Welfare economics

Welfare economics is a branch of economics that uses microeconomic techniques to simultaneously determine the allocational efficiency of a macroeconomy and the income distribution consequences associated with it. It attempts to maximize the level of social welfare by examining the economic activities of the individuals that comprise society.

Income distribution

There are many combinations of consumer utility, production mixes, and factor input combinations consistent with efficiency. In fact, there are an infinity of consumer and production equilibria that yield Pareto optimal results. There are as many optima as there are points on the aggregate production possibilities 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 is a way of mathematically stating the relative importance of the individuals that comprise society.

Related Topics:
Production possibilities frontier - Social welfare function

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A utilitarian welfare function (also called a Benthamite welfare function) sums the utility of each individual in order to obtain society's overall welfare. Everyone is treated the same, no matter what their initial level of utility is. 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 that already has all the wealth he/she could ever spend. At the other extreme is the Max-Min function proposed by John Rawls. 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.

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The social welfare function is typically translated into social indifference curves 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.

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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.

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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).

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