Welfare economics 

is a branch of economics that uses microeconomic techniques to

evaluate well-being (welfare) at the aggregate (economy-wide) level.[1]
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.[2]
The field of welfare economics is associated with two fundamental theorems. The first states that
given certain assumptions, competitive markets produce (Pareto) efficient outcomes;[3] it captures
the logic of Adam Smith's invisible hand.[4] The second states that given further restrictions, any
Pareto efficient outcome can be supported as a competitive market equilibrium.[3] 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.[3][5] Because of welfare
economics' close ties to social choice theory, Arrow's impossibility theorem is sometimes listed
as a third fundamental theorem.[6]
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).

Contents

 1Approaches
o 1.1Cardinal utility
o 1.2Ordinal utility
 2Criteria
o 2.1Efficiency
o 2.2Equity
 3Fundamental theorems
 4Social welfare maximization
 5Criticisms
 6See also
 7Notes
 8References
 9Further reading

Approaches[edit]
Main articles: Social welfare function and welfare definition of economics

Cardinal utility[edit]
See also: cardinal utility
The early Neoclassical approach was developed by Edgeworth, Sidgwick, Marshall, and Pigou. It
assumes the following:

 Utility is cardinal, that is, scale-measurable by observation or judgment.

 Preferences are exogenously given and stable.
 Additional consumption provides smaller and smaller increases in utility
(diminishing marginal utility).
 All individuals have interpersonally commensurable utility functions (an assumption that
Edgeworth avoided in his Mathematical Psychics).
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.

Ordinal utility[edit]
See also: ordinal utility
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).

Criteria[edit]
Efficiency[edit]
Situations are considered to have distributive efficiency when goods are distributed to the people
who can gain the most utility from them.
Pareto efficiency is a useful efficiency goal that is standard in economics. A situation is Pareto-
efficient only if no individual can be made better off without making someone else worse off. An
example of an inefficient situation would be if Smith owns an apple but would prefer to consume
an orange while Jones owns an orange but would be prefer to consume an apple. Both could be
made better off by trading.
A pareto-efficient state of affairs can only come about if four criteria are met:

 The marginal rates of substitution in consumption for any two goods are identical for all
consumers. We cannot reallocate goods between two consumers and make both happier.
 The marginal rate of transformation in production for any two goods is identical for all
producers of those two goods. We cannot reallocate production between two producers and
increase total output.
 The marginal physical product of a factor input (e.g. labor) must be the same for all
producers of a good. We cannot reduce production cost by reallocating production between
two producers.
 The marginal rates of substitution in consumption equal the marginal rates of
transformation in production for any pair of goods. Producers cannot make consumers
happier by producing more of one good and less of the other.
There are a number of conditions that lead to inefficiency. They include:

 Imperfect market structures such as monopoly, monopsony, oligopoly, oligopsony,

and monopolistic competition.
 Factor allocation inefficiencies in production theory basics.
 Externalities.
 Asymmetric information, including principal–agent problems.
 Long run declining average costs in a natural monopoly.
 Taxes and tariffs.
 Government restrictions on prices and quantities sold and other regulation resulting
from government failure.
Note that if one of these conditions leads to inefficiency, another condition might help by
counteracting it. For example, if a pollution externality leads to overproduction of tires, a tax on
tires might restore the efficient level of production. A condition inefficient in the "first-best" might
be desirable in the second-best.
To determine whether an activity is moving the economy towards Pareto efficiency, two
compensation tests have been developed. Policy changes usually help some people while
hurting others, so these tests ask what would happen if the winners were to compensate the
losers. Using the Kaldor criterion, the change is desirable if the maximum amount the winners
would be willing to pay is greater than the minimum the losers would accept. Under the Hicks
criterion, the change is desirable if the maximum the losers would be willing to offer the winners
to prevent the change is less than the minimum the winners would accept as a bribe to give up
the change. The Hicks compensation test is from the losers' point of view; the Kaldor
compensation test is from the winners'. If both conditions are satisfied, the proposed change will
move the economy toward Pareto optimality. This idea is known as Kaldor–Hicks efficiency. If the
two conditions disagree, that yields the Scitovsky par