossibility theorem.
4) What is the Theory of Second Best? Prove the theorem with the help of
a diagram.
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