Welfare economics

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The term economic welfare denotes the well-being of the individual, and the subject matter of welfare economics is the influence of collective decisions upon the welfare of groups of individuals. At the theoretical level welfare economics has provided limited support for other economic theories, and has contributed to philosophical debates about the role of the state. At the operational level it has been widely applied by economic advisers to the problem of estimating the effects of proposed policy changes upon the well-being of those who would be affected. Welfare economics cannot itself provide the value judgments that are frequently necessary for its application, and in its applied form it has to embody judgments provided by the community or its representatives.


The definition of the welfare of an individual is the same as the definition of utility that is presented in the article on that subject, but the problem of defining the welfare of a community is greatly complicated by the logical impossibility of summing increments of welfare to an individual or of making inter-personal comparisons of utility. The nature of that problem is discussed on the tutorials subpage, where it is noted that no completely satisfactory theoretical solution is available.

Theoretical welfare economics

The welfare criteria

The basic definitional criterion of welfare economics states that economic welfare is increased by an action that makes somebody better off without making anybody worse off, termed the Pareto criterion following its statement by the Italian economist Vilfredo Pareto [1].

A more widely employed criterion, termed the Kaldor-Hicks criterion[2][3] which requires that economic welfare is increased by action that can benefit those who gain from it after they have compensated those who lose from it. It has been criticised as a criterion on the grounds that, unless the compensation is actually paid there could be welfare losses from income redistribution[4].

The welfare theorems

The fundamental theorems of welfare economics define the properties of an intensely hypothetical economy in which there are markets for everything that is supplied and that supply every demand, each of which operates in conditions of perfect competition and flexible prices, and which together are in general equilibrium.

In such an economy there are no externalities, no spillovers, no external economies, and no public goods; every firm operates on its production possibility frontier, the price of every product is equal to its marginal cost of production, every wage rate is equal to its wage-earner's marginal product, all consumers are perfectly informed about all products and none are influenced by customs, fashions or advertising.

  • The first theorem states that every complete economy that is entirely made up of perfectly competitive markets is Pareto-efficient when in general equilibrium.
  • The second theorem states that other characteristics of such an economy can be changed without limit without departing from its Pareto-efficient condition, provided that all of its markets continue to be perfectly competitive.

The first theorem is a demonstration that an economy can operate to everyone's satisfaction when each of its members acts solely in his own interests, in the absence of any organised coordination. It can be regarded as highly restricted formal proof of Adam Smith's contention that the economy itself provides a "hidden hand" which coordinates all economic activity. There is no role for government in the first theorem, but one implication of the second theorem is that it is theoretically possible for a government to alter the distribution of wealth without causing an economy to depart from an initially Pareto-efficient condition, provided that it does so without creating departures from perfect competition and flexible pricing. The proviso excludes the use of instruments that alter consumer choice (such as sales taxes, that distort choices between products, and income tax, which distorts the choice between consumption and leisure) leaving only unconditional lump-sum taxes such as a poll tax or a tax on land values.

The two welfare theorems have no direct implications for the analysis of real economies because no real economy has the characteristics that they require. They have had some indirect influence, however, as the result of the work of theorists and philosophers who have experimented with the consequences of removing some of the theorems' more unrealistic assumptions with the intention of deriving some general rules concerning the policies needed to maximise the welfare of the community. Their findings have generally been controversial and inconclusive.

Applied welfare economics

Cost-benefit analysis

Welfare criteria provide the basis of the advice provided to governmental policy-makers concerning the provision of public goods. The usefulness of cost-benefit analysis is limited by the practical problems of measuring welfare changes, but broad estimates can often be obtained from observations of consumers' willingness to pay to gain benefits or to avoid disbenefits.

Competition policy

The conduct of competition (antitrust) policy is complicated by the theorem of welfare economics termed the "theory of the second best" which states that, although perfect competition can be deemed Pareto-efficient, efficiency is not necessarily increased by the removal of anticompetitive practices in an economy which is not otherwise in a state of perfect competition. In principle that theorem undermines the rationale of competition policy but its commonsense implication is the need to take account of the relevant interactions when they arise [5]. The problem of interpersonal comparison seldom arises, but mergers policy is often faced with the difficult problem of setting an increase in allocative efficiency against an alternative increase in productive efficiency. Typically of the practical application of competition policy, many solutions have to be judgmental rather than analytical.


  1. Vilfredo Pareto: Manuale d'Economia Politico, Milan,1906
  2. N Kaldor: Welfare Propositions of Economists and Interpersonal Comparisons of Utility, Economic Journal, September 1939
  3. J R Hicks: The Valuation of Social Income, Economica, May 1940
  4. IMD Little: A Critique of Welfare Economics, Oxford University Press, 1960
  5. For example, in a market dominated by a major supplier, the merger of two of its rivals might be a second-best solution.