UNIT 1 WELFARE FOUNDATIONS OF

ECONOMIC POLICIES
Structure
1.0 Objectives
1.1 Introduction
1.2 Public Economics and Welfare Economics: Interface
1.3 Concept of Welfare
1.3.1 Social Welfare Function (SWF)
1.3.2 Utilitarian SWF
1.3.3 Scitovsky-Bergson SWF
1.3.4 Rawlsian SWF

1.4 Efficiency and Pareto Optimality

1.5 Utility Possibility Frontier
1.5.1 Compensation Principles

1.6 Application of Welfare Criteria in Public Economics

1.6.1 Monopoly Power
1.6.2 Public Goods
1.6.3 Externalities
1.6.4 Imperfect Information

1.7 Let Us Sum Up

1.8 Key Words
1.9 Some Useful Books
1.10 Answers or Hints to Check Your Progress Exercises

1.0 OBJECTIVES
After reading this unit, you will be able to:
 outline the interface between the objective of public economics with that of
the principles of welfare economics;
 discuss the welfare concepts, inbred in the different forms of social welfare
functions, which form the foundation of policies in public economics;
 show how the welfare foundations of economic policies in a competitive
market is guided by Pareto Criterion;
 explain how by redistribution, a socially more desired welfare level can be
attained by considering the Utility Possibility Frontier;
 state the three compensation principles of redistribution for attaining of
better welfare levels in society; and
 describe the different contexts in which the welfare criteria are applied in
public economics.
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Basic Concepts of
Public Economics
1.1 INTRODUCTION
Any economy offers scope for policy interventions by the government, although
the degree varies, depending on the institutional set up of the economy. A
competitive market based economy is largely dominated by actions of individual
decision making agents (like households and firms). On the other hand, a
command economy is largely dictated by the government policy planners. In both
types, government is needed for appropriate policy interventions when the
economy does not perform as desired. This issue of desirable outcomes of actions
performed by agents (either in a market or a command economy) leads to the
consideration of welfare of individuals in the economy. The market economy has
very strong welfare theorems that provide the yardstick for its optimal
performance. In the command economy also, individual welfare cannot be ignored
although the role of government in determining the welfare of an individual is
much stronger in scope relative to a market economy. The present unit will focus
mainly on the welfare foundations of economic policies in a competitive market
economy.

1.2 PUBLIC ECONOMICS AND WELFARE

ECONOMICS: INTERFACE
The basic objective of public economics is to provide insights for policy
interventions by the government to correct any distortion prevailing in the
decision making space of various agents in the economy. The main characteristic
of a competitive market economy is the existence of large number of buyers and
sellers who are fully informed and do not face any barriers or transactions costs
for entry and exit in the markets. The markets may be for goods and services or
for factors of production. The distortions may appear in the form of: (i) monopoly
or monopsony power for sellers or buyers, (ii) taxes on or subsidies to firms or
households, (iii) existence of public goods where individual ownership or
consumption is impossible or (iv) external economies or diseconomies which
affect individuals even though they are not directly involved in the concerned
activities. All these cases are examples where the individual agents fail to attain
their optimal welfare levels. Further, if individuals are not able to attain their
optimum, it is not expected that the aggregate welfare of the economy (as
represented by some kind of social welfare function) will be able to attain its
optimum.
The above outline puts the welfare issues involved in any government intervention
in its perspective. Any policy measure undertaken by the government in such a
competitive market economy is solely aimed at improving the outcome of the
decentralised actions of the individual agents in the economy. This therefore
forms the core (or principle) of public economics in its theoretical perspective. If
households consume with the main objective of maximising their utility, then with
any distortion in the functioning of the competitive economy, the consumers will
be left with a lower level of utility than the maximum. Welfare, in whatever sense
we define it, will then be dependent on individual utility levels. In such situations,
government has to devise suitable policy interventions to correct the outcome
leading the economy to its optimum. Thus, welfare considerations form the
backbone of economic policies in general and any public economics oriented
decisions in particular.
Public economics has therefore considerable overlaps with welfare economics.
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There is still a clear demarcation between the two in the sense that welfare Welfare Foundations
economics deals mostly with aggregate levels of welfare (though it is nothing but of Economic Policies
aggregation of individual utility levels) while public economics focuses on
representative individual buyer or seller (since in a competitive market economy,
the buyers will be assumed to be identical as also the sellers). Therefore, in public
economics, welfare is often measured as the sum of consumer’s surplus (in terms
of utility), producer’s surplus (in terms of profit) and government’s surplus (in
terms of net tax revenue). Thus, unlike the social welfare concept frequently
encountered in welfare economics, public economics views any kind of surplus to
be welfare enhancing. This perspective is essential to pinpoint the features of
those welfare considerations which will form the basis of public economics.

1.3 CONCEPT OF WELFARE

The definition of social welfare in economic literature is based on an
‘individualistic’ approach (Graaff, 1975; Green,1976). This implies that the
overall welfare of the society essentially depends on the individual utility levels
and as such will follow many properties of individual utility functions. But the
economic policies in a competitive market economy start with a very simple
assumption that individuals derive utility from their own consumption of goods
and services and are not influenced by consumption of their neighbours. As a
result, the social welfare function is individual centric ignoring such aspects as
social networks prevalent in many developing economies. In social networks, the
actions of groups influence individual’s utility (e.g. self-help groups or tribal
village networks). Hence, the predominant ideas in public economics are governed
by welfare concepts rooted in individualistic utility levels. We, therefore,
highlight in this section the welfare concepts which form the basic foundations of
economic policies discussed in public economics.

1.3.1 Social Welfare Function (SWF)

Suppose in an economy, there are m numbers of individuals who derive their
utilities from quantity consumed of n number of goods. Let the utility of the ith
individual be defined as ui, where i= a,b,c,….,m. Then the Social Welfare
Function (SWF) is defined as:
W = W(ua, ub, ……, um) (1.1)
where the ith individual derived his utility from his own consumption of the n
goods in the economy, such that ui = ui(qi1, qi2, …….., qin), where qij = amount of jth
good consumed by ith individual, j = 1, 2, …….., n. The individual utility functions
satisfy the standard properties assumed in neo-classical theory of consumer
behaviour. However, such a SWF raises the question on what weights should be
assigned to individuals? Do they get equal weights or should it be different for
individuals? In case they are different, what should be the criteria for determining
individual weights? Additional issues include whether consumption of future
generations should also be included in a SWF. The only property which is
imposed on the SWF is the Pareto Criterion (suggested by Italian economist
Vilfredo Pareto, 1929). This means welfare increases if one individual’s utility
increases without any change in anyone else’s utility. In other words, welfare
increases if one individual is better off and nobody else is worse off.
Mathematically, this means:
W
 0 for all i = a, b, c, ……., m (1.2)
u i 9
Basic Concepts of In an analogy to individuals, one can hold the social welfare at a fixed level and
Public Economics redistribute utility among the individuals so that the social welfare does not
change. In case of only two individuals in the society, one can plot the locus of
various such combinations of utility levels of the two individuals which yield a
fixed level of social welfare. Such a locus is called the social indifference curve
(SIC). If the utility functions of individuals give rise to convex shaped
indifference curves [due to diminishing Marginal Rate of Substitution (MRS)],
then the SIC will also be convex to the origin (Fig. 1.1). The standard social
indifference curves in the Fig. are derived from individual utility levels of two
individuals labelled as a and b. Clearly, by Pareto Criterion B is a superior point
to A since b is better off in B than A without hurting a. Also, point C is valued
more by society than point A since C lies on a higher SIC. However, the society is
indifferent between positions C and B.

ub

SIC1
A
SIC0

O ua

Fig. 1.1: Social Indifference Curves for a Paretian SWF

1.3.2 Utilitarian SWF

An alternative type of utilitarian SWF was suggested by Jeremy Bentham (1789).
The form of the SWF suggested by Bentham is:
W = ua + ub + uc + ……….. + um (1.3)
The above welfare function is additive in nature such that the society does not care
much about the wealth position of the individuals. Thus, if some utility is taken
away from a poor individual to a rich individual, the welfare will remain the same.
This implies the gain and loss of the individuals are independent of their wealth
positions. Hence, this welfare function does not overcome the individualistic
nature of social welfare function that Equation (1.2) does. In terms of social
indifference curves, the SIC in this case is straight line having a slope of 45o with
the two axes. The reason is that the society can trade off utility between the two
individuals one to one.

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 Welfare Foundations
b of Economic Policies
u

SIC0

Fig. 1.2: Utilitarian Social Indifference Curve

1.3.3 Scitovsky-Bergson SWF

Scitovsky-Bergson (1941, 1938) suggested a type of SWF (rather a class of social
welfare functions) which satisfy the Pareto Criterion without assuming the
equality of gain and loss for individuals in the society. This shows that if a poor
individual loses utility successively, then the rich have to gain increasingly more
utility in order that the society can be indifferent for the redistribution. This does
not hold for the Utilitarian SWF considered in sub-section 1.3.2. Bergson’s
welfare function overcomes some of the problems of Scitovsky’s type function
(i.e. Bergson’s social welfare function is a frontier which envelopes the
Scitovsky’s community indifference curves). However, the basic welfare functions
(for either Bergson or Scitovsky) look similar as they show aggregate welfare as a
function of individual utility levels. Thus, it suffices for the present purpose to
club them under the same type of SWF. That is, society cares for wealth position
of each individual member. To put it differently, a transfer of income from the
rich to the poor increases the utility values more for the poorer persons. The social
indifference curves for this kind of situation is the same as in Fig. 1.1 above.

1.3.4 Rawlsian SWF

An extreme view about the SWF is put forward by Jon Rawls (1971). His view is
that welfare of the society depends on the welfare of the worst-off individual in
the society. Thus, if the poorest person in the society is taken to be the worst-off
individual, then social welfare will entirely depend on whether economic policies
increase the welfare of that individual, irrespective of gain or loss of the better off
individuals in the society. In other words, even if the better off individuals gain
more utility on account of some policies, and the worst-off individual is left
untouched, then welfare of the society will not increase. In terms of the social
indifference curve, the SICs are L-shaped since fixing the utility of worst off
person at u0a will lead to no increase in social welfare no matter how much utility
is increased for the other better off individuals.

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Basic Concepts of
Public Economics ub

u0 b A SIC0

O u0 a ua

Fig. 1.3: Rawlsian SWF and the Social Indifference Curve

Check Your Progress 1 [answer within the given space in about 50-100 words]
1) What is the basic tenet of Public Economics?
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2) Why is Social Welfare Function said to be ‘individualistic’?
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3) How does the Utilitarian Social Welfare Function deviates from its
individual centric character?
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4) Why is the Rawlsian Welfare Function L-shaped?
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 ........................................................................................................................... Welfare Foundations
of Economic Policies
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1.4 EFFICIENCY AND PARETO OPTIMALITY

The welfare foundation of economic policies in a competitive market economy is
clearly guided by Pareto Criterion which suggests that the most efficient solution
in any economy is provided by a Pareto optimal situation. This leads to the first
theorem of welfare economics.
Welfare Theorem 1: In a competitive market economy which allows free trading
among individuals, any mutually beneficial trading will result in efficient
distribution of resources (or goods).
The above theorem suggests that market itself guides individuals to the best
possible solution. As noted in Section 1.3, if individuals could reach their
maximum utility levels, the social welfare is also maximised. The theorem of
welfare economics does not allow government intervention since it assumes away
complications which deters individuals from pursuing their goal of utility
maximisation. Thus, the theorem shows that if individuals do not have ‘external’
effects (i.e. neighbour’s consumption affecting my utility, goods that are not
divisible and jointly consumed do not exist, market does not fail due to existence
of one buyer and seller holding complete market power, etc.), the economy will
automatically attain the most efficient solution. This can be shown in terms of a
technique known as the Edgeworth-Bowley Box (Fig. 1.4).
qb1
Ob
qa2 Ub0
Ub3
J
H
G
F
E

Ua3
Ua0 qb2
Oa qa1
Fig. 1.4: Edgeworth-Bowley Box

The box in Fig. 1.4 (named after Edgeworth and Bowley) shows that the welfare
theorem 1 leads to the Pareto optimal outcome in a competitive market economy.
The box has two origins, one for individual a and the other at the north east corner
for individual b. So, it is a 2 person and 2 commodity simplified SWF on the
individual decisions of only 2 persons. The indifference curves of the two
individuals are based on their quantities consumed of the two goods where the
first good is measured for both on the horizontal axis and the second good too is
measured on the vertical axis for both. The distance of the horizontal and vertical
axes from the origin (drawn identical for both) shows the given endowment of the
two goods. Note that, since we assume away production, to understand consumer 13
Basic Concepts of behaviour better we have to talk in terms of initial endowments of the two goods.
Public Economics The two utility levels Ua0 and Ub0 are like sustenance level indifference curves
below which the individuals will not choose any level of utility.
To understand the importance of free trade among the individuals, let us suppose
the initial solution is at the point L showing individual a at the sustenance level. It
is always an improvement for the society to allow trading at the existing prices in
order that the individuals land at the point F. This satisfies the Pareto Criterion
since individual b gains while individual a does not lose (i.e. suffer any loss).
Thus, it is a Pareto optimal point from the point of view of welfare theorem 1. In
fact, all the tangency points of the indifference curves of the two individuals
satisfy Pareto Criterion and is an improvement over any point outside the
tangency points. The locus of these tangency points within the sustenance levels
of the two individuals (i.e. FGH) is the contract curve. The curve shows that the
optimal trading of the individuals for the available endowment of the two goods
should always lie on this locus. The individuals will never deviate from this curve
as all the points here are Pareto optimal. In general, the points on the contract
curve satisfies the equality that MRSa,12 = MRSb,12 i.e. they should be equal to the
prevailing price ratio.
The Pareto optimality shows the most efficient solution for the economy is where
there is a win-win situation for all the individuals. This also shows that economic
policies cannot play any significant role since the market itself drives the economy
toward the optimal solution. The problem however begins if one is interested to
know which of the possible infinite number of combinations on the contract curve
is the best among the optimal points. This brings the question of equity in the
society imposing additional value judgements on the relative position of
individuals in the society. This also brings into focus the welfare theorem 2 which
spells out the important role of economic policies for bringing the best among
many optimal feasible situations in the economy. To know more about this we
first need to explain the concept of Utility Possibility Frontier (UPF).

1.5 UTILITY POSSIBILITY FRONTIER

The contract curve in Fig. 1.4 shows the efficient allocation of goods among
consumers maintaining Pareto optimality criterion. Any point off the contract
curve is a sub-optimal distribution although one cannot say which of the infinite
points on the contract locus is more desirable than the others. In order to
understand this, we need to use the concept of Utility Possibility Frontier (UPF).
UPF is the locus of all possible optimal combinations of Ua and Ub lying on the
‘Contract Locus’. Since the total endowment of goods is given, an increase in one
individual’s utility can only come at the expense of utility of another individual.
We first draw one such UPF in Fig. 1.5. Any movement from point A (which is
inside the frontier) to any point in the north east quadrant to point A, is welfare
improving in Pareto sense. So points B, C and D are all improvements over A as
they satisfy the Pareto Criterion (i.e. since somebody’s welfare increases without
reducing anybody’s welfare). But which of these points B, D and C is the most
desirable point to the society is clear as one moves from point B to point C (where
utility of individual a is reduced but that of b is increased). Generally, UPF is
concave to the origin implying that if one takes away some utility from an
individual a, then one has to compensate that loss by an increasing amount of
utility given to another individual b. This becomes clear with the statement of
Welfare Theorem 2.
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 Welfare Foundations
Ua of Economic Policies

A C

O Ub

Fig. 1.5: Utility Possibility Frontier

Welfare Theorem 2: In a competitive market economy, given that the

indifference curves of individuals satisfy the standard properties, for any initial
distribution of goods among the individuals, any point on the utility possibility
frontier is a point of equilibrium.
The above theorem implies that if the existing equilibrium point is not the one
which is desirable from society’s point of view, then a redistribution of income
(and as a result goods) can lead to a more desirable outcome at some other Pareto
optimal point. Thus, if point B is a Pareto optimal efficient equilibrium point, but
at that point individual b gets more utility than individual a, and the society wants
a better deal for a since a happens to be poorer than b, it requires a policy
intervention so that the richer individual can be suitably taxed and the poorer
individual subsidised so that the resulting redistribution of income leads to a new
Pareto optimal equilibrium D with better distribution of utility. Recall that
Welfare Theorem 1 suggests competitive market economy can generate Pareto
optimal situation without any external policy intervention. However, all Pareto
optimal situations may not be desirable since additional value judgements may
place one Pareto optimal situation better than the others. This brings the Welfare
Theorem 2 into limelight for suggesting that starting from any initial distribution
of income (or goods), policy induced redistribution can bring the desired Pareto
optimal situation based on some value judgement of the society.

1.5.1 Compensation Principles

In cases where the redistribution improves the welfare of all individuals (or
groups), there are no issues. However, in case the redistribution results in some
individuals losing out, there could be resistance from the losers to such a
redistribution. To deal with such situations, some compensation principles are
suggested by which the gainers compensate the losers and still have a net gain.
The three most well-known compensation principles are the following (Henderson
and Quandt, 1971, pp.279-280).
The Kaldor Criterion: Allocation α is preferred by society to an alternative
allocation β if the gainers from a redistribution from α to β can compensate the
losers but still remain gainers.
The Hicks Criterion: Allocation α is preferred by society to an alternative
allocation β if the losers cannot profitably bribe the gainers in not making such a
redistribution.
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Basic Concepts of The Scitovsky Criterion: Allocation α is preferred by society to an alternative
Public Economics allocation β if the gainers could compensate the losers to make the change while
the losers cannot profitably bribe the gainers in not making the change. Since this
combines both the principles of Kaldor and Hicks, it is also called as Scitovsky’s
double criteria.
The main problem of the compensation principles is that they are all potential and
not actual. Thus, it is entirely possible that the gainers do not compensate the
losers in reality or the losers do not make any effort to thwart the move of
redistribution although they could.
Check Your Progress 2 [answer within the given space in about 50-100 words]
1) Define a contract curve.
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2) How are Utility Possibility Frontier and Contract Curve related?
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3) How does the second welfare theorem envisage scope for policy intervention
by the government?
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4) State the limitation of compensation principles.
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 Welfare Foundations
1.6 APPLICATION OF WELFARE CRITERIA IN of Economic Policies
PUBLIC ECONOMICS
The above discussion on welfare and efficiency is relevant for various real world
issues. What is highlighted is that the most efficient solution to allocation of goods
(and resources) depends on fulfilment of Pareto optimality condition. In case of
preference for some particular Pareto optimal situation among the many possible
ones, one needs to apply some compensation principle. Let us now see some
application of these principles in specific economic contexts.

1.6.1 Monopoly Power

Welfare maximisation assumes a competitive market economy. The basic
foundation of the competitive economy hinges on the existence of a large number
of buyers and sellers. If this condition is violated, market witnesses conflict either
on the part of seller or buyer. This will create problem in the Edgeworth-Bowley
box. Although the diagram leaves out the production side, one can visualise the
flavour of monopoly power on the part of buyer or seller.
Suppose, instead of the given endowment of the two goods as assumed in drawing
the Edgeworth box, the size of the box is given by the actual production of the two
goods. This hardly changes the argument presented, but it will affect the size of
the box depending upon the type of market structure. Let the production of
commodity 1 be controlled by a monopolist but the second commodity is
produced by competitive sellers. Then by the standard neo-classical theory, the
first seller will charge prices which will exceed the corresponding competitive
price and the quantity produced will be relatively less. As a result, the consumers
will face prices which are not competitive and hence the consumer will not be able
to move along the contract curve but remain outside it. As a result, there will be
inefficient outcome and the consumers will lose some utility compared to the
competitive market solution.
Policy intervention by the government can solve this to a great extent. In case the
monopoly is a ‘natural monopoly’, since its production enjoys increasing returns
to scale (or simply economies of scale), larger the production, lower will be the
per unit cost of production. As a result, the producer can simply drive out the
competitors by undercutting their prices. Such situation may arise for utilities like
water supply or power supply. Thus, it is not uncommon that these utilities are
controlled by the government by law and they are known as ‘public utilities’.
On the other hand, monopoly may arise for other reasons like patents. In such
cases, government can constitute price regulatory bodies who oversee the pricing
of these goods. This ensures monopolist cannot earn too high profits by taking
away some utility from the consumers. In some cases, instead of monopoly, a
cartel may be formed by some producers (like OPEC for oil producers). In this
case also, prices are higher than competitive prices and consumers will be off the
contract locus. Here also, government can subsidise the consumers so that they
pay a price which comes closest to the competitive price. This will bring the
consumers back to the contract curve again.
A similar situation arise on the buyers side as well. A common example is the
employers’ associations in the labour market. For instance, if in the case of a nichè
good like fifth generation telephone handsets, only two producers produce it and
plenty of workers are ready to offer their services, then the two producers can
dictate the wages. In this case also price of labour becomes much lower than 17
Basic Concepts of competitive wages and cause the workers to lose utility to the buyers of their
Public Economics labour services. In such cases, government may intervene to legally enforce
minimum wage. Such cases also occur when the labour market becomes
unorganised so that buyers wield considerable bargaining power. Here also,
minimum wage laws could be a good policy intervention to bring efficient
solution in the market.

1.6.2 Public Goods

Pure public goods are those goods for which nobody can be excluded and once
this is available for consumption, it has to be jointly consumed. In this case, since
the good cannot be privately owned, competitive market mechanism does not
work. Thus, the Edgeworth-Bowley diagram does not provide a correct solution.
The main problem is that individuals will not reveal how much they are ready to
pay for consuming the good since it cannot be consumed solely by the individual.
As a result, one cannot equate the marginal rate of substitution between a private
and public good to their price ratio since everybody will try to have a free ride (as
nobody can be excluded from the good’s consumption even if the individual does
not pay anything). Common example cited in this context is a lighthouse. A
similar example is the defence force whose service is enjoyed equally by all
citizens of a nation. In the absence of a market determined price, the optimal point
on the contract curve or utility possibility frontier cannot be determined rendering
welfare based Pareto optimal criterion redundant. In such circumstances,
government has to carefully devise a tax system which reflects true preferences of
the individuals towards the public good. The taxes here will act similar to price
but determination of correct tax rate (so that the individuals can maximize their
utility) is difficult.

1.6.3 Externalities
Externalities are commonly present in society but are very hard to control. A
positive externality is an action on the part of consumers or producers, whereby
action of one increases the utility of all others in that neighbourhood. A garden in
somebody’s backyard may increase utility of all the neighbours through breeze
and good scent. Similarly, if more schools increase the average knowledge level in
a society, it not only helps the school goers but helps the whole society. On the
side of negative externality, one may cite the existence of household enterprises in
densely populated neighbourhoods, whereby noise and air pollution adversely
affects the health of all who reside there.
Both kinds of externalities suggest action of some not only affects his or her utility
but utility of many others. Thus, the indifference curves of one individual are not
independent of movement in such curves of another individual. As a result, the
whole mechanism by which optimal welfare is determined becomes questionable.
Since the individuals (or firms) who create such externalities in many cases think
about their private costs and benefits (as a result of which the goods or services
carrying such externalities are most often either over or under supplied), there
would be significant difference between private and social benefits (and costs).
This calls for policy interventions on the part of government through tax and
subsidies (i.e. taxing the negative externality creating activities and subsidising the
positive externality creating ones).

1.6.4 Imperfect Information

One of the necessary conditions for the smooth operation of competitive market
18
economy is perfect information on the part of both buyers and sellers. In case one Welfare Foundations
of them has imperfect information, the amount of goods supplied may fall short of of Economic Policies
the desired amount or the buyer may not get the right quality of the good. The
welfare criteria discussed so far assumes that the consumers get utility from
consumption of goods with perfect information of the product so that the pricing
of the goods does not deviate from its competitive optimum nor the quality of the
product leads to lower than the desired utility from the consumption of the goods.
In such cases, government needs to intervene for course correction. One example
is drug control by government agencies (which is prevalent in many countries).
The US Food and Drug Administration oversees the introduction as well as the
efficacy of all drugs in United States and sets a benchmark for the world also.
Another example is information provided by the weather bureau of a country
which helps sellers and buyers in various ways. Similarly, an agency like
Insurance Regulatory and Development Authority of India (IRDAI) is given the
responsibility of ensuring the right kind of insurance products to the customers as
the insurance market always has imperfect information. The sellers are likely to
undersupply insurance in many instances distorting the pricing of the goods,
thereby throwing the consumers off the contract curve.
Check Your Progress 3 [answer within the given space in about 50-100 words]
1) Why does the government need to intervene in case of a patented product?
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2) What problem does a public good pose for welfare maximisation?
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3) In case of household enterprises being set up in densely populated area, what
is expected in terms of policy intervention?
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4) For what reason do drugs need regulation?
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Basic Concepts of ...........................................................................................................................
Public Economics
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1.7 LET US SUM UP

Public economics deals with economic policies pursued by governments of a
nation based on some welfare considerations. The most accepted welfare criterion
in a competitive market economy is the Pareto Criterion. The welfare foundation
of public policies is based on two important welfare theorems– one suggesting the
importance of free trading in a competitive economy leading to welfare
maximisation and the second one suggesting that starting from an initial
distribution of resources any distribution can be made optimal through
compensatory redistributive policies in a competitive economy. Given this
foundation, several applications of welfare maximisation policies need attention
under circumstances which violate the basic assumptions underlying the operation
of a competitive market economy. These include monopoly power, public good,
externalities and imperfect information. In case of occurrence of any such
distortionary events, only appropriate public policies can correct the situation
contributing to the achievement of welfare maximisation objectives of individuals
in the society.

1.8 KEY WORDS

Social Welfare Function : An aggregate measure of welfare for the
society based on individual preferences.
Social Indifference Curve : A locus of utility levels of individual in a
society which yields a fixed level of utility.
Edgeworth-Bowley Box : A rectangular box showing given endowment
(production) of two goods and indifference
curves of two individuals.
Contract Curve : A locus of points in Edgeworth-Bowley box
showing optimal welfare of each individual
given the price ratios of the commodities.
Pareto Criterion : A situation where no individual’s welfare can
be increased without hurting at least one other
individual’s welfare.
Utility Possibility Frontier : A locus of optimal utility levels derived from
the contract curve.
Compensation Principle : A scheme of compensation to make a
redistribution of resources through tax and
subsidies feasible.
Market Failure : Situations where competitive market
mechanism fails to operate.

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 Welfare Foundations
1.9 SOME USEFUL BOOKS of Economic Policies
1) Graaff, J de V (1979). Theoretical Welfare Economics (CUP-VIKAS
Students’ Edition) New Delhi: Vikas Publishing House.
2) Green, H.A. John (1976). Consumer Theory. New Delhi: The Macmillan
Company of India Limited.
3) Henderson, James M and Richard E. Quandt (1971). Microeconomic Theory.
Tokyo: McGraw-Hill Kogakusha, Ltd.
4) Pindyck, Robert S. and Daniel L. Rubenfeld (2006). Microeconomics, 6th
Edition. New Delhi: Prentice-Hall of India Private Limited.
5) Stiglitz, Joseph E. (1986). Economics of the Public Sector. New York: W.W.
Norton & Company.

1.10 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) That welfare is measured as the sum of consumers surplus, producers
surplus and the government’s surplus. It views any kind of surplus to be
welfare enhancing.
2) Because the overall welfare of the society essentially depends upon the
individual utility levels and hence the SWF is individual centric ignoring
such aspects as social networks.
3) Despite being additive in nature, it ignores the gain and loss of individuals.
The SIC is a straight line having a slope of 45o with both the axes since the
society can trade-off utilities between individuals.
4) The SICs are L-shaped since it shows what happens to the SIC when the
welfare of the worst-off is left fixed.
Check Your Progress 2
1) It is the locus of the tangency points of the different indifference curves
satisfying the Pareto Criterion.
2) UPF is the locus of all possible optimal combinations of welfare points on
the ‘contract locus’.
3) By stating that if a particular equilibrium point is not desirable from the
society’s point of view, a redistribution of income can lead to more desirable
outcome (welfare or utility) at another Pareto optimal point.
4) They are all potential and not actual.
Check Your Progress 3
1) To oversee the pricing of patented goods.
2) The individuals do not reveal how much they are willing to pay as they
cannot be excluded from its consumption.
3) Noise and air pollution needs controlled by setting of norms for their
emissions.
4) To oversee their safety and efficacy and to set benchmark in standards.

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