WELFARE ECONOMICS

THE OBJECT OF GOVERNMENT IS THE WELFARE OF THE PEOPLE. THE MATERIAL PROGRESS AND PROSPERITY OF A NATION ARE DESIRABLE CHIEFLY SO FAR AS THEY LEAD TO THE MORAL AND MATERIAL WELFARE OF ALL GOOD CITIZENS.

~THEODORE ROOSEVELT

Pick up a newspaper any day and you are sure to find a story about a debate concerning the government’s role in the economy.

Should income taxes be cut?
Do we need to subsidize the purchase of medicine for the elderly?
Is it advisable to use public land for oil exploration?

The list is, virtually endless.

The above discussion must have given you a taste of welfare! Yes, today we will be exchanging our views on Welfare Economics.

Welfare Economics, the framework used by most public finance specialists, the branch of economic theory concerned with the social desirability of alternative economic states.

We begin by considering a very simple economy. It consists of two people who consume two commodities with fixed supplies. The economic problem discussed here in welfare economics is to allocate resources such that the amount of two goods between the two people maximizes the welfare of both.

Let the two consumers be A and B and the two goods to be consumed be Food and Clothing. An analytical device known as the Edgeworth Box depicts the distribution of Food and Clothing between A and B.

The welfare of a society, in the broadest sense, depends upon the satisfaction levels of all its consumers. But almost every change in the economic state of the society will have favorable effects on some members and unfavorable effects on others.

The Italian economist Vilfredo Pareto (1848-1923) said that if a change in the economic state makes at least one individual better off without making anyone worse off, then the change is for the betterment of social welfare, i.e., the change is desirable.

Or, it can be said as a situation where one individual can’t be made better off without making some other individual worse off.

Suppose a situation where the total resource of the economy is Rs. 100, where A has Rs. 99 of the total resource and B has Rs. 1.

Now, the above situation is said to be Pareto Optimal because in any condition if we make better off B, we will have to worse off A by the same amount. Thus here it brings a condition where one individual (B) can’t be better off, without worsening off of another individual (A).

Another case where everyone gets Rs. 0.99 and the whole Rs. 99.01 gets wasted, this is not Pareto optimal allocation as we could have allocated the total resource to better off the society. A better case of optimality would be to give a Rs.1 and not giving anything to anyone else. This would make A better off and no one else is worse off.

Let us now link the above, example with Edgeworth box.

In the Edgeworth Box above, each point in the box is an allocation of endowments of both X and Y to A and B.

Let us suppose Q is the endowment point. Now we can draw ICs of A and B, to show how much of X and Y does A and B prefer at endowment point Q.

Moving to the next figure, IC (A & B) shows A’s preferences, and IC (D & E) shows B’s preferences, for different endowment points. In this figure, we see that ICs of A and B intersect each other. This condition is not Pareto Optimal for the reason being that we can still improve any of the party’s allocation and worse off another. That improvement can be found in the eye-shaped region formed by the intersection of the two ICs.

Now, to translate the definition of Pareto efficient condition we must know a point where both ICs are tangent to each other and give the efficient outcome.

The point A and E are the best allocation points or the Pareto optimal points because, at any other point say D or C, we are either going to make A better off and B worse off or vice versa, which violates the Pareto-optimal efficient conditions.

Thus we can draw a diagonal curve in the box which shows that any point on the line is Pareto-optimal as the ICs of A & B are tangent to each other.

In mathematical terms, the indifference curves are tangent where the slopes of ICs are equal. And in economic terms, the absolute value of the slope of the IC curve indicates the rate at which an individual is willing to substitute one endowment for an additional endowment of another; called the Marginal Rate of Substitution.

Hence, Pareto Efficiency requires the MRS be equal for all the consumers: MRS_{A =} MRS_B.