THE A, B, C OF

WELFARE ECONOMICS

ANABA, SYLVESTER ANANI (ACS, M.SC)

CRITERIA FOR SOCIAL ECONOMIC WELFARE

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WHAT IS WELFARE ECONOMICS?

According to Policonomics.com, Welfare economics is defined as: “A part of normative economics which objective is to evaluate different situations of a given economic system, in order to choose the best one” The study of Welfare Economics can be traced back to Adam Smith, who related an increase of welfare with an increase on production, and to Jeremy Bentham, whose utilitarian views made him think that welfare was equal to the sum of individuals’ utilities. However, some Economists argued the term, “welfare economics” dates back to Pigou’s text- Wealth and Welfare (1912) and Economics of Welfare (1920). Pigou defined Economic Welfare as: “That part of social welfare which can be brought directly or indirectly, into relation with the measuring-rod of money” or “that “consists in the balance of satisfactions from the use of the national dividend over the dissatisfactions involved in

the making of it” (Pigou 1920: 12).

Business Dictionery.com defined welfare economics as: “Cost-benefit analysis of the allocation of resources, economic activity, and distribution of the resulting

output on a society's welfare”.

Encyclopaedia Britannica defined welfare economics as: “A branch of economics dealing with human welfare, the defining of wealth, and the establishment of guides for social policy aiming at the maximization of total individual utilities”.

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Concise encyclopaedia defined Welfare Economics as: “A Branch of economics established in the 20th century that seeks to evaluate economic policies in terms of their effects on the community's well-being”.

According to Investopedia “Welfare economics is 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 achieved 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”.

PROPONENTS OF TRADITIONAL WELFARE ECONOMICS Traditional welfare economics is based three neoclassical economists: ALFRED MARSHALL: stated that consumer’s welfare was the consumer’s surplus, and therefore was measurable in monetary units. VILFREDO PARETO: Criticized the cardinal view, built a true theory of welfare economics in his book “Manual of Political Economy”, 1906: based on the principles of unanimity and individualism, he designed the Pareto optimality which is the core of welfare economics. PIGOU: wrote “The Economics of Welfare”, 1920, stating that a definition of social welfare must include both efficiency and equity. 20TH CENTURY WELFARE ECONOMISTS Nicholas Kaldor and John Hicks developed the compensation criteria, criticized by Scitovsky, Little and Samuelson, aimed at classifying different optima. Bergson’s social welfare function, and Kenneth Arrow’s impossibility theorem, proved the former could not be identified. Lipsy’s and Lancaster’s second best theorem, aimed at

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finding an optimum that Pareto optimality could not. Finally, cost-benefit analysis marks the validity of welfare economics currently.

CRITERIA FOR SOCIAL ECONOMICS WELFARE Welfare economists are concerned about setting up simple welfare criteria that can be used to evaluate the level of economic well being in a society. Below are some simple criteria proposed to determine if a reallocation of resources will increase social welfare. THE PARETO CRITERION-VILFREDO PARETO (1848-1923) Efficiency criterion was developed by Vilfredo Pareto in his book “Manual of Political Economy”, 1906.

DEFINITION IN TWO STEPS:

A. A change from situation A to B is a Pareto improvement if at least one individual is better off without making other individuals worse off

B. Is Pareto optimal if there is no possible Pareto improvement?

Using Edge-worth box to explain Pareto criterion

Starting from point C, two Pareto improvements can be made:

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-from C to D: individual 1 would increase its utility, since a further indifference curve would be reached, while individual 2 will remain with the same utility. -from C to E: individual 2 would maintain its utility while individual 2 increases theirs.

Once we are at point either D or E, no further Pareto improvements can be made. Therefore, D and E are Pareto optimal. Following the same steps for every indifference curve, we can say that every point in which indifference curves from different individuals are tangent is Pareto optimal. The curve that links these infinite Pareto optima is called the contract curve.

TYPES OF PARETO CRITERION: WEAK PARETO CRITERION: Everyone is made better off.

STRONG PARETO CRITERION: Some people are made better off,

while none is made worse off. Pareto criterion breaks down if even one individual is made worse off.

PURPOSE FOR PARETO CRITERION: Pareto criterion is a technique use for comparing or ranking alternative states of the economy.

LIMITATIONS OF PARETO CRITERION: It breaks down if single individual is made worse off Many alternatives simply not comparable:

(A) Alternative Pareto optimum (corresponding to different income distributions) not Pareto comparable

(B) Pareto criterion does not allow choosing between alternative incomes distributions.

It favors status quo

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Not all first-best Pareto-optimal choices are superior to some second-best (Pareto-inefficient) choices Second-best may have superior income distribution

Pareto Criterion cannot be used to evaluate most projects. Most projects make at least one person worse off. In these cases

the Pareto Criterion gives us no guidance. THE KALDOR CRITERION-NICHOLAS KADOR (1939) This is a compensation criterion developed by Nicholas Kaldor in his paper “Welfare Propositions of Economics and Interpersonal Comparisons of Utility”, 1939. This criterion is satisfied if state Y is preferred to state X and there is such a compensation and reassignment that Y turns to Yˈ that is at least as good as X in a Pareto sense. In the graph below, I illustrate the utility of two persons (A on the x-axis and B on the y-axis), which we will compared using the utility possibility frontier of two different moments.

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When moving from state X to Y, Mr. A’s utility decreases, while Mr. B’s increases. Mr. B is willing to compensate Mr. A and move to Yˈ where both increase their initial utility. The opposite, moving from Y to X, can also occur if the winner, this time A, compensates the looser, Mr. B, and is willing to relocate to Xˈ. When moving from state Y to Z, the utility of Mr. A decreases, while Mr. B’s increases. Mr. B is willing to compensate Mr. A and go to Zˈ where both increase their initial utility. On this case the opposite, moving from Z to Y, would not be feasible.

LIMITATIONS OF KALDOR CRITERION: Scitowsky pointed a key flaw with the Kaldor criterion. The Kaldor Criterion claims that a move from X to Y will increase social welfare, but once at Y the Kaldor Criterion might tell us a move from Y to X will also increase social welfare. This is a key flaw of the Kaldor Criterion. NON-ASYMMETRIC PROBLEM WITH KALDOR’S CRITERION:

In the figure above, at I, the Kaldor Criterion posits a move to II increases social welfare; if at II, the Kaldor Criterion says a move to I increase social welfare. The Kaldor Criterion does not give an asymmetric ordering.

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THE SCITOWSKY CRITERION-TIBOR SCITOWSKY (1941) This was developed by Tibor Scitowsky in his paper “A Note on Welfare Propositions in Economics”, 1941, poised to solve the inconsistencies, -known as the Scitowsky paradox-, that Nicholas Kaldor’s and John Richard Hicks’ criteria presented, he required the fulfilment of both criteria simultaneously. Below, I analyse the graph using the utility possibility frontier of two different moments, where I consider the utility of two persons (A on the x-axis and B on y-axis).

Kaldor’s criterion is met when moving from X to Y, Y to X or Y to Z, but not when moving from Z to Y. However, Hicks’ criterion is only met when going from Y to Z. Therefore, when comparing point Y to Z, winners can compensate the loss of the losers, but losers cannot compensate the other part in order to avoid the change. This is the only case where the Scitowsky criterion is met; making Z preferred to Y. Scitowsky considered the possibility of changes in Pareto terms caused by state changes. This justified the dual requirements. Analytically,

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Although this criterion has some positive contributions, there are still minor changes that need to meet these conditions. The question of a Pareto improvement is yet to be answered. Nevertheless, the Scitowsky criterion contributes to an intransitive organisation of different states

INTRANSITIVITY PROBLEMS WITH SCITOWSKY CRITERION:

SCITOWSKY INTRANSITIVITY RANKING: Point I preferred to II Point III preferred to I Point IV preferred to III But Point II preferred to IV Transitivity should have IV preferred to II. CRITIQUE OF KALDOR AND SCITOWSKY CRITERIA: The Kaldor and Scitowsky Criteria developed tools policy makers could use to know whether implementation of a government project will increase or decrease social welfare. The brain behind this was to come

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up with criteria that didn't involve the comparison of different individual's utility. The Kaldor and Scitowsky Criteria do, however involve equity judgements. Each criterion takes the existing distribution of utility as fair. There is a problem. How can both distributions be "fair"? Both the Kaldor and Scitowsky criteria make equity judgements. They assume the status quo, whatever it is, is fair. They both were developed so we could solve the problem of specifying a Social Welfare and making interpersonal utility comparisons. Unfortunately, they did not accomplish this goal.

HICKS CRITERION-JOHN RICHARD HICKS (1940) Hicks’ criterion was developed by John Richard Hicks in his paper “The Valuation of the Social Income”, 1940. It is similar to that of Kaldor’s, with different implications although with the same limitations. In this criterion, state Y is preferred to X, if there is no potential reassignment that turns X into Xˈ, that is at least as good as Y in Pareto terms. In the graph below I consider the utility of two persons (A on the x-axis and B on the y-axis), which will be compared using the utility possibility frontier of two different moments.

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When moving from state X to Y, Mr. A’s utility decreases while Mr. B’s increases. Base on this, Mr. A should compensate Mr. B so the change of states does not happen, going from X to X’, which will increase B’s utility as much as going from X to Y, while the drop in A’s utility would not be as large. The same would happen if moving from Y to X. Since this ex-ante compensation is possible, neither X is preferred to Y nor Y will preferred to X.

When moving from state Y to Z, Mr. A´s utility decreases while it increases for Mr. B. When going from Y to Z, there is no possible compensation from Mr. A to Mr. B, since to the left of Y the utility possibility frontier is always higher. Mr. A cannot compensate Mr. B, so Z is preferred to Y in Hicks’ terms. However, when comparing moving from Z to Y, logically the opposite occurs. Mr. A’s utility increases while Mr. B’s decreases. Mr. B would compensate Mr. A going from Z to Z’, and hence Y is not preferred to Z.

COMPARING HICKS CRITERION WITH KALDOR’S CRITERION

If we compare Hicks criterion with Kaldor’s criterion some major changes will be seen, still both criteria fall under the Scitowsky paradox. This paradox is centred in the phenomenon that while Y can be preferred to X the opposite can also be true. This does not give a truly asymmetric result as it could just mean that going back to the initial situation is preferred. The economy would therefore oscillate between both points.

LITTLE’S CRITERION--LAN M. D. LITTLE (1949) This was developed by Ian M.D. Little in his paper “A Critique of Welfare Economics”, 1949, and it was a step further for compensation principle theory. Little criticised the distinction between efficiency and

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distribution and he demanded for the Kaldor’s and Hicks’ criteria to hold. Moreso, this criterion also requires that the income distribution

is not worsened by the change of states. This criterion however, brings some limitations, as a result of its implicit value judgement. The criterion will be met, if by a change of states the positively affected person (winner) is poorer than the negatively affected person (loser). I will explain the graph below, where I consider the utility of two persons (A on the x-axis and B on the y-axis), using the utility possibility frontier of two different moments.

SAMUELSON CRITERION-PAUL A. SAMUELSON (1950) The Samuelson criterion, also known as the Samuelson condition, was raised by the economist Paul A. Samuelson in his paper “Evaluation of Real National Income”, 1950, and belongs to the theory of welfare economics and used as a condition for the efficient provision of public goods. This critique provides a way to avoid intransitivity problems:

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state X will be preferred to Y if the alternative of X, X’, is preferred to the alternative of Y, Y’. LIMITATIONS OF SAMUELSON CRITERION: This criterion however, has some limitations, since it is very similar to Pareto optimality. Samuelson explains that previous compensation criteria, such as Kaldor’s, Hicks’ or Little’s, hold just because they consider partial redistribution. COST-BENEFIT ANALYSIS: Cost-Benefit analysis posits a project will increase social welfare if the present value of the benefits from the project is greater than the present value of the costs. This criterion will lead to the correct answers if the social benefits and costs are measured correctly. HOW SOCIAL BENEFITS-COSTS ARE MEASURED: Cost-benefit analysts measure the social benefits and costs by using market prices. But, how are market prices determined? The existing vectors of prices rely on the allocation and distribution of resources. When one uses cost-benefit analysis, one assumes that the existing distribution of income is fair. This is a very strong implicit assumption about equity.

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REFERENCE Allan M. Feldman, Welfare Economics 2006, http://newmonetarism.

blogspot.com/2011/07/economic- Edward Morey, September 9, 2002. Notes on Welfare Economics-111

Proposed Welfare Criteria

Pattanaik, P.K. 2003, “Little and Bergson on Arrow’s concept of social

welfare”, mimeograph

welfare.html, http://www.investopedia.com/terms/w/welfare_eco

nomics.asp#axzz1dxuSDV1L,

welfare.http://www.Policonomics.com