Unit 5: Basics of Welfare Economics

1. Welfare Economics: Individual vs Social Welfare

Welfare economics analyzes the criteria for evaluating the well-being of individuals and society.

• Individual Welfare: Refers to the level of satisfaction or utility an individual reaches through consumption.
• Social Welfare: Refers to the overall well-being of the entire community, often viewed as an aggregation of individual utilities.

2. Value Judgements & Pigovian Welfare Economics

Value Judgements

Normative statements based on personal or social ethics that determine what "should" be done in economic policy are known as value judgements.

Pigovian Welfare Economics

A.C. Pigou's approach emphasizes that economic welfare is closely linked to national income and its distribution.

• Pigou suggested that social welfare increases if the national income grows without becoming less equally distributed.
• He introduced the distinction between private and social costs/benefits, advocating for government intervention when they diverge.

3. Pareto Optimality: Concept and Conditions

The Pareto criterion is a key benchmark for economic efficiency.

Definition: A state is Pareto Optimal if it is impossible to make one person better off without making someone else worse off.

Core Conditions:

• Exchange Efficiency: Goods are distributed such that consumers cannot benefit further from trading with each other.
• Production Efficiency: Inputs are allocated such that output of one good cannot be increased without decreasing another.
• Allocative Efficiency: The mix of goods produced matches the preferences of consumers.

4. Social Welfare Function

A Social Welfare Function (SWF) provides a way to rank different economic states based on the utilities of all individuals in the society.

• It helps resolve conflicts between different Pareto-efficient states by applying specific social preferences or weights to individual utilities.
• The "Grand Optimum" is the point where social welfare is maximized given the economy's technical constraints.

5. Externalities and Public Goods

Market failure occurs when the price mechanism fails to achieve Pareto optimality.

Externalities

Externalities are costs or benefits experienced by third parties who are not involved in the market transaction.

• Negative Externalities: (e.g., pollution) lead to over-production because private costs are lower than social costs.
• Positive Externalities: (e.g., education) lead to under-production because private benefits are lower than social benefits.

Public Goods

Public goods are non-excludable (cannot prevent non-payers from using) and non-rivalrous (one person's use doesn't diminish another's).

• Examples include national defense, street lighting, and lighthouses.
• Because of the "free-rider" problem, the private market usually fails to provide these goods, necessitating government provision.