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Welfare Economics

Welfare Economics

What is welfare economics? Is it practical or does it draw a hypothetical economic picture? Let's find out what exactly it is all about.
WealthHow Staff
Economics is a subject that does not greatly respect one's wishes.
~ Nikita Khrushchev

True indeed, because the basic principles upon which the edifice of economics stands are laid upon the foundation of scarcity and choice. Had it not been so, anyone could have had anything he wished for! Wow! Just imagine...life would have been so much easier; but then, we would not have remained the intelligent beings that we are. A life of effortless abundance would have turned the entire human population into vegetables. It is because of this basic principle of economics - that of scarcity and choice - that the entire evolutionary machinery runs. Don't get the link? Well, scarce resources means everyone cannot have equal access to them. That means only the fittest and most deserving will have claim over these resources. This clearly proves the Darwinian maxim survival of the fittest, since survival and social success is directly proportional to the ability of an organism to get a hold on these scarce resources. That was an aerial view of what economics is all about. Now, let's zoom in to understand and what the welfare concept of economics is all about.

What is Welfare Economics?

Economics is all about scarcity, choice and allocation of scarce resources among the various economic factors, collectively known as factors of production, that harness these resources to generate revenue and meet the consumption demands of the society. The welfare concept of economics deals with the optimum allocation of these scarce resources by analyzing the present state of economic welfare based on the current trends of resource distribution. Such an analysis involves the use of analytical tools that are typical to microeconomic evaluations for gaging economic health. These tools measure the economic health by observing the interactions of demand and supply within the economy to ascertain the magnitude of economic efficiency and the associated income distribution among all factors of production. In short, this economic concept strives to incorporate equitable allocation of resources within an economy in order that such an economy achieves the utmost possible degree of economic welfare for every individual existing and functioning within that framework.

So, basically, it all boils down to resource management and distribution with the aim of achieving maximum possible social and economic welfare. There are two approaches to the welfare economy concept - the Neo Classical approach and the New Welfare Economics approach. The Neo Classical approach was developed by such eminent figures in the field of economics as Francis Edgeworth, Henry Sidgwick, Alfred Marshall and Arthur Pigou. This approach is based upon certain assumptions which are as follows:-
  • Cardinal nature of utility;
  • Preferences are stable and are derived from external factors;
  • The law of diminishing marginal utility exists in consumption patterns;
  • Interpersonal comparability of utility functions exist among all individuals within the economy.
A social welfare function ranking possible social states from the lowest to the highest can be constructed by adding all individual utility functions together.

The second approach traces its origins to the intensive research and economic theories developed by the likes of Vilfredo Pareto, John Hicks and Nicholas Kaldor. Rather than the distribution of economic utilities, this approach puts more stress upon the efficiency of the distributed utilities. According to this approach, the distributive efficiency of utilities is determined by ascertaining the degree of requirement for these utilities among the consuming units. To put it simply, those goods or services are said to have maximum distributive efficiency which are most needed by those who receive them or among whom they are distributed.

This is based upon the principle of priority. For instance, a fruit vendor would be operating at total economic welfare if he stocks only those fruits which have a staple demand. He would not bother about stocking other lesser common or exotic fruits which have low demand as he would incur the costs of procuring them but he would not get the proportional revenues out of them. There would be wastage and this would make him run into diseconomies. Distributive efficiency can be achieved only if the following conditions are fulfilled:-
  • Identical marginal rate of substitution in consumption for all consumer units, ruling out the possibility of making a consumer better off at the cost of robbing another consumer of a consumption opportunity;
  • Identical marginal rate of transformation in production for all product units, ruling out the increase of production of one good at the cost of another;
  • The marginal cost of production resources is equal to the marginal revenue of the end product due to the marginal physical product of each factor being the same for all firms manufacturing the same utility;
  • Marginal rate of substitution (consumption) is equal to marginal rate of transformation (production) making it possible for production processes to optimally match consumer demands.
Imperfect market structures such as monopoly and oligopoly make it impossible for distributive efficiency to take form due to price discrimination policies and allocation inefficiencies. Also, tariffs, taxes and other social costs also make it impossible for the economy to achieve distributive efficiency.

Total welfare economics is, thus, more of a hypothesis as it requires perfect market structure-like conditions to be implementable. However, some or the other form of welfare economy mechanisms are always at play, be it in the regulation of markets forces or the fixing of remunerations and prices of various factors of production and utilities, respectively. Most economic mechanisms are of an automatic nature and they exist in the economic system whether or not we deliberately interfere. Welfare concept of economics is no exception.