Welfare economics

Welfare economics is a branch of economics that uses microeconomic techniques to evaluate well-being (welfare) at the aggregate (economy-wide) level. Attempting to apply the principles of welfare economics gives rise to the field of public economics, the study of how government might intervene to improve social welfare. Welfare economics also provides the theoretical foundations for particular instruments of public economics, including cost–benefit analysis, while the combination of welfare economics and insights from behavioral economics has led to the creation of a new subfield, behavioral welfare economics. The field of welfare economics is associated with two fundamental theorems. The first states that given certain assumptions, competitive markets produce (Pareto) efficient outcomes; it captures the logic of Adam Smith's invisible hand. The second states that given further restrictions, any Pareto efficient outcome can be supported as a competitive market 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 to social choice theory, Arrow's impossibility theorem is sometimes listed as a third fundamental theorem. A typical methodology begins with the derivation (or assumption) of a social welfare function, which can then be used to rank economically feasible allocations of resources in terms of the social welfare they entail. Such functions typically include measures of economic efficiency and equity, though more recent attempts to quantify social welfare have included a broader range of measures including economic freedom (as in the capability approach). The early Neoclassical approach was developed by Edgeworth, Sidgwick, Marshall, and Pigou. It assumes the following: With these assumptions, it is possible to construct a social welfare function simply 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 the Benthamite tradition. The New Welfare Economics approach is based on the work of Pareto, Hicks, and Kaldor. 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 as Pareto efficiency and the Kaldor-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 with ordinal utility, which merely ranks commodity bundles (with an indifference-curve map, for example). Situations are considered to have distributive efficiency when goods are distributed to the people who can gain the most utility from them.