UNIT 14 PIGOVIAN VS PARETIAN

APPROACH
Structure
14.0 Objectives
14.1 Introduction
14.2 Pigovian Approach
14.2.1 Pigovian Analysis
14.2.2 Case for the Market
14.2.3 Case for Improving upon the Market System
14.3 Pareto Optimal Conditions
14.3.1 Pareto-Optimal ity
14.4 Two Fundamental Welfare Theorems
14.5 Let Us Sum Up
I 14.6 Key Words
14.7 Some useful Books
14.8 Answer or Hints to Check Your Progress
14.9 Exercises

14.0 OBJECTIVES
After going through this unit you will be able to:
understand two major approaches, Pigovian and Paretian, adopted in
analyzing economic welfare;
assess the role of market in the attainment of welfare;
examine the Pareto optimality condition; and
evaluate the two fundamental welfare theorems.

14.1 INTRODUCTION
In the ambit of welfare economics, there are two clear trends, Pigouvian and
'
Paretian, which have influenced the analytical content. While the former is
considered as 'cardinalist', the latter is termed 'ordinalist' from the
methodology point of view. In this unit we shall explain both these
approaches including the requirement of value judgment that helps develop
the analysis.

14.2 PIGOVIAN APPROACH

Pigou assumed that the aim of social policy is to 'promote welfare'. But in
order to simplifL this, he chose to restrict the range of his inquiry to 'that part
of social welfare that can be brought directly or indirectly into relationship
with the measuring rod of money'. He therefore suggested that, "this part of
welfare may be called economic welfare". For an individual, Pigou identified
economic welfare with satisfaction by assuming expected and realised
Welfare Economics satisfaction from economic activity to be equal except in the case of the
saving decision.

Pigou had assumed measurability and interpersonal comparison of utility, and

had drawn some conclusions from the premise that aggregate social utility
ought to be maximised. He explained this through the concept of 'ideal output
or ideal allocation'.

For Pigou, a situation 'in which each several sort of resource is allocated in
such a way that the last unit of it in any one use yields a physical product of
the same money value as the last unit of it in any other use' is one of ideal
allocation, irrespective of the distribution of money incomes. If it is a
community comprising rich and poor people, then 'though it is true that
aggregate satisfaction can be increased by departures from this type of
allocation in ways deliberately designed to benefl poor people, it is probable
that departures taken at random, e.g., through the operation of monopoly
power, would diminish aggregate satisfaction'. Therefore, according to Pigou,
such an allocation is properly called the ideal allocation with respect to the
existing distribution of money income.

14.2.1 Pigovian Analysis

The starting point of the Pigovian welfare analysis is the notion that there is a
resource allocation problem that can be optimally solved. Through his work,
Pigou made clear that society was faced with the choice of how to allocate
scarce productive resources to competing ends and was to maximise total
social welfare. In practical terms, this reduced to maximising economic
welfare, "that part of total welfare which can be brought directly or indirectly
into relation with a money measure".

Pigou was concerned about the channeling of "real" factors of production to

their best uses. He saw particular configurations of factors of production as
yielding a measurable worth of total output and sought that arrangement
generating a maximum value.

After setting the main problem of inquiry as 'the allocation of real factors of
production to maximise the total value of output', Pigou tried to describe
some characteristics iadicative of an optimal configuration and define
deviations from this optimal solution as inefficient. A crucial part of the
analysis was the concept of changes in output resulting from a movement of
resourcesfrom one use to another. Pigou defined marginal netproduct as 'the '
difference between the aggregate flow of product for which flow of resources,
when appropriately organised, is responsible and the aggregate flow of
product for which a flow of resources differing from that flow by a small .
(marginal) increment, when appropriately organised, would be responsible'.

Pigou then drew a distinction between social and private marginal net
product. The marginal social net product is the 'total net product of physical
things or objective services due to the marginal increment of resources in any
given use or place, no matter to whom any part of this product may accrue'. It
might happen, for example, that costs are thrown upon people not directly
concerned, through, say, uncompensated damage done to surrounding woods
by sparks from railway engines. All such effects must be included-some of
them positive, others negative elements in reckoning up the social net product
of the marginal increment of any volume of resources turned into any use or
place. The marginalprivate net product is that 'part of the total net product of
 physical things or objective sewices due to the marginal increment of Pigovian vs Paretian
resources in any given use or place which accrues in the first instance i.e., Approach

prior to sale to the person responsiblefor investing resources there'. In some

conditions this is equal to, in some it is greater than, in others it is less than the
marginal social net product. '

In a first pass through the problem, assuming no costs of resource movement,

Pigou noted that a necessary condition for a maximum is that the marginal
social net product (MSNP) of each resource employed in any use or place be
exactly equal. Were resources to be distributed so that the MSNP of each
factor of production was unequal, the total value of output could be increased
by moving resources from uses with lower MSNP to those with higher MSNP.
This straightforward application of the equinlarginal principle is the key to
Pigou's analysis.

The natural extension to the notion of an ideal, global optimum is

consideration of impediments that block the realisation of the best possible
result. Starting from a decentralised system in which self-interested resource
owners make decisions concerning the employment of their labor and capital,
Pigou presented a framework that paired "obstacles to free movement" and
divergence of private from social marginal net product as two fundamental
elements that prevent resources from flowing to their best uses.
I
Obstacles to free movement are composed of 'costs of movement and
imperfect knowledge'. For Pigou, costs of movement include 'not only the
payments to the agents who transport factors of production from one place to
another ("promoters, financing syndicates, investment trusts, solicitors,
i bankers and others", but also the imperfect divisibility of productive
i resources'. De Serpa points out that Pigou's costs of movement can be broadly
interpreted to include 'transactions costs' of every type (principal-agent,
holdout and similar problems). In other words, it would seem more correct, to
consider Pigou's overarching category, "obstacles to free movernent," which
encompasses both costs of movement and imperfect knowledge, as the
appropriate counterpart to today's "transactions costs."

When the assumption of no costs of movement is relaxed, Pigou modifies the

optimal solution to be one in which the MSNP of each resource diverges by
less than the cost of movement. Obviously, if the gain from driving two
MSNPs to equality is outweighed by the cost of the movement, then such a
move is inefficient. Thus, in the presence of costs of movement, a given
configuration might show some inequalities in MSNP yet may be the best
arrangement, not indeed absolutely, since if there were no costs, a better
arrangement would be possible, but relatively to the fact of the initial
distribution and the existing costs of movement.

Pigou also discussed second order conditions and considered the implications
of several local maxima. He offered the possibility that State action might be
"justfled" if it could 'yerk the industrial system out of its present poise at a
position of relative maximum, and induce it to settle down again at the
position of absolute maximum-the highest hill-top of all. Later, however, he
adds that worries about relative versus global maxima are a "secondary
matter" (see Hla Myint, "Theories of Welfare Economics", Harvard
University Press, 1948, p. 128).

After discussing how imperfect knowledge can, like costs of movement,

prevent the attainment of an optimal resource allocation, Pigou turned to the
welfare Economics issue of divergence between private and social marginal net products. It is
important to note that Pigou sees obstacles to movement and divergence of
private and social net product as separate, but possibly concurrently operating
factors, either of which may be manipulated by the State in order to effect an
improved allocation of resources.

For Pigou, the problem facing society is one of allocating resources so that the
total value of output is maximised. He makes extensive use of the "$owing
resources" metaphor: A flowing stream of resources is continually coming
into being and struggling, so far as unavoidable costs of movement allow of
this, to distribute itself away from points of relatively low returns towards
points of relatively high returns. A clear signal of the performance of any
observed configuration of resources is the marginal social net product of each
resource. There is an answer to society's resource allocation problem and,
thus, deviation from optimality cannot only be judged inadequate, it can be
improved1.

14.2.2 Case for the Market

With the objective of maximising total value of output focused on observing
real factors of production, through the logical 'tool of marginal product, and
the awareness of obstacles to movement and divergences of private and social
product, Pigou set about judging how well a market system performs. He
considered the market allocation mechanism as the default scheme and was
interested in comparing the optimal resource configuration to that yielded by
the market system.

Pigou thought it a settled matter that the market system often generated an
optimal solution and, thus, did not spend much time or effort explaining this
result. Self-interested resource owners, unhampered by ignorance, seeking to
maximise their private returns, will allocate resources so that marginal private
net products will everywhere deviate by less than the costs of movement and,
thus, the sum total of returns will attain a maximum. If private and social
products are equivalent, the free play of self-interest yields a socially optimal
allocation.

14.2.3 Case for Improving upon the Market System

Unlike the "optimistic followers" of the "classical school" who believed that
markets would "natural!yn or "automatically" produce a socially optimal
result "if only Government refrains from interference,'' Pigou pointed out that
"even Adam Smith himself" recognised the needfor "an organised system of
civilised government and contract law." So, the invisible hand, the
spontaneous order and the self-organised, emergent patterns that are touted as
congruent with a socially optimal configuration are not a routine outcome of
.
every decentralised system. On the contrary, human institutions and rules have
evolved "to the end of directing self-interest into benejcial channels." There
is no reason to reject out of hand "Government interference" because
Government is already intimately involved in the system.

For Pigou, Government sets the rules to which the agents respond. He
advocated State action in selective and studied ways and did not propose
direct government control of individual agents; instead, he saw government

' M. W. Reder, Studies in the Theory of Welfare Economics, Columbia University Press, New
York, 1947, p. 34.
 providing the necessary incentives, carrots or sticks that would improve upon Pigovias w Paretian
the current allocation of resources. This implies Pigou's continued reliance on Approach
individual ownership and control of resources by self-interested agents.
Returning to his framework of deviations from an ideal, global optimum being
caused by obstacles to movement and divergences of private from social
product, he argued that decreases in either of these factors would improve
economic welfare. In successive chapters in The Economics of Weyare, he
described how decreases in obstacles to movement due to improved
information or lower costs of movement could be effected by manipulating
the rules of the market game. For example, Pigou sees the development of
stock exchanges as an ingenious way to make capital more finely divisible.
This lowers the costs of movement of capital because it can flow more
perfectly, in Pigou's metaphor, 'into ever-smaller streams and tributaries'.
But with regard to inefficiency caused by imperfect knowledge, Pigou cites
securities regulations as an appropriate means of combating fraud and the
associated misallocation of resources because they check the fraudulent
! exploitation of incompetent investors by dishonest professionals and thus tend
to diminish the range of error to which the general mass of operative forecasts
made in the community is liable.
His view of a stock exchange and the government regulatory apparatus
surrounding it shows how Pigou saw the market system as a decentralised
group of self-interested resource owners making decisions about the use of
their factors of production under a set of rules designed to channel those
resources to their highest valued uses.
When Pigou turns his attention to the second main category that leaves a
socially inefficient allocation, the divergence of private and social returns, he
simply applies the same set of ideas.
Subject to costs of movement, self-interest will tend to bring about equality in
the values of marginal private net products of resources invested in different
ways. But it will not tend to bring about equality in the values of the marginal
social net products except when marginal private net product and marginal
social netprgduct are identical. When there is a divergence between these two
sorts of marginal net products, self-interest will not, therefore, tend to make
the national dividend a maximum; and, consequently, certain specific acts of
interference with normal economic processes may be expected, not to
diminish, but to increase the dividend.
, Uncompensated services or disservices cause divergences between private and
social product that are "bound to lead to maladjustments." In such cases, it is
always possible, on the assumption that no administrative costs are involved,
to correct them by imposing appropriate rates of tax on resources employed in
'.
uses that tend to be pushed too far and employing the proceeds to provide
bounties, at appropriate rates, on uses of the opposite class.
There is no need to go into further detail because in the discussion on
'externality' in coming units, we shall explore the conditions under which
"appropriate" tadsubsidy schemes will correct the "maladjustment." The
point here, however, continues to be that Pigou saw tadsubsidy manipulations
as one way to improve the incentive structure of the system. Agents maintain
control of their resources and follow their self-interest in generating a
configuration of resource uses. For this reason, taxes and subsidies are merely
one of a myriad of incentive-altering options available. Pigou cites penalties in
contracts or threat of lawsuit, for situations in which the parties are in dirqct
contact, as other ways of closing the gap between private and social product.
WeHare Economics When it is difficult to extract payment for services or damages to other parties,
Pigou sees the Government as the means by which the rules can be rewritten
to better align private and social marginal net products. In the case of patents,
Pigou pointed out that, "By offering the prospect of reward for certain types of
invention they do not, indeed, appreciably stimulate inventive activity, which
is, for the most part, spontaneous, but they do direct it into channels of general
usefulness."
In some cases, the divergence of private and social product may be so
pathological, e.g., fraudulent advertising or adulterated products, because
from the first dose the MSNP is negative, that absolute prohibition is required.
And, finally, when other remedies have been exhausted, there may be certain
cases in which direct government intervention, "either by the exercise of
control over concerns left in private hands or by direct public management"
may be necessary in order to maximise the national dividend. In these extreme
cases, Pigou warns that we should not proceed, until we have considered the
qualifications which governmental agencies may be expected to possess for
intervening advantageously. It is not sufficient to contrast the imperfect
adjustments of unfettered private enterprise with the best adjustment that
economists in their studies can imagine. For, we cannot expect that any public
authority will attain, or will even whole-heartedly seek, that ideal. Such
authorities are liable to ignorance, to sectional pressure and to personal
corruption by private interest.
Consistent with his focus on maximising the national dividend, Pigou warned
against blind application of every conceivable rule that could lower the
obstacles to movement or close the gap between private and social marginal
net product. The gains from the proposed incentive must be weighed against
the costs of implementation: "Of course, in real, life considerable
administrative costs would be incurred in operating [tadsubsidyl schemes of
this kind. These might prove so large as to outweigh the benefit even of the
optimum scheme, and, a fortiori, of the others".
Pigou's view of the economic world has self-interested individuals operating
within a given system of institutions and rules of which the Government is a
major part. The system works fairly well, according to Pigou, "in the main
body of industries," but can be improved upon by decreasing obstacles to
movement and divergences between private and social cost. Government is
responsible, not for the direct control of resources, but for providing an
environment, which ensures that the free play of self-interest will yield the
maximum total value of output. Seen in this context, Pigovian tadsubsidy ,
proposals are merely one of many devices that Government might use, in
addition to many already in effect, in order to maximise economic welfare by
improving the incentive mechanisms operating in a completely unfettered
market. Thus, Pigovian analysis constitutes the foundation of welfare '
economics, which inspired the modem economists to comprehensively
elaborate on the subject in succeeding periods.
Check Your Progress 1
1) What constitutes the starting point of Pigouvian welfare analysis?
 2) What is ideal output or ideal allocation as mentioned by Pigou? Plgovirn vs Parctian
Approach

3) What are obstacles to free movement? Explain how they affect welfare
situations?

4) What are the conditions of optimum welfare in Pigovian analysis?

5) Does market system always generate socially optimal solution in the

Pigovian analysis?

14.3 PARETO OPTIMAL CONDITIONS

-
A change that can make at least one individual better off, without making any
other individual worse off is called a Pareto improvement. An allocation of
resources is Pareto efJicient when no further Pareto improvements can be
made.

The term is named after Vilfredo Pareto, an Italian economist who used the
concept in his studies of economic efficiency and income distribution. If an
economic system is not Pareto eflcient, then it is the case that some
individual can be made better off without anyone being made worse off. It is
commonly accepted that such inefficient outcomes are to be avoided, and '
therefore Pareto eflciency is an important criterion for evaluating economic
systems and political policies.
-- -

Welfare Economics In particular, it can be shown that, under certain idealised conditions, a system
of free markets will lead to a Pareto efficient outcome. This was first
demonstrated mathematically by economists Kenneth Arrow and Gerald
Debreu, although the restrictive assumptions necessary for the proof mean
that the result may not necessarily reflect the workings of real economies.

The original constructors of the Paretian system were satisfied with the
equality of the number of equations and unknowns to establish the existence
of equilibrium. Instead of pursuing this question more vigorously, their
attention was turned onto something else: supposing such a set of prices did
exist, is the resulting equilibrium allocation an "efficient" one? By
"efficiency" they referred to the concept of "Pareto optimality": i.e., a
situation is Pareto-optimal if by reallocation you cannot make someone better
off without making someone else worse off.

However, not every Pareto eflcient outcome will be regarded as desirable.

For example, consider a dictatorship run solely for the benefit of one person.
This will, in general, be Pareto optimal because it will be impossible to raise
the well-being of anyone except the dictator without reducing the well-being
of the dictator, and vice versa. Nevertheless, most people (except perhaps the
dictator) would not see this as a desirable economic system.

There is often more than one Pareto efjcient outcome for a given amount of
resources. For example with a dictatorship, both with dictator X or with
dictator Y, the outcome will be Pareto eflcient because in the first instance it
will be impossible to raise the well-being of anyone without reducing X s
benefit and similarly for Y.

On the basis of resource allocation in order to achieve pareto optimality, there

are two types of allocation analysed from the point of view of degree, strongly
allocated or weakly allocated. A strongly Pareto optimal (SPO) allocation is
one such that it is strictly preferred by one person, and no other allocation
would be as good for everyone. A weakly Pareto optimal (WPO) allocation is
one where a feasible reallocation would be strictly preferred by all agents.

14.3.1 Pareto-Optimality
On the basis of the definition given by Pareto, three important sets of
efficiency conditions are to be considered. They are (a) production efficiency
or optimal allocation of factors; (b) consumption efficiency, or (c) product
mix efficiency or Optimum Direction of Production. The three sets of
efficiency conditions can be expressed through equality conditions as follows:

a) Consumption Efficiency: MRS~XY= M R S for

~ any
~ ~pair of households,
A, B and any two goods, X, Y.

b) Production Eflciency: M R T S ' ~ =

~ M R T S for
~ ~any
~ pair of outputs, X,
Y, and any two factors, K, L.
c) Product Mix Eficiency: MRsAxy = MRPTxy for any household A and any
pair of outputs, X, Y.

These marginal conditions are based on the following important assumptions:

Each individual has hisher own ordinal utility function and possesses a
definite amount of each product and factor.
 Production function of every firm and the state of technology is given and Pigovian vs Paretian
remains constant. Approach

Goods are perfectly divisible.

A producer tries to produce a given output with the least-cost combination

of factors.

Every individual wants to maximise hisher satisfaction.

Every individual purchases some quantity of all goods.

I All factors of production are perfectly mobile.

I We shall explain each condition in detail.

The marginal condition of production efficiency requires that the available

factors of production should be utilised in the production 6f different goods in
such a manner that it is impossible to increase the output of one good without
a decrease in the output of another or to increase the output of both the goods
by any reallocation of the existing factors of production. This situation would
be achieved if the marginal technics! rate of substitution between any pair of
factors must be the same for any two jirms producing two dlflerent goods and
utilizing both the factors to produce the goods. This condition can be

1 explained with the help of Edgeworth-Bowley box diagram as depicted in

Figure14.1.

Consider the case of a two sector model: there are two firms producing two
goods in the economy, X and Y, using two factors of production, say, labour
and capital. At point G, the two firms are producing output levels X and Y
through allocation of resources. Although existing factors are fully utilised,
yet, this allocation is "Pareto-inefficient". This implies that, we can reallocate
factors between firms such that firm Y increases output from Y to YO and firm
X stays at the same level of output as before. Thus, moving from allocation G
to allocation F is a Pareto-improving movement. In contrast, this new
allocation, point F, is obviously a Pareto-efficient situation, as any attempt to
reallocate resources in order to increase output of one firm inevitably requires
a reduction in output of the other.

Further, it can be seen that, fiom the isoquants formed at any possible
allocation, if there is "lens" between the two isoquants; then we can undertake
a Pareto-improving reallocation. As evident fiom the above figure, an
allocation such as G will yield output levels that will lie in the interior of the
production possibilities set (the area below the Production Possibility
Frontier). Thus, one of the first conditions for Pareto-efficiency is that the
marginal rates of technical substitution between any two factors must be the
same among all firms. In this case, M R T S ' ~ ~= MRTS'~~,which, in turn,
implies that output combinations will belie on the PPF.
 Fig. 14.1: Movement from Inefficient to EfFicient Allocation

Though the equality of the MRTS is the central production efficiency

condition in a two-sector model, yet, there is another production efficiency
condition. Suppose, there are two firms, say, A and B, both producing outputs
X and Y. They each have their own (possibly different) PPFs and thus
whatever output mix they produce will define their own marginal rate of
product transformation between the two goods, X and Y. Thus, production
efficiency in this case requires that both firms should produce output mixes
where they have the some marginal rate of product transformation, i.e.,
M R P T A ~=~ M R P T ~ ~ ~ .
This efficiency condition is applied in analyzing the theory of comparative
advantage in international trade. Consider A and B to be different nations,
each producing two different goods. Then production will be efficient if each
country specializes and trades (i.e., changes output combinations) until their
MRPTxYare equal. If they are already equal, then no specialization is possible
as the opportunity cost of gcod X in terms of good Y (i.e., MRPTxy) is the
same in both firmslcountries.

This production efficiency condition can be explained with the help of -

mathematical equations. Abba Lemer has summarised the production
efficiency conditions in the following simple rule. Suppose we have 'F'
number of firms, producing 'n' number of goods by using 'm' number of
factors. Lerner proposed a general "transformation" function of the following
form for the ffh firm:

Where xf = [xlf, x,, ..,]:x and an xi'can be either an input or an output.

Lerner's Rule, therefore, is that for any two firms, f, g = 1,2, ..., F such that

&i'l&,j'=&ig/&jg for any i, j = 1,2, .., n+m.

If xi is an output and xj is an input, then this equation states that the marginal Pigovinn vs Pnnthn
product of xi should be the same for both firms. If both xi and x, are input, Approach
then this states that the marginal rates of technical substitution between the
inputs are the same for both firms (MRTS'~ = MRTSgu).Finally, if xi and xj
are both outputs, then this states that the marginal rate of product
transformation are the same for both firms (MRPT',, = MRTSgij).

The second main marginal condition for Pareto-optimality is consumption

eficiency. It is to be noted that, in a consumer Edgeworth-Bowley box as
shown in Figure 14.2 below; there are always gains to exchange till the
allocation moves a point on the contract curve. Consider point E, where A
receives goods, xA and Y* and her utility is uA(E) and B receives
combination of goods, xBand yB and her utility is uB(E). This is a Pareto-
inferior allocation because through reallocation one's say A's utility can be
increased without reducing the utility of B and vice versa. For instance, if by
exchanging A's allocation of good Y with B's allocation of good X, thereby
moving from allocation E to allocation D, B's utility will increase, which rises
from u ~ ( E )to u ~ ( D ) )without worsening A's utility, which stays at u A ( ~ ) ) .
As can be seen, allocation D is Pareto-optimal because any further
reallocations to increase one's utility cannot be done without reducing the
utility of the other.

Fig. 14.2: Consumption Edgeworth-Bowley Box

As evident from Figure 14.2, D is Pareto-superior to E, but it is not the case

that another Pareto-optimal allocation, such as C, is also Pareto-superior to E.
In fact, C is not comparable to E by the Pareto criteria because one cannot go
from initial allocation E to allocation C without reducing B's utility (as B's
utility at C is lower than that at E). Thus, while D is Pareto-superior to E,
allocation C is not Pareto-comparable to either E or D.

We know that the contract curve that connects origins OAand OB represent the
set of Pareto-optimal allocations. It can be seen that, unlike the case of
wc~are
koaomics production efficiency, the shape of the contract curve for consumers is not
clearing comparison to that for the producers. However, it is to be noted that
the condition for consumption efficiency requires that an allocation between A
and B has to be Pareto-optimal and it must lie on the contract curve.
Moreover, the second order condition is that the marginal rate of substitution
between two goods be the same among all consumers. In other words, for
consumption efficiency of A and B, M R S ~ X ~
= MRS~XY.

The third condition for Pareto-optimality is that of product-mix efJiciency

which states that the marginal rate of substitution between two goodsfor any
consumer be equal to the marginal rate of product transformation between
those goods, i.e., M R S ~ =X MRPT*.
~ In other words, the marginal utility of
good X with respect to Y equals the marginal cost of good X with respect to
Y. The "efficiency" of the third condition may be explained easily, but it can
be simplified by using the "community indifference curve" (CIC) or the
"Scitovsky indifference curve" (SIC) as put forth by Tibor Scitovsky.

Community indifference curves can be viewed in various ways. CIC is a set of

output combinations that yield the same "aggregate utility". We can explain
this diagrammatically in a simple two-sector model, as in Figure 14.3. As
shown in the figure, at point F, the consumers A and B have the output levels,
XF and YF,which set the borders of an Edgeworth-Bowley box. Suppose that
there is some allocation of that output between the two individuals A and B
such that M R S =~MRS~XY,~ denoted by point CF in the Edgeworth-Bowley
box. Let us denote the utility levels achieved by agents A and B at point CFas
uA(c) and uB(c). Thus, assuming comparability of utility, it can be argued
that "aggregate" utility is the combination of the two utility levels, e.g., U(C)
= u A ( c )+ uB(c).

To derive the CIC, we have to change the outputs X and Y such that the
consumers remain at their same utility levels they had at C (and thus retain the
same "aggregate" utility, U(C)). However, changing outputs X and Y changes
the dimensions of the Edgeworth-Bowley Box. Clearly, if we see F as the
origin of agent B, then changing output levels from F = (XF, YF) to G = (XG,
YG) we are changing the agents B's origin from F to G. Consequently, the
whole indifference map of agent B changes. Of course, the indifference map
of A does not change as it starts from the bottom left origin, OA.Nonetheless,
if the change in output is done carefully enough so that the utilities of A and B
do not change, we need to somehow remain on A's indifference curve u*(c)
and the tangency of that curve with the indifference map of agent B (at point
CG) will yield an indifference curve for B that has exactly the same utility
level as it had before (i.e., uB(c)). Thus, at output levels (XF,YF) and (XG,
Yo), both A and B have the same utility levels, u*(c) and uB(c) that they @.h
before. In this case, aggregate utility, U(C), remain the same as a result of the ,.
movement from F to G and thus we can say that F and G lie on the same
"community indzflerence curve", U(C). It is to be noted that the slope of the
CIC curve at point F is the same as the slope of the individual indifference
curves at point CF. Similarly, the slope of the CIC at point G is the same as the
slope of the individual indifference curves at point, CG.
 Fig. 14.3: Construction of the CIC

Scitovsky suggested considering the CIC as the minimal levels of outputs X

and Y that yield the same utility for each consumer, so that, CIC can be
constructed algebraically via a minimisation problem. To put it, given a fixed
amount of good X (say Xo), we wish to find the minimum level of Y so as to
keep both A and B at a particular utility level (say, uA(x,Y) = uAoand uB(x,
Y) = uBo). From consumption efficiency, we require that X = xA+ xBand Y
= yA+ yB. In other words, it states, quite simply, that the slope of the CIC
curve is equal to the slope of the indifference curve for A, i.e., M R S " ~ .Thus,

The CIC curve that is constructed for a particular level of utility U(C),
however, is not the only CIC curve that can be constructed that passes through
point F. In the same Edgeworth-Bowley box - and thus at the same levels of X
and Y - we can construct a different CIC curve by considering a different level
of aggregate utility. This is shown below in Figure 14.4.

As can be seen, in the Edgeworth-Bowley box constructed from point F, we

have isolated two points of allocation, C and D, each yielding different levels
. of individual and aggregate utility. From point C, we have U(C) = u A ( c ) +
uB(c) and thus are able to construct CICc corresponding to that aggregate
utility level, U(C). From point D, we have U(D) = u ~ ( D )+ u ~ ( D )from which
we construct CICD corresponding to aggregate utility level U(D). As both
U(D) and U(C) are attainable from allocations within the Edgeworth-Bowley
box emanating from point F, both CICc and CICDpass through F.
Welfare Economics

Fig. 14.4: Intersecting CIC Curves

There is no reason to assume that CICc and CICD have the same slope.
Indeed, as long as the indifference curves of both agents within the
Edgeworth-Bowley box have different MRSs at points C and D, CICc and
CICDwill necessarily have di'fferent slopes at point F and intersect each other.
These different slopes of the CICc and CICDcurves at point F, are captured by
examining the price lines tangent to CICc (with slope -(p~/py)C - which is also
tangent to the MRSs of the agents at point C) and CICD(with slope - ( p ~ / p ~-) D
which is also tangent to the MRSs at point D).

There are infinite numbers of allocations along a contract curve from F to OA

representing different tangencies. This implies that there could be an infinite
number of CIC curves that pass through point F. Intersecting CIC curves are
not troublesome, unless we wish to visualize the CICs as representing a social
indifference mapping over outputs.

In the figure, CICc is tangent to the PPF while CICD is not. Now, both CICc
and CICDrepresent different aggregate utility levels and, it cannot be said as
to which one is superior because of their intersecting properties. However, it is
to be noted that CIC, represents a Pareto-optimal allocation whereas CICD .
does not. This is explained in Figure 14.5.

As shown in the figure, at output combination F and our allocation of that

output among households is at point D so that we are faced with CICD,We can
move along the CICD curve to point G with~utreducing anyone's utility (as
we saw before, everywhere alon% the CICD, the utility levels of persons
remain unchanged, at u ~ ( D )and U (D) respectively). At the new point G, we
form a new Edgeworth-Bowley box with size XG and YG and the origin of
agent B at G. Yet, note that G is in the interior of the production possibilities
set and thus it represents an inefficient point. In other words, it is not true at G
that the MRTSKLfor both outputs are the same. Consequently, we can expand
output outwards from point G to point E, thereby expanding outputs from XG
to XE and YG to YE. This will increase the utility of agent B (as B's "distance
from the origin" is greater, and B's utility at allocation D is greater than
before) while not affecting the utility of A (still at u A ( ~ ) )In. short, by moving
 from G to E, we have undertaken a Pareto-improving allocation. This is Pigovhe vs Parctha
Approach
represented graphically in Figure 14.5 as an upward shift in the CICDcurve to
a new, higher level of aggregate utility, CICw,

Fig. 14.5: Intersecting CIC Curves

Thus, this implies that undertaking a Pareto-improving reallocation 6om the

original point F to point E, then point F could not have been a Pareto-eficient
allocation. However, this result depends crucially on the fact that CICDwas
not tangent to the PPF at point F. If we had instead an allocation in the
Edgeworth-Bowley box such that we had CICc at point F, which is tangent to
the PPF, then we immediately see that a Pareto-improving reallocation is not
possible. Thus, the third condition for Pareto-optimality, that MRSW =
4
MRPTXYmakes perfect sense, as MRSxy is the slope of the CIC curve at any
output combination. Incidentally, the set of outputs that yield Pareto-superior
allocations to a particular output combination is known as the "Scitovsky set".
Thus, in Figure 14.5, the Scitovsky sets of points F and G are merely the set of
outputs above CICc and CICDrespectively. It shows that any CIC can be seen
merely as the lower boundary of the Scitovsky set defined at a point.

Clearly, as a concept of "efficiency", Pareto-optimality may seem quite

adequate, but as a concept of "optimal", in any ethical sense, it is definitely
not suficient. As Amartya Sen notes, 'an economy can be Pareto-optimal, yet
still "perfectly disgusting" by any ethical standardsy2.It is thus of crucial
importance to recall that Pareto-optimality, is merely a descriptive term, a
property of an allocation, and that, at least a priori, there are no ethical

Amartya Sen, On Ethics and Economies, Welfare and Measurement, Harvard University
Press, 1990, p. 34.
WeMarc ~cbsomics propositions about the desirability of such allocations inherent within that
notion. Thus, there is nothing inherent in Pareto-optimality that implies the
maximisation of social welfare.
A second important note to recall is that Pareto-optimality is a general
equilibrium notion and thus quite dependent on what we wish to include. For
instance, two particular countries may have Pareto-optimal allocations within
themselves, but when allocation is made for the trading opportunities that
exist between both countries, the general allocation is no longer Pareto-
optimal.
In the literature of welfare economics, quite often, the terms Pareto-optimality
and Pareto-eflciency are interchangeably used. Nonetheless, the term Pareto-
efficiency is somewhat inadequate as some people naturally think of efficiency
as a "technological" feature; but efficiency in production is only one part of
what we mean. By "efficiency, in a Paretian context, we are also required to
take into consideration "consumer efficiency". Thus, an economic situation
can be "efficient" in a production sense, yet "inefficient" in a general Paietian
sense.
Moreover, Pareto's own term, "maximum ophelimity", may not be a much
better way of conveying the purely descriptive (and ethically neutral) meaning
of the concept of Pareto-optimality. Perhaps the best description of Pareto-
optimality is the underutilized concept, coined by Maurice Allais: "an
allocation is "Pareto-optimal" if there is an "absence of distributable
surplus "3. This is an excellent term as it conveys the true meaning of Pareto-
optimality and suboptimality. One can think of a "distributable surplus" as the
set of mutually beneficial (or at least not harmful) trades between parties
(firms, agents, countries, etc.)'that have not been undertaken (e.g., the "lens"
between indifference curves or isoquants in an Edgeworth-Bowley box
constitutes a "distributable surplus"). By Allais's definition, if there is no
distributable surplus, the situation is clearly Pareto-optimal.

Check Your Progress 2

1) What do you mean by Pareto optimality?

2) Distinguish between strongly Pareto optimal and weakly Pareto optimal .

allocation.

Anthony Barnes Atkinson, "The Economics of the Welfare State", American Economist,
Vol. 40, 1996.
3) Are all Pareto efficient situations optimal?

......................................................................................
4) What are the conditions of Pareto optimality?
......................................................................................
......................................................................................
......................................................................................
......................................................................................
5) What is community indifference curve?
......................................................................................
......................................................................................
......................................................................................
......................................................................................
6) What is Scitovsky Set?
......................................................................................
......................................................................................
......................................................................................
......................................................................................

14.4 TWO FUNDAMENTAL WELFARE

THEOREMS
The Fundamental Theorems of Welfare Economics link the concept of a
competitive equilibrium with that of a Pareto-optimal allocation. There are
three crucial conditions for Pareto-optimal allocations in a Paretian system, as
laid down explicitly by Abba Lerner and Harold Hotelling:
Consumption Efficiency: M R S ~ X =
Y MRSBxy for any pair of households,
A, B and any two goods, X, Y.
Production Efficiency: M R T S ' ~ =
~ MRTS'KL for any pair of outputs, X,
Y, and any two factors, K, L.
Product Mix Efficiency: MRSAxv= MRPTxy for any household A and
any pair of outputs, X, Y.
As we can see these conditions are similar to those for equilibrium we stated
earlier. In fact, they are (almost) identical. The two Fundamental Theorems of
Welfare Economics, which stretch back to Pareto (1906) and Barone (1908),
can thus be stated as follows:
Welfare Ecoaomki First Fundamental Welfare Theorem: every competitive equilibrium is
Pareto-optimal.
Second Fundamental Welfare Theorem: every Pareto-optimal allocation
can be achieved as a competitive equilibrium after a suitable redistribution
of initial endowments.
The First and Second Welfare Theorems were proved graphically by Abba
Lerner (1934) and mathematically by Harold Hotelling (1938), Oskar Lange
(1942) and Maurice Allais.

Graphically, the basic idea of the First Theorem is simple: as we discussed

above in the equilibrium in the Paretian system, if we have a competitive
equilibrium, all three of the Pareto-optimal conditions are met. The Second
Welfare Theorem is almost equally clear intuitively: any Pareto-optimal
allocation fulfills the three conditions. Thus, assuming differentiability, we
can place price lines with slope px/py between the indifference curves so that
M R S X= ~ px/pY
~ = MRsBn. Further, we can place the same price line with
the same slope between the CIC and the PPF so that MRsAxy = pxIpy =
MRPTxy are on the PPF (by production efficiency), and then we can place a
factor price line with slope rlw between the iso uants of the production
Edgeworth-Bowley box so that M R T S ' ~ ~ 1
= MRTS KL. Of course, the series
of price lines we are inserting in this case may not correspond to the budget
constraints of households properly speaking as we are only determining their
slopes and not their precise location - which depends on endowments. Thus,
the Second Welfare Theorem requires that we "adjust" the budget constraints
(i.e., reallocate endowments) so that, upon utility-maximisation, the resulting
allocations will be equivalent to the Pareto-optimal one we are trying to
reach.

Check Your Progress 3

1) What is the role of fundamental welfare theorem?

2) Explain the two fundamental welfare theorems.

LET US SUM UP
In this unit, we started with two trends of welfare economics such as Pigovian
and Paretian. We saw how Pigou explained that the major problem of the
society is that of resource allocation and he analyzed optimum welfare
through his concept of ideal output. Pigou pointed out that the main objective
of society is the maximisation of welfare, that part of welfare, which can be
measured in money. Further, he explained how the market system plays a role
in obtaining optimum welfare and the case for improving upon the market Pigovian vs Pantian
conditions in order to maximise social welfare. However, Pigovian analysis is Approach

purely cardinal and subject to value laden.

Pareto on the other hand based his welfare economics on ordinal principles
and emphasised on the concept of Pareto optimality. We saw how the
condition of Pareto optimality is obtained through production efficiency,
consumption efficiency and product-mix efficiency. We also explained how
consumer indifference curve play a role in establishing pareto optimal
conditions. At last we analysed the two fundamental welfare theorems that
link the competitive equilibrium conditions with the Pareto optimal allocation.
We found that Pareto optimal and Pareto efficient are different concepts. The
allocation, which is Pareto efficient from the point of view of production, is
not optimal from the point of view of consumption.

14.6 KEY WORDS

Community Indifference Cuwe: A set of output combinations that yield the
same level of aggregate utility.

Contract Curve: A contract curve is the set of all points in an Edgeworth box
that are Pareto efficient.

Edgeworth Box: An Edgeworth box, named after Francis Ysidro Edgeworth,

is a way of representing various distributions of resources. Imagine two
people (Mahesh and Abhay) with a fixed amount of resources between the
two of them--say, 10 liters of water and 20 cakes. If Mahesh takes 5 liters of
oil and 4 liters of water, then Abhay is left with 14 cakes and 6 liters of water.
The Edgeworth box is a rectangular diagram with Mahesh's origin on one
comer (represented by the 0) and Abhay's origin on the opposite comer
(represented by the A). The width of the box is the total amount of one good,
and the height is the total amount of the other good. Thus, all possible
distributions of the goods between the two people can be represented as a
point in the box. The curve connecting points 0 and A is often called the
contract curve. Edgeworth's original two-axis depiction was developed into
the now familiar box diagram by Pareto in 1906 and was popularised in a later
exposition by Bowley. The modem version of the diagram is commonly
referred to as the Edgeworth-Bowley box.

Ideal Output o r Allocation: A situation in which each several sort of

resources is allocated in such a way that the last unit of it in any one use yields
a physical product of the same money value as the last unit of it in any other
use.

Marginal Net Product: The difference between the aggregate flow of a

product for which flow of resources, when appropriately organised is
responsible and the aggregate flow of the product for which a flow of
resources differing from that flow by a small (marginal) increment, when
appropriately organised would be responsible.

Marginal Private Net Product: It is that part of the total net product of
physical things or objective services due to the marginal increment of
resources in any given use or place which accrues in the first instance, i.e.,
prior to sale to the person responsible for investing resources there.
Marginal Rate of Substitution: The marginal rate of substitution is the rate
at which consumers are willing to give up one good in exchange for more
units of another good. Numerically, this is the negative slope or derivative
(evaluated at a point) of the indifference curve. The marginal rate of
substitution is also the negative marginal utility of X over the marginal utility
of Y. The two relationships are mathematically equivalent.
Marginal Social Net Product: It is the total net product of physical things or
objective services due to the marginal increment of resources in any given use
or place, no matter to whom any part of this product may accrue.

Pareto Efficiency: An allocation of resources is Pareto efficient when some

individuals can be made better off without anyone being made worse off.

Pareto Optimality: Evaluative principle according to which: "The

community becomes better off if one individual becomes better off and none
worse ofP.

Production Possibility Frontier (PPF): A curve depicting all maximum

output possibilities of two or more goods given a set of inputs (resources,
labor, etc.). The PPF assumes that all inputs are used efficiently.

Strongly Pareto optimal (SPO): It is one allocation such that it is strictly

preferred by one person, and no other allocation would be as good for every
one.

Weakly Pareto Optimal (WPO): It is one allocation where a feasible '

reallocation would be strictly preferred by all agents.

14.7 SOME USEFUL BOOKS

Hla Myint, Theories of Welfare Economics, Harvard University Press, 1948.

J. De. V. Graff, Theoretical Welfare Economics, Cambridge University Press,

1963.

14.8 ANSWER OR HINTS TO CHECK YOUR

PROGRESS
Check Your Progress 1

1) The starting point of Pigovian welfare analysis is the contention that

there is a problem of resource allocation in society. The main objective
of the society is to attain maximum social welfare by reallocating
existing resources or achieving what he calls ideal allocation.

2) Ideal out put or ideal allocation refers to a situation in which each

several sort of resources is allocated in such a way that the last unit of it
in any one use yields a physical product of the same money value as the
last unit of it in any other use.

3) Obstacles to movement are composed of costs of movement and

imperfect market knowledge. These are also called transaction costs in
modem economics. Due to the presence of these it becomes difficult to
attain maximum welfare in society.
4) A necessary condition for optimal welfare is that the marginal social net digwha vr pantima
product of each resource employed in any use or place be exactly equal. A-C~

Check Your Progress 2

1) Pareto optimality refers to the evaluative principle according to which:

"The community becomes better o f fi one individual becomes better off
and none worse off '.

2) A strongly Pareto optimal is one allocation such that it is strictly

preferred by one person, and no other allocation would be as good for
every one, while a weak Pareto optimal is one allocation where a
feasible reallocation would be strictly preferred by all agents.

3) The three important sets of efficiency conditions of Pareto optimality are

Consumption efficiency, production efficiency and product-mix
efficiency.

4) No. All Pareto efficient solutions or outcomes are not optimal in the
sense that viewing from ethical sense, Pareto optimality is adequate as a
concept of efficiency, but not optimal.

5) Community indifference curve (CIC) represent a set of output

combinations that yield the same level of aggregate utility.

6) The set of outputs that yield Pareto-superior allocation to a particular

output combination is known as the "Scitovsky Set".

Check Your Progress 3

1) The role of fundamental welfare theorem' is to link the concept of a

competitive equilibrium with that of a Pareto optimal allocation.

2) The first hndamental theorem states that 'every competitive equilibrium

is Pareto optimal'. The second welfare theorem holds that 'every Pareto
optimal allocation can be achieved as a competitive equilibrium after a
suitable redistribution of initial endowments'.

14.9 EXERCISES
1) Explain Pigovian Welfare economics. Show how Pigou attempted the
maximisation of social welfare.

2) What are the conditions of Pareto optimality? Point out the main
weakness of Paretian analysis.

3) Explain the two fundamental welfare theorems.