Welfare Economics

MEC-101
Microeconomic
Indira Gandhi Analysis
National Open University
School of Social Sciences
Block
5
WELFARE ECONOMICS
UNIT 13
Pigovian vs Paretian Approach 5
UNIT 14
Social Welfare Function 26
UNIT 15
Imperfect Market Externality and Public Goods 42
UNIT 16
Social Choice and Welfare 62
Expert Committee
Prof. Bhaswar Moitra Prof. Gopinath Pradhan
Department of Economics School of Social Sciences
Jadavpur University Indira Gandhi National Open University
Kolkata New Delhi
Dr. Naresh Kumar Sharma Prof. Narayan Prasad
University of Hyderabad School of Social Sciences
School of Economics, Hyderabad Indira Gandhi National Open University
New Delhi
Dr. Anirban Kar
Deptt. of Economics Prof. Kaustuva Barik
Delhi School of Economics School of Social Sciences
University of Delhi Indira Gandhi National Open University
New Delhi
Dr. Indrani Roy Chowdhury
Economics Faculty, Jamia Millia Islamia Prof. B.S. Prakash
New Delhi School of Social Sciences
Indira Gandhi National Open University
Prof. Sudhir Shah
New Delhi
Deptt. of Economics, Delhi School of Economics
University of Delhi Mr. Saugato Sen
School of Social Sciences
Dr. Manish Gupta
Indira Gandhi National Open University
NIPFP, New Delhi
New Delhi
Course Editor : Prof. Gopinath Pradhan

Programme Coordinators Course Coordinator
Prof. Gopinath Pradhan, IGNOU, New Delhi Prof. Gopinath Pradhan
Dr. Kaustuva Barik, IGNOU, New Delhi
Block Preparation Team
Unit Writer
13-16 Mr. Pravakar Sahoo
Material Production
Mr. Manjit Singh
Section Officer (Pub.)
SOSS, IGNOU, New Delhi
September, 2016
 Indira Gandhi National Open University, 2016
ISBN-81-266
All rights reserved. No part of this work may be reproduced in any form, by mimeograph
or any other means, without permission in writing from the Indira Gandhi National Open
University.
Further information on Indira Gandhi National Open University courses may be obtained
from the University's office at Maidan Garhi. New Delhi-110 068.
Printed and published on behalf of the Indira Gandhi National Open University, New Delhi by
Director, School of Social Sciences.
Laser Typeset by : Tessa Media & Computers, C-206, A.F.E.-II, Okhla, New Delhi
Printed at :
BLOCK 5 WELFARE ECONOMICS
Introduction
In this block we discuss welfare economics that uses microeconomic techniques to

simultaneously determine the allocation efficiency of an economy and the income
distribution consequences associated with it. Unit 13 presents the formulation of
social welfare frameworks by Pigou and Pareto using respectively cardinal and
ordinal measures. It highlights the two fundamental theorems to link the concept of
competitive equilibrium with that of Pareto optimal allocation. The next unit
(Unit 14), extends the analysis to include value judgment in drawing inference on
the attainment of welfare in a society along with the construction of social welfare
function to address the income distribution concerns. Its discussion encompasses
the compensation principles dealing with the efficiency issues. Existence of a number
of features like imperfect market structure, market failures and externalities and
production of public goods hinder the achievement of optimal social welfare
conditions. These are discussed in Unit 15 and solutions to such problems are
touched upon. The last unit of the block (Unit 16) takes up the available choices
to the society when ideal Pareto optimal conditions not achieved. It starts with the
insights offered by the theory of second best and examines Arrow’s impossibility
theorem; the social choices enunciated by Rawls’s theory of justice have been
looked into. The unit concludes with equity-efficiency trade off as a limit to just
distribution of social welfare.
Pigovian vs Paretian
UNIT 13 PIGOVIAN VS PARETIAN Approach
APPROACH
Structure
13.0 Objectives
13.1 Introduction
13.2 Pigovian Approach
13.2.1 Pigovian Analysis
13.2.2 Case for the Market
13.2.3 Case for Improving upon the Market System
13.3 Pareto Optimal Conditions
13.3.1 Pareto-Optimality
13.4 Two Fundamental Welfare Theorems
13.5 Let Us Sum Up
13.6 Key Words
13.7 Some Useful Books
13.8 Answer or Hints to Check Your Progress
13.9 Exercises
13.0 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.
13.1 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.
13.2 PIGOVIAN APPROACH

Pigou assumed that the aim of social policy is to ‘promote welfare’. But in
order to simplify 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
5
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 benefit 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 indicative 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
resources from one use to another. Pigou defined marginal net product 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
6
place. The marginal private net product is that ‘part of the total net product of
physical things or objective services 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 responsible for 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 equimarginal 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.
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,
bankers and others”, but also the imperfect divisibility of productive
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 movement,” 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
“justified” if it could “jerk 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
7
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 “flowing
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.
13.2.2 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.
13.2.3 Case for Improving upon the Market System

Unlike the “optimistic followers” of the “classical school” who believed that
markets would “naturally” or “automatically” produce a socially optimal
result “if only Government refrains from interference,” Pigou pointed out that
“even Adam Smith himself” recognised the need for “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 beneficial 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
1
M. W. Reder, Studies in the Theory of Welfare Economics, Columbia University Press, New
8 York, 1947, p. 34.
providing the necessary incentives, carrots or sticks that would improve upon Pigovian vs 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 Welfare, 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 net product 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” tax/subsidy schemes will correct the “maladjustment.” The
point here, however, continues to be that Pigou saw tax/subsidy 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 direct
contact, as other ways of closing the gap between private and social product. 9
Welfare 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 [tax/subsidy] 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 tax/subsidy
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 modern economists to comprehensively
elaborate on the subject in succeeding periods.
Check Your Progress 1
1) What constitutes the starting point of Pigouvian welfare analysis?
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
10
2) What is ideal output or ideal allocation as mentioned by Pigou? Pigovian vs Paretian
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?
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
13.3 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 efficient 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 efficient, 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 efficiency is an important criterion for evaluating economic
systems and political policies.
11
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 efficient 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 efficient 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 efficient 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.
13.3.1 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: MRSAXY = MRSBXY for any pair of households,

A, B and any two goods, X, Y.
b) Production Efficiency: MRTSXKL = MRTSYKL for any pair of outputs, X,

Y, and any two factors, K, L.
c) Product Mix Efficiency: 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 his/her own ordinal utility function and possesses a
definite amount of each product and factor.
12
• Production function of every firm and the state of technology is given and Pigovian vs Paretian
Approach
remains constant.
• Goods are perfectly divisible.
• A producer tries to produce a given output with the least-cost combination

of factors.
• Every individual wants to maximise his/her satisfaction.
• Every individual purchases some quantity of all goods.
• All factors of production are perfectly mobile.
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 of 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 technical rate of substitution between any pair of
factors must be the same for any two firms producing two different goods and
utilizing both the factors to produce the goods. This condition can be
explained with the help of Edgeworth-Bowley box diagram as depicted in
Figure 13.1.
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 Y0 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, from 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 from 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, MRTSXKL = MRTSYKL, which, in turn,
implies that output combinations will belie on the PPF.
13
Welfare Economics
Fig. 13.1: 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 same marginal rate of product transformation, i.e.,
MRPTAXY = MRPTBXY.
This efficiency condition is applied in analysing 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 specialises and trades (i.e., changes output combinations) until their
MRPTXY are equal. If they are already equal, then no specialisation is possible
as the opportunity cost of good X in terms of good Y (i.e., MRPTXY) is the
same in both firms/countries.
This production efficiency condition can be explained with the help of

mathematical equations. Abba Lerner 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 fth firm:
Φf (xf) = 0,
Where xf = [x1f, x2, .., xnf] and an xif 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
∂xif/∂xjf = ∂xig/∂xjg for any i, j = 1, 2, .., n+m.
14
If xi is an output and xj is an input, then this equation states that the marginal Pigovian vs Paretian
product of xi should be the same for both firms. If both xi and xj are input, Approach
then this states that the marginal rates of technical substitution between the
inputs are the same for both firms (MRTSfij = MRTSgij). Finally, if xi and xj
are both outputs, then this states that the marginal rate of product
transformation are the same for both firms (MRPTfij = MRTSgij).
The second main marginal condition for Pareto-optimality is consumption

efficiency. It is to be noted that, in a consumer Edgeworth-Bowley box as
shown in Figure 13.2 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 YA and her utility is UA (E) and B receives
combination of goods, XB and 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 UB(E) to UB(D)) without worsening A's utility, which stays at UA(E)).
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. 13.2: Consumption Edgeworth-Bowley Box
As evident from Figure 13.2, 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 OA and OB represent the
set of Pareto-optimal allocations. It can be seen that, unlike the case of 15
Welfare Economics 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, MRSAXY = MRSBXY.
The third condition for Pareto-optimality is that of product-mix efficiency

which states that the marginal rate of substitution between two goods for any
consumer be equal to the marginal rate of product transformation between
those goods, i.e., MRSAXY = MRPTXY. 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 13.3. 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 MRSAXY = MRSBXY, denoted by point CF in the Edgeworth-Bowley
box. Let us denote the utility levels achieved by agents A and B at point CF as
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)
= UA(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 UA(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,
YG), both A and B have the same utility levels, UA(C) and UB(C) that they had
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 indifference 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.
16
Pigovian vs Paretian
Approach
Fig. 13.3: 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 X0), 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) = UA0 and UB(X,
Y) = UB0). From consumption efficiency, we require that X = XA + XB and 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., MRSAXY. Thus,
dY0/dX0 = MRSAXY = MRSBXY.
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 13.4.
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) = UA(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) = UA(D) + UB(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 CICD pass through F.
17
Welfare Economics
Fig. 13.4: 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
CICD will necessarily have different slopes at point F and intersect each other.
These different slopes of the CICC and CICD curves at point F, are captured by
examining the price lines tangent to CICC (with slope -(pX/pY)C - which is also
tangent to the MRSs of the agents at point C) and CICD (with slope -(pX/pY)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 CICD represent 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 CICc represents a Pareto-optimal allocation whereas CICD
does not. This is explained in Figure 13.5.
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 without reducing anyone's utility (as
we saw before, everywhere along the CICD, the utility levels of persons
remain unchanged, at UA(D) and UB(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 MRTSKL for 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
18 before) while not affecting the utility of A (still at UA(D)). In short, by moving
from G to E, we have undertaken a Pareto-improving allocation. This is Pigovian vs Paretian
represented graphically in Figure 13.5 as an upward shift in the CICD curve to Approach
a new, higher level of aggregate utility, CICD’.
Fig. 13.5: Intersecting CIC Curves
Thus, this implies that undertaking a Pareto-improving reallocation from the

original point F to point E, then point F could not have been a Pareto-efficient
allocation. However, this result depends crucially on the fact that CICD was
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 MRSXY =
MRPTXY makes 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 13.5, the Scitovsky sets of points F and G are merely the set of
outputs above CICC and CICD respectively. 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 sufficient. As Amartya Sen notes, ‘an economy can be Pareto-optimal, yet
still “perfectly disgusting” by any ethical standards’2. 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
2
Amartya Sen, On Ethics and Economies, Welfare and Measurement, Harvard University
Press, 1990, p. 34. 19
Welfare Economics 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-efficiency 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 Paretian
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.

1) What do you mean by Pareto optimality?
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
2) Distinguish between strongly Pareto optimal and weakly Pareto optimal

allocation.
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
3
Anthony Barnes Atkinson, “The Economics of the Welfare State”, American Economist,
20 Vol. 40, 1996.
3) Are all Pareto efficient situations optimal? Pigovian vs Paretian
Approach
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
4) What are the conditions of Pareto optimality?
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
5) What is community indifference curve?
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
6) What is Scitovsky Set?
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
13.4 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: MRSAXY = MRSBXY for any pair of households,
A, B and any two goods, X, Y.
• Production Efficiency: MRTSXKL = MRTSYKL for any pair of outputs, X,
Y, and any two factors, K, L.
• Product Mix Efficiency: MRSAXY = 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:
21
Welfare Economics • 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
MRSXYA = pX/pY = MRSBXY. Further, we can place the same price line with
the same slope between the CIC and the PPF so that MRSAXY = pX/pY =
MRPTXY are on the PPF (by production efficiency), and then we can place a
factor price line with slope r/w between the isoquants of the production
Edgeworth-Bowley box so that MRTSXKL = MRTSYKL. 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.

1) What is the role of fundamental welfare theorem?
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
2) Explain the two fundamental welfare theorems.
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
13.5 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 analysed 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
22 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 Paretian
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.
13.6 KEY WORDS

Community Indifference Curve: 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 13 cakes and 6 liters of water.
The Edgeworth box is a rectangular diagram with Mahesh's origin on one
corner (represented by the O) and Abhay's origin on the opposite corner
(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 O 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 modern version of the diagram is commonly
referred to as the Edgeworth-Bowley box.
Ideal Output or 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.
23
Welfare Economics 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 off”.
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.
13.7 SOME USEFUL BOOKS

Hla Myint, Theories of Welfare Economics, Harvard University Press, 1948.
J. De. V. Graff, Theoretical Welfare Economics, Cambridge University Press,

1963.
13.8 ANSWER OR HINTS TO CHECK YOUR

PROGRESS
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
modern economics. Due to the presence of these it becomes difficult to
attain maximum welfare in society.
24
4) A necessary condition for optimal welfare is that the marginal social net Pigovian vs Paretian
product of each resource employed in any use or place be exactly equal. Approach
1) Pareto optimality refers to the evaluative principle according to which:

“The community becomes better off if 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”.
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 fundamental 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’.
13.9 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.
25
Welfare Economics
UNIT 14 SOCIAL WELFARE FUNCTION
Structure
14.0 Objectives
14.1 Introduction
14.2 Value Judgment
14.3 Social Welfare Function
14.4 Compensation Principle
14.4.1 Kaldor-Hicks Criteria
14.4.2 Scitovsky Reversals and the Double Criteria
14.4.3 William Gorman’s Intransitivity Problem
14.4.4 Samuelson’s Criteria
14.5 An Appraisal
14.6 Let Us Sum Up
14.7 Key Words
14.10 Exercises
14.0 OBJECTIVES
• identify the themes used as value judgment in welfare formulation;
• understand the process of constructing the social welfare function and its
analytical significance;
• assess the new welfare economics approach through compensation
principle;
• explain various criteria of the compensation principle; and
• understand the intransitivity problem and its significance.
14.1 INTRODUCTION
In the previous unit we have seen two approaches, neo-classical and new
welfare economics, dealing with the norms of efficient resource allocation.
We extend the discussion presently to see the appropriateness of value
judgement in analysing the welfare issues and search for the areas of
development and refinement. In the process, we will discuss the ethical social
basis of welfare function and of compensation principle. We will discuss how
through compensation principle optimum welfare is achieved. We shall also
be able to decipher whether the compensation principle is an improvement
over the earlier attempts or not.
14.2 VALUE JUDGMENT

Value judgments refer to the conceptions or ethical beliefs of people about
what is good or bad or simply what is desirable or not from the point of view
of the well being of the society. These conceptions or perceptions of the
people in society are based on ethical, political, philosophical and religious
beliefs of the people and are not based on any scientific logic or law. In a
broader sense, ‘any statement which implies a recommendation of any kind is
26
a value judgment’. This definition covers all ethical judgments as well as Social Welfare Function
statements, which might appear to be merely descriptive, but are in certain
contexts recommendatory, persuasive or influential. Some examples of value
judgments are: ‘a country grows faster if profits are taxed lightly’; ‘honesty is
the best policy’; ‘monopolies need to be controlled’; and ‘an essential aim of
public policy anywhere is a reduction in the inequalities of incomes’. In fact,
economist I.M.D. Little has argued that any persuasive statement needs to be
regarded as a value judgment.
Value judgments are basic to welfare economics for a number of reasons.
First, in welfare economics some propositions are formulated about the
welfare of individuals comprising a group; since welfare is an ethical term,
any theorem incorporating the word welfare is also ethical and must rest on
some obvious or hidden value judgments. Second, value judgments are basic
to welfare economics also because it has always been considered to be that
part of economics where prescriptions for policy are studied. No prescriptions
can ever be made without starting explicitly or implicitly with some notion of
what is desirable, good or suitable or simply the social objective. Again, no
objectives can be formulated, or questions of desirability or suitability settled,
without implicitly or explicitly assuming some value judgments.
However, there is no general agreement among economists over the role of
value judgments in welfare economics. Lionel Robbins critised the idea of
value judgments as out of place scientific-objective-analysis. According to
him these must be dealt with descriptively by accepting the values of the
community as observational data.
In the face of such criticisms Kaldor, Hicks and others sought to isolate a
value free, purely objective kernel of welfare economics, which later came to
be known as ‘New Welfare Economics’. The chief outcome of their efforts is
known as the ‘Compensation Principle’. However, it was later pointed out that
the procedures of the new welfare economics did not dispense with ethical
assumptions such as consumer sovereignty and indifference of resources in
different uses. It was Abram Bergson, by his introduction of the concept of the
Economic Welfare Function, who solved these problems and achieved a
notable isolation and clarification of the function of value judgments in
welfare economics. The economic welfare function was ideally suited to the
formalisation of any set of value assumptions within a welfare analysis, and to
the compact tracing out of their implications. He explicitly introduced a set of
value judgments in the economic welfare function so that, economists can
judge the desirability of certain economic reorganisations or policy changes.
These value judgments are determined by their compatibility with the values
prevailing in the community the welfare of which is being studied.
To illustrate, let us introduce some value judgments that are assumed in most
welfare studies, and as put forward by Jeremy Rothenberg, in his book, ‘The
Measurement of Social Welfare’, (1961):
1) Non-labour resources employed in different uses. “A shift in a unit of
any factor of production, other than labour, from one production unit to
another would leave economic welfare unchanged, provided the amounts
of all other elements in welfare were constant”. In other words, “factory
smoke,” etc., are assumed to have no effect on social welfare.
2) Consumer sovereignty. “Individual’s preferences are to ‘count’ ”. Any
change, which leaves everyone indifferent, has the same level of social
welfare; a change by which one person is better off while everyone else is
indifferent represents an increase in social welfare; a change by which one 27
Welfare Economics person is worse off while everyone else is indifferent represents a decrease
in social welfare. In other words, this assumption decentralises the
evaluation of alternatives so that each individual first orders various
alternatives so that these orderings become the determining variables of
social welfare.
3) Equal distribution of “shares”. “If the shares of any ith and kth
individuals were equal, and if the prices and wage rates were fixed, the
transfer of a small amount of the share of i to k would leave welfare
unchanged”. To put it differently, for given prices and wage rates, any
departure from equal shares will bring about a social welfare decrease; any
closer approximation to it will bring about a social welfare increase.
Moreover, Prof S.K. Nath, in his book, “A Reappraisal of Welfare
Economics”, (1969), has identified certain value judgments embedded in
Paretian welfare economics. According to him, “since the Paretian economic-
welfare theory of allocation contains propositions about allocation of
resources which are meant to be suitable, good, or optimum, it is necessarily
based on certain value judgments”. The Paretian value judgments are the
following:
1) The concern is to be with the welfare of all the individuals in the society
rather than with that of some mythical entity called ‘society’ or ‘state’, or
with that of some special group or class.
2) Any non-economic causes affecting an individual’s welfare can be
ignored.
3) An individual should be considered the best judge of her economic
welfare; and therefore also of her welfare. This value judgment is often
referred to as that of ‘complete consumer sovereignty’.
4) If any change in the allocation of resources increases the income and
leisure of everyone or at least one person (or more strictly one household)
without reducing those of any other, then the change should be considered
to have increased social welfare.
Thus, it can be mentioned that welfare economics cannot be purged of value
judgments. In fact the study of welfare economics has been developed to
make policy recommendations for promoting social welfare and for doing so
economists cannot escape from introducing ethical norms or value judgments.
Therefore, I.M.D. Little in his book, ‘A Critique of Welfare Economics’
(1957) has observed, “Welfare economics and ethics cannot, then, be
separated. They are inseparable because the welfare terminology is a value
terminology…Getting rid of value judgments would be throwing the baby with
the bathwater. The subject is one about which nothing interesting can be said
without value judgments for the reason that we take a moral interest in
welfare and happiness”.
However, it should not deducted from the above analysis that the explicit
introduction of value judgments makes the study of welfare economics
unscientific. In spite of the explicit introduction in welfare analysis, the
economist’s approach can still be scientific in the sense that one scientifically
deduces the welfare propositions from the given value judgments.
14.3 SOCIAL WELFARE FUNCTION

Treating a number of economic variables as inputs, a social welfare function
gives a measure of the aggregate material welfare of a society. Abram
28
Bergson first introduced the idea of a social welfare function in his article ‘A Social Welfare Function
Reformulation of Certain Aspects of Welfare Economics’ in 1938. By
introducing the concept of ‘social welfare function’, Bergson and Samuelson
approached welfare analysis in a different way. They based the concept of
SWF on ordinal preferences of individuals and argued that welfare economics
is essentially a normative study, but the approach should be scientific despite
the fact that the incorporation of value judgments in it is simply unavoidable.
It would be prudent to have a brief overview of some alternative welfare
functions, which will be helpful in bringing out some embedded ethical
judgments. The classical welfare function was put forward by Bentham, Pigou
and Marshall, popularly known as ‘Benthamite welfare function’. According
to them, social welfare is the sum of cardinal utilities obtained by all members
of a society. In algebraic form, this can be denoted as:
W=U1+U2+…………+Un
where W denotes social welfare, U1, U2, etc.; represent the cardinal utilities of
the individual members of the society. The goal of a society is to maximise
social welfare, that is, the aggregate of the utilities of the individual members
of society. Given this, maximum social welfare will be achieved if income is
so distributed that marginal utility of income is equal for all individuals in a
society. Moreover, the classical viewpoint is that maximisation of social
welfare is achieved only with equal distribution of income.
Another important social welfare function has been propounded by the noted
philosopher John Rawls. Rawls analysed welfare economics by posing a
problem: “what type of welfare criterion would be adopted by the society
when it is in such an initial position where everybody has to behave under
uncertainty about how the welfare criterion chosen will ultimately affect his
utility or welfare”. Assuming that individuals are risk averse, he asserts that
such a welfare criterion will be chosen that deviations from perfect equality
would be made only when with unequal distribution of utilities, the worst off
individual is better off actually than under equality conditions. This can be
stated algebraically as follows:
W (U1, U2, U3,………….Un) = min (U1, U2, U3,……………Un)
This implies that social welfare of resource allocation depends only on the
worst off individual, that is, the person with minimum utility.
Social welfare function is an ordinal index of society’s welfare and is a
function of the utility level of all individuals comprising the society. The
“Bergson-Samuelson” social welfare function (SWF) can be expressed in the
following general form:
W = W (U1, U2,.., UH),
where “society’s” welfare denoted by W, is merely a function of the utilities
of its constituent members, Uh, h = 1, 2, …...., H, where H are the number of
households in the society. In other words, U1, U2,.., UH represents the ordinal
utility indices of different individuals or households in the society. The ordinal
utility index of an individual depends upon the goods and services she
consumes and the magnitude and kind of work she does and the amount of
leisure she enjoys.
The Bergson-Samuelson SWF can be explained with the help of the grand
utility possibilities frontier (GUPF). We know that every point on the GUPF is
a Pareto-optimal allocation, and thus it seems that no point is necessarily
preferable to another. The Bergson-Samuelson SWF shows that, given the set 29
Welfare Economics of Pareto-optimal points, which is more desirable from “society’s” point of
view, where the notion of social desirability was subsumed in a social welfare
function.
Heuristically, we can envisage the upper contour set of the SWF as a set of
“social indifference curves” in utilities space, as shown in Figure 14.1.
According to Bergson, there are some desirable properties of a society which
are captured by the SWF: for instance, social welfare increases if the utility of
any of its members increase and none decrease (the “Pareto principle”) that
yields northeasterly ascendance of the social indifference curves. It is worth
mentioning that the consideration of fairness and equity are incorporated into
the SWF and are reflected in the shapes of social indifference curves. In other
words, it can be argued that equity is socially desirable; consequently, extreme
distributions of utility ought to be given less weight. Thus, the convexity of
the social indifference curve needs to be accepted and like the usual
indifference curves they are also non-intersecting.
Fig. 14.1: Social Welfare Function and the Social Optimum

By superimposing social indifference curves on the GUPF as in Figure 14.1,
we can see that allocation S = (UA*, UB*) is the point on the GUPF that
attains the highest social indifference curve, and maximises the social welfare
function, yielding social welfare index W*. Thus, the “social optimum” is
determined by the tangency of the social indifference curves and the GUPF.
The SWF as depicted in Figure 14.1 can be explained by the following
functional form:
W = Π h=1H (Uh)α h
where αh are the weights assigned to each household in the social welfare
function. Such a function yields the convex social indifference curves in
Figure 14.1 and is sometimes called a “Bernoulli-Nash” social welfare
function.
It is to be noted that the slope of the social indifference curves is equal to the
negative of (δW/δUA)/ (δW/δUB). This last term in the expression is the
30
“marginal rate of social substitution” between consumers A and B, or Social Welfare Function
MRSSAB. Now, we know that the slope of the GUPF will be merely the ratios
of the marginal utilities of income of households A and B, thus the tangency
condition is that:
MRSSAB = (δW/δ UA)/(δW/δUB) = µA/µ B, and (δW/δUA)/ µA = (δW/δ UB)/
µB, or the social marginal utility for each household is equal across
households.
We can extend this explanation to analyse some alternative welfare function
as
mentioned above. As per the classical or Benthamite or “utilitarian” social
welfare function, the SWF can be constructed as a linear sum of weighted
utilities, e.g;
W = Σ h=1HαhUh
which is a direct sum. Thus, as stipulated by Jeremy Bentham and the
Utilitarians, this one maximises the (weighted) sum of individual utilities and
yields linear social indifference curves (WB’, WB*, WB’’), as shown in Figure
14.2 below.
Fig. 14.2: Benthamite and Rawlsian Welfare Function

Bergson-Samuelson SWF states the conditions for “social justice”, as that,
‘the marginal rate of social substitution between households A and B is equal
to the ratio of marginal rates of substitution of A and B. In other words, this
implies that the allocation of goods is done in such a manner so as to have the
utility distribution compatible with the “worthiness” of the individuals
according to the social welfare function.
Thus, social welfare is a function of the levels of utility of members in the
society. Alternatively, the social welfare function can be expressed as a
function of other variables relevant to welfare, such as income or life
expectancy. The form of the social welfare function can be seen as expressing
a statement of the objectives of a society. For example, take a social welfare
function:
W=Y1+Y2+………+Yn 31
Welfare Economics where W is social welfare and Yx is the income of each of the xth individual in
a society. In this case, maximising the social welfare function means
maximising the total income of the people in the society, without regard to
how incomes are distributed in the society. Alternatively, consider the Max-
Min utility function:
W= min (Y1, Y2,…., Yn)
Here, the social welfare of the society is taken to be related to the income of
the poorest person in the society, and maximising welfare would mean
maximising the income of the poorest person without regard for the incomes
of the others.
These two social welfare functions express very different views about how a
society would need to be organised in order to maximise welfare. While the
first emphasises the total incomes, the second considers the needs of the
poorest.
However, often choice of such a function is considered part of political
economy. Choosing between two such functions may be a matter of tolerances
versus preferences, or some broader political or ethical issue that cannot be
resolved by economics at all. A related problem is the need of individual
capital for rest and recreation, which prevents anyone from actually
maximising the total income. This is at the root of many of the balanced
growth assumptions of macroeconomics: Unless a uniform social welfare
function is chosen across an entire society, growth is not balanced. Due in part
to this concern, more direct means of measuring well-being than “total
incomes” or GDP are required by modern human development theory.
Amartya Sen makes the point more directly: “What is the relation between our
wealth, and our ability to live as we would like?” Without answering this
question, income and welfare are only indirectly related.
1) What is the meaning of value judgment?
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
2) Write the general form of social welfare function.
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
3) What is social optimum and how is it determined?
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
32
Social Welfare Function
14.4 COMPENSATION PRINCIPLE
As discussed in the previous unit, Pareto criterion simply states that an
economic change, which harms no one and makes someone better off,
indicates an increase in social welfare. This does not apply to those economic
changes, which harm some and benefit others. In terms of Edgeworth Box
diagram, Pareto criterion fails to say as to whether or not social welfare
increases as movement is made in either direction along the contract curve
because it rejects the notion of interpersonal comparison of utility. Thus, this
criterion leaves a considerable indeterminacy, for, there are numerous Pareto
optimum points on the contract curve. Economists like Kaldor, Hicks and
Scitovsky have made efforts to evaluate the changes in social welfare
resulting from any economic reorganisation, which harms somebody and
benefits others. They have put forward a criterion known as the Compensation
Principle based on the following assumptions:
• The satisfaction of an individual is independent of others and she is the
best judge of her welfare.
• There exist no externalities of consumption and production.
• The tastes of individuals remain constant.
• The problems of production and exchange can be separated from those of
distribution. Compensation principle accepts the levels of social welfare to
be a function of the production. Thus, it ignores the effects of change in
distribution on social welfare.
• Utility can be measured ordinally and interpersonal comparisons of
utilities are not possible.
Given the above assumptions, Hicks, Kaldor and Scitovsky have claimed to
formulate a value free objective criterion of measuring the changes in social
welfare with the help of the concept of ‘compensating payments’.
14.4.1 Kaldor-Hicks Criteria
Let us consider the Edgeworth-Bowley box as shown in Figure 14.3 below. It
is evident that allocations D and F (and indeed, all allocations in the "lens"
formed by UA(E) and UB(E)) are Pareto-superior to E, but allocation C cannot
be compared to either D, F or E.
An alternative criterion of judging whether an allocation was “preferable” to
another was proposed by Nicholas Kaldor in his article, ‘Welfare Propositions
of Economics and Interpersonal Comparison of Utility’, published in The
Economic Journal, September, 1939. According to Kaldor’s welfare criterion,
if a certain change in economic organisation or policy makes some people
better off and others worse off, then that change will increase social welfare, if
those who gain from the reorganisation could compensate the losers and still
be better off than before. In other words, Kaldor argued that an allocation is
preferred to another if by moving from the second to the first, the “gainer”
from the move can, by a lump-sum transfer, compensate the “loser” for her
loss of utility and still make a gain in utility for herself. Hicks stated that, ‘if A
is made so much better by the change that he could compensate B for his loss
and still have something left over, then the reorganisation is unequivocal
improvement’. To put it in other way, a change is an improvement if the losers
in the changed situation cannot profitably bribe the gainers not to change from
the original situation. Hicks has given his criterion from the loser’s point of
view, while Kaldor had formulated this criterion from the gainer’s point of 33
Welfare Economics view. Thus, the two criteria are really the same though they are exposited
differently. That is why they are generally called by a single name, ‘Kaldor-
Hicks Compensation Criteria’.
Suppose we want to reorganise the allocation by moving from allocation E to
allocation C. This shows that, individual A gains in utility (from UA(E) to
UA(C)) and individual B loses (from UB(E) to UB(C)). This implies that, E and
C are not Pareto-comparable. However, if we move to allocation C, individual
A can pay individual B a portion of her gains so as to keep individual B at her
old utility level UB(E). For instance, A can pay B the amount XAC - XAF (thus
she moves to point F) so that B retains the same old utility level UB (E) while
the utility of A is now UA(F). As the utility of A at allocation C is greater than
that at F, (XAC > XAF), individual A makes a net gain (XAE + (XAC - XAF) plus
whatever she gained in terms of good Y. Thus, as shown in the figure when
U A (F) > UA(E), it is worthwhile for her to propose moving to C and then
paying individual A the amount XAC - XAF, thereby moving the economy to F.
Fig. 14.3: Kaldor Compensation Criteria

Now, if the Kaldor compensation criteria implied merely that we moved from
E to F, then it is not an improvement on the Pareto criterion as F is obviously
Pareto-superior to E. However, Kaldor’s innovation is to propose that
allocation C is superior to that of E because it is possible for A to compensate
B and still be better off. The crucial point is that A can compensate B, and not
that A will compensate B. Thus, the move from E to C is actual, but the move
from C to F is only hypothetical. Thus, Kaldor proposed that we can compare
Pareto-incomparable points via the “hypothetical compensation” test. In sum,
an allocation is preferable to another if it is possible to hypothetically
redistribute goods so that a Pareto-improvement occurs.
It is to be noted that, while the Kaldor criteria can be used to compare Pareto
sub-optimal points with each other and with Pareto optimal points, it remains
incomplete. For, it cannot compare Pareto-optimal points with each other. For
34
example, a movement from one Pareto-optimal allocation to another by C and Social Welfare Function
F in Figure 14.3 will require, via compensation, that the winning individual
surrenders all her gains, such that she will be not be better off.
An alternative test, proposed by John Hicks was that of “bribery” by the losers
as opposed to “compensation” by the winners. An allocation would be
preferable to another if, given a proposed move from the second to the first,
the losers would not be able to bribe the winners into not undertaking the
move. If they were willing to give such a bribe and the winners were willing
to take it instead of moving to the proposed allocation, then the proposed state
would not be superior. Thus, in the case of Figure 14.11 we might think that
individual B might offer individual A, a bribe not to move from allocation E
to allocation C, but clearly A would not accept. There is thus, from E, no
lump-sum transfer that individual B would be willing to give individual A that
would make A no worse off than in state C. As a consequence, C is preferred
to E by the Hicks criteria. Conceptually, then, the Hicks criteria reverts the
Kaldorian notion: C is preferred to E if from E it is not possible to undertake a
hypothetical lump-sum redistribution to achieve a Pareto-improvement over
state C.
The Kaldor-Hicks criteria in a production economy can be explained through
the GUPF and the various allocation possibilities within them. Thus, an
allocation is superior to another if it is possible that the winners compensate
the losers for moving to the former (Kaldor) or if the losers bribe the winners
not to move to the former (Hicks). In a production context, there are now two
forms of the Kaldor criteria:
• The strong Kaldor criteria requires any compensations to be a lump-sum
transfer between individuals and thus, by not allowing production to
change as part of the compensation, one is confined to making transfers
within a given UPF;
• The weak Kaldor criterion allows production to change as part of the
compensation, and thereby the entire GUPF is available.
It is clear that the weak Kaldor criteria can compare all Pareto-sub-optimal
points in the GUPF. However, the strong criteria cannot do so. This is the
complication that Kaldor criteria bring in a production economy. This is
explained in the Figure 14.4 below.
As shown in the figure, there are two Utility Possibility Frontiers (UPF’s).
Suppose we want to compare points E and G. Obviously, E is Pareto-
inferior to F and G is Pareto-inferior to D, but it is not possible to compare
E and G by the Pareto criterion. Let us then employ the strong Kaldor
compensation test: if we move from point E to point G, it is obvious that
individual B is the winner and individual A the loser. However, B can
(hypothetically) compensate A for her loss and still remain better off by
offering a compensation that takes the allocation to point H (note that both
G and H are on the same frontier, UPFF – this is the requirement of the
strong Kaldor criteria). At H, individual A would be at her old utility level,
UA(E), but individual B would have utility UB(H) > UB(E). Thus she is
strictly better off and by the Kaldor compensation criteria allocation G is
superior to allocation E.
35
Welfare Economics UB
UPFD
G K
U B (G )
H
U B (H )
UPFF
U B (E ) E
W'
U A (G ) U A (K ) U A (E ) UA
Fig. 14.4: Incomparability with Strong Kaldor Compensation Criteria

However, suppose we begin at G and want to move towards E. This implies
that Individual A is now the winner and B the loser. Yet, individual A can
hypothetically compensate individual B by offering a transfer payment that
takes the allocation to point K. At K, individual B stays at her old utility level
UB(G), but individual A improves her utility position from UA(G) to UA(K).
Thus, by the strong Kaldor compensation criteria, E is superior to G. And by
the same criteria, G is superior to E. Thus points E and G are not consistently
comparable.
14.4.2 Scitovsky Reversals and the Double Criteria
Not only the strong Kaldor criteria is unable to compare various allocations
consistently, but also there are problems regarding the weak Kaldor criteria
for comparisons of welfare under different types of change. The famous
Scitovsky reversal paradox, first identified by Tibor Scitovsky, uncovered an
important drawback of the weak Kaldor criterion. Scitovsky pointed out that if
some situation position, say B, is shown to be an improvement over position
A on Kaldor-Hicks criterion, it may be possible that position A is also shown
to be an improvement over B on the basis of same criterion. For getting
consistent results when position B has been revealed to be preferred to
position A on the basis of a welfare criterion, then position A must not be
preferred to position B on the same criterion.
Suppose in a production economy, the production conditions change due to
change in technology. This will lead to the shift of the position and as a result
the move from PPFD to PPFF (Figure 14.5). In order to judge whether this
technological change improved or worsened welfare, the corresponding
Pareto-optimal points D and F represented by the tangencies of CICD with
PPFD and CICF with PPFF can be compared.
36
Social Welfare Function
Fig. 14.5: Scitovsky Reversal

It can be seen that CICD and CICF intersect each other, which implies that
intersecting CICs imply Pareto-improvements. This means that F is Pareto-
superior to E. Moreover, E represents the same level of “aggregate” utility as
D as they are on the same CICD. Thus, from D, it is possible to hypothetically
redistribute goods and outputs so that we obtain a Pareto-improvement.
According to the weak Kaldor criteria, situation F is superior to D. However,
by a reverse argument, it can be seen that as a result of the movement from
PPFF to PPFD, D is Pareto-superior to G and G yields the same level of
“aggregate” utility as F as it lies on CICF. Thus, by the weak Kaldor criteria
again, situation D is ranked higher than that of F. There is a “reversal” of
rankings between D and F by the weak Kaldor criteria as F is better than D
and D is better than F.
Therefore, Scitovsky suggested that resolution to this reversal paradox might
be done by combining both the Hicks and Kaldor criteria. This is explained in
the figure above. As can be seen from the figure, the movement from D to F
fulfills the Kaldor criteria but not the Hicksian one, as from D, it is possible to
undertake hypothetical lump-sum redistribution within PPFD that achieves a
Pareto-improvement over F (e.g., a point slightly above G in PPFD is a Pareto-
improvement over G and thus over F).
The Scitovsky double criteria state that an allocation is preferred to another if
it fulfills both the Kaldor and Hicks criteria. This would, it seems, eliminate
Scitovsky reversals as that depicted in Figure 14.5 above. Thus when the two
utility possibility curves are non-intersecting and change involves movement
from a position on a lower utility possibility curve to a position on a higher
utility possibility curve, the change raises social welfare on the basis of the
Kaldor-Hicks-Scitovsky criterion. This occurs only when a change brings
about increase in aggregate output or real income.
14.4.3 William Gorman’s Intransitivity Problem
William Gorman demonstrated that while the Scitovsky double criteria rules
out Scitovsky reversals, it does not rule out intransitive chains. For instance, it
may be that an allocation G is preferred to allocation D, allocation D is 37
Welfare Economics preferred to allocation F but allocation F is not preferred to allocation G. This
is shown in Figure 14.6, where there are three PPFs (PPFD, PPFF and PPFG)
and three CICs corresponding to the Pareto-optimal allocations on each PPF
(allocation D on CICD, allocation F on PPFF and allocation G on PPFG). It can
be seen that unlike in Figure 14.5, D is superior to F by the Scitovsky double
criteria because it is better than F by both the Kaldor and Hicks criteria and
moreover, CICD does not intersect PPFF while CICF intersects PPFD.
Fig. 14.6: Scitovsky Double Criteria - and Gorman Intransitivity

The problem of intransitivity can now be visualized in Figure 14.6. As noted,
by the double criteria, D is preferred to F. By the same double criteria, it can
be argued that G is preferred to D, as CICD intersects PPFG but CICG does not.
However, G and D do not fulfill the double criteria, as CICF intersects PPFG
and CICG intersects PPFF, a situation similar to the one described in Figure
14.5. Thus, by the Scitovsky double criteria, G is preferred to D, D is
preferred to F but G is not preferred to F. Consequently, although the
Scitovsky double criteria rules out ranking reversals and although G is not
preferred to F, F is also not preferred to G and they are merely incomparable,
which implies that the ranking is intransitive.
14.4.4 Samuelson’s Criteria
A way out of Gorman's intransitivity problem has been proposed by Paul
Samuelson, popularly known as the Samuelson Criteria. The Samuelson
criteria argues that a situation G is preferred to a situation D if all hypothetical
redistributions from situation G will achieve utility allocations that are
superior to some hypothetical redistributions from situation D and that no
hypothetical redistribution from situation D will yield utility allocations that
are unattainable through any hypothetical redistributions from situation G. in
other words, the utility space lies everywhere above UPFD. In production
space, it requires that PPFG intersects the interiors of CICD and the interior of
any other CIC tangent to PPFD. Clearly, this will often require that PPFG lies
everywhere above PPFD - as in Figure 14.6. Naturally, if we deal exclusively
with PPFs of this type, neither Scitovsky reversals nor Gorman intransitivities
arise. But it also obviously highly restrictive as it rules out quite reasonable
38
situations (e.g., those depicted in Figures 14.5 and 14.6). Thus, in this sense, Social Welfare Function
the Samuelson criterion is far more restrictive than the Kaldor, Hicks or
Scitovsky double criteria.
1) What are the assumptions of compensation Principle?
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
2) Differentiate between Kaldor and Hick compensation principle.
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
3) What are Scitovsky’s double criteria of compensation?
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
14.5 AN APPRAISAL
In sum, disregarding the problems inherent in the Kaldor, Hicks and Scitovsky
criteria, the question must be raised again: are these objective criteria make
any sense? Ethically, of course, the Kaldor criteria is easily disputed as it is
only a “could” and not a “would” or even a “should”. As In M.D. Little
writes, in his famous critique:
“It seems improbable that so many people would, in England now, be
prepared to say that a change, which, for instance, made the rich so much
richer that they could (but would not) overcompensate the poor, who were
made poorer, would necessarily increase the wealth of the community.”
A point that has been reiterated by many contemporaries’ economists such as,
Baumol, Reder and Samuelson.
However, there were three lines of defense followed by the advocates of the
compensation principle. The first was to agree and make the “could” into a
“would”, i.e; to have the winners actually compensate the losers. This, of
course, leads to an improvement of sorts; the practical objection that arises is
that once we are at a new allocation, winners are unlikely to surrender any of
their gains.
The second defense, pursued by Hicks (1941), was that even if the losers do
not get compensated in the move, they might still benefit in the “long-run” if
the criteria were followed consistently by the society. This argument is similar
to that of “trickle-down” theory and that support for free trade. Some people
may be worse off in the short-run, but in the long run, everyone will be better
off. The underlying assumption, of course, is that at some point, those who
lost utility initially will come across a possible move in which they benefit and 39
Welfare Economics a society which follows the Kaldorian rule will move to it and thus they will
gain in the end. Of course, as Little notes, this is completely hypothetical.
There is nothing to guarantee that there will eventually be a move in which the
initial losers will be the ultimate winners.
The third (and perhaps considered better) line of defense is that the Kaldor-
Hicks criteria merely lay out what is economically possible and that it is up to
policy-makers, on the basis of their own value judgments, to choose which
move to make and whether compensation of the losers should be forced. Thus,
they argue, they are merely underlining that certain options may be more
economically possible than others, but they are still only options. The final
decision will require more philosophical, ethical and political considerations
to be brought into the story.
14.6 LET US SUM UP

Value judgments are crucial in welfare analysis and hence the analysis cannot
be purged of them. However, despite the explicit introduction of value
judgments, the economist’s approach can still be scientific in the sense that
one scientifically deduces the welfare propositions from the embedded value
judgments in the welfare analysis. In fact value judgements play a role in
formulating social welfare function, which is a measure of social welfare of
society. There are different types of social welfare functions. The classical or
Benthamite SWF and the Rawlsian ethical SWF emphasises on the cardinal
approach, while the Bergson-Samuelson SWG is based on ordinal approach
and hence scientific. However, the construction of SWF is a matter of political
economy.
We also analysed the compensation principle as an improvement over the
Paretian optimality, as it evaluates the changes in social welfare as a result of
any economic reorganisation, which harms somebody and benefits others,
neglected by the indeterminate Paretian optimality analysis. We also discussed
the two different ways of Kaldor and Hicks exposition of Pareto optimality
from the gainers and loser’s point of view respectively. We explained how
Hicks criterion revert the Kaldor’s criterion. Then we examined the Scitovsky
reversal criteria and the Gorman’s problem of intransitivity and how
Samuelson’s criterion offers a solution. We summed-up by pointing out that
disregarding the problems inherent in the above criteria, whether these
objective criteria make any sense or not and came to the conclusion that
ethically, Kaldor criteria can be easily disputed as it is only a ‘could and not a
‘would’ and a ‘should’.
14.7 KEY WORDS

Benthamite or Utilitarian Welfare Function: A utilitarian welfare function
(also called a Benthamite welfare function) sums the utility of each individual
in order to obtain society's overall welfare. Everyone is treated the same, no
matter what their initial level of utility is.
Hicks’ Criterion: An activity will contribute to Pareto optimality if the
maximum amount the losers are prepared to offer to the gainers in order to
prevent the change is less than the minimum amount the gainers are prepared
to accept as a bribe to forgo the change.
Kaldor Criterion: An activity will contribute to Pareto optimality if the
maximum amount the gainers are prepared to pay is greater than the minimum
amount that the losers are prepared to accept.
40
Max-min Criterion: ‘Welfare is maximised when the utility of those society Social Welfare Function
members that have the least is the greatest’. No economic activity will
increase social welfare unless it improves the position of the society member
that is the worst off.
Social Welfare Function (SWF): A function that measures the material
welfare of a society using a number of economic variables.
Value Judgment: Ethical beliefs of people about what is good or bad, not
based on scientific logic or law.

H. L. Ahuja (1997), Advanced Economic Theory, New Delhi: S.C.Chand &
Company Ltd
Paul A. Samuelson (1947), Foundations of Economic Analysis. 1983 edition,
Cambridge, Mass: Harvard University Press.
S. K. Nath (1969), A Reappraisal of Welfare Economics, London: Routledge
and Kegan Paul Ltd.

PROGRESS
1) Ethical beliefs of people about what is good or bad not based on
scientific logic or law.
2) W = W (u ,1 u 2 ..............u 4 )
3) Social optimum is determined by the tangency of social indifference
curve and grand utility possibilities frontier.
1) See section 14.4 and answer
2) Hick Criteria revert the Kaldorian notion. See sub-section 14.4.1
3) An allocation is preferred to another if it satisfies both Kaldor and Hicks
criteria.
14.10 EXERCISES
1) Write short note on value judgments and their role in welfare analysis.
2) What do you mean by social welfare function? Explain different
approaches to it.
3) Critically evaluate compensation criteria. Do they serve any purpose in
welfare analysis? Explain.
41
Welfare Economics
UNIT 15 IMPERFECT MARKET
EXTERNALITY AND PUBLIC GOODS
Structure
15.0 Objectives
15.1 Introduction
15.2 Inability to Obtain Optimum Welfare
15.2.1 Market Failure
15.2.2 Imperfect Competition
15.2 3 Natural Monopoly
15.2.4 Imperfect Knowledge, Uncertainty, Non-existent and Incomplete Market
15.3 Externality
15.3.1 Types of Externalities
15.3.2 Externalities in Supply and Demand
15.3.3 Negative Externalities
15.3.4 Beneficial Externalities
15.3.5 Externality and Coase Theorem
15.4 Public Goods and Market Failure
15.4.1 Scitovsky Contour for Public Goods
15.4.2 Inefficient Provision of Public Goods
15.4.3 The Lindahl Formula
15.5 Let Us Sum Up
15.6 Key Words
15.9 Exercises
15.0 OBJECTIVES
• understand the reasons for the inability to obtain optimum welfare;
• explain the phenomenon of externality and its significance; and
• able to realise the problems inherent in the consumption of public goods.
15.1 INTRODUCTION
In the last unit, we discussed how through different compensating criteria, we
will be able to obtain optimum welfare in competitive market conditions
through economic reorganisation. But the real life conditions do not always
exhibit the competitive features of the market owing to some constraints.
Therefore, we are unable to attain optimum welfare. In this unit, we will
examine these conditions, which lead to market failure and inability to obtain
optimum welfare in the society. We shall also discuss the phenomenon of
externality, which is peculiar to the consumption of public goods.
15.2 INABILITY TO OBTAIN OPTIMUM

WELFARE
In the last unit, we noted that under some assumptions a perfectly competitive
42 economy in equilibrium is a Paretian optimum. Let us now examine if there
are likely to be situations in practice for which all or some of the assumptions Imperfect Market Externality
are not satisfied. In other words, in real world situation there are some and Public Goods
situations in which it is not possible to achieve optimum welfare. The
conditions to be broadly examined here one imperfections, market failure,
decreasing costs, uncertainty and non-existent and incomplete markets.
15.2.1 Market Failure
A market failure is a case in which a market fails to efficiently provide or
allocate goods and services. In general terms, market failures are situations
where market forces do not serve the perceived "public interest". The two
main reasons for which it fails are (1) sub-optimal market structures and (2)
the lack of internalisation of costs or benefits in prices.
Examples of sub-optimal market structures include:
Imperfect competition
• Monopoly
• Monopsony
• Oligopoly
• Oligopsony
• Monopolistic competition
• Downward sloping long run average cost curve, i.e. natural monopoly
• Price discrimination
• Price skimming
External costs and benefits
Examples of latter include:
Externality
Public goods and common property resources
• Tragedy of the commons
• Free rider problem
Uncertainty and non-existent and incomplete markets
• Asymmetrical information
• Adverse selection
• Moral hazard
• Principal-agent problem
• Market power
15.2.2 Imperfect Competition
Imperfect competition is one of the standard examples of market failure,
which leads to the non-achievement of Pareto optimality. It is on this basis
that economic policy is usually suggested as necessary to reduce in efficiency.
Forms of imperfect competition include:
• Monopoly, in which there is only one seller of a good.
• Oligopoly, in which there is a small number of sellers.
43
Welfare Economics • Monopolistic competition, in which there are many sellers producing
highly, differentiated goods.
• Monopsony, in which there is only one buyer of a good.
• Oligopsony, in which there is a small number of buyers.
There may also be imperfect competition in markets due to buyers or sellers
who lack information about prices and the goods being traded. There may also
be imperfect competition due to a time lag in a market. For example, in the
1990s, there was a shortage of computer programmers as becoming a skilled
programmer requires several years of experience the shortage of such skilled
personnel continued. Another example is the "jobless recovery". There are
many growth opportunities available after a recession, but it takes time for
employers to react, which would result in gainful employment. Hence high
unemployment persists.
To demonstrate that imperfect competition fails to generate a Pareto optimum,
it is necessary to provide a suitable characterisation of Pareto optimality.
There are several ways in which this can be done. First, by consideration of
the competitive equilibrium it can be appreciated that competitive firms price
at marginal cost which is one of the conditions for Pareto optimality. In
contrast, price will not be equal to marginal cost in the imperfectly
competitive industry.
A second method of comparison is that at a Pareto optimum, the ratio of
shadow prices for any pair of goods is equal to the ratio of market prices. But
for the economy with imperfect competition, assuming that there is a single
firm in each imperfectly competitive industry, prices are not proportional to
the marginal rates of transformation, which captures the social cost of
producing each good. In addition, the imperfectly competitive firms take the
effects of their actions upon prices into account, which eliminates the direct
proportionality.
The imperfectly competitive equilibrium cannot maximise the value of any
social welfare function that satisfies the Pareto criterion. This observation
then makes it natural to consider what the degree of welfare loss may actually
be, either for a real economy or for simulated examples. The assessment of
monopoly welfare loss has been a subject of some dispute in which
calculations have provided a range of estimates from the effectively
insignificant to considerable percentage of potential welfare.
That monopoly causes loss of welfare and misallocation of resources will
become clear by considering the following Figure 15.1.
It will be seen from the figure that the transformation curve of the community
AB is tangent to the community indifference curve IC3 at point E. Therefore,
at point E MRTxy of the community is equal to the MRSxy. Thus, E represents
maximum possible level of social welfare and the combination of two
commodities being produced represents optimum allocation of resources. But
when the commodity X is being produced under conditions of monopoly, the
equilibrium will be at H, not at E
44
Y
Imperfect Market Externality
l and Public Goods
A
k
R k'
H
P
l
Comm odity Y
IC4
E
N
IC3
P' IC2
IC1
O Q M B X
Commodity X
Fig. 15.1: Monopoly as an Obstacle to Attain Pareto Optimum
This is because, under monopoly, producers would be equating MRT or the
ratio of marginal costs with the ratio of marginal revenues and not with the
ratio of prices of two goods. Since consumers would be equating MRS with
the price ratio of two goods, the MRT in the equilibrium position at point H
will not be equal to the MRS. This is quite obvious from the figure where at
point H transformation curve AB and consumers indifference curve IC1 are
intersecting. This implies that the slopes of transformation curve at point H,
which indicates MRT and the slopes of consumer’s indifference curve IC2,
which indicates MRSxy will not be the same. It will be observed from the
figure that at point H, MRS is greater than MRTxy, as tangent ll’ drawn to
point H on IC1 is steeper than the tangent kk’ drawn to point H on the
transformation curve AB. This means that consumers’ preference is that good
X should be produced more but because of the existence of monopoly in the
production of commodity X, it is not being produced to the desired quantity.
As a result, the level of satisfaction or welfare of the consuming community is
at a lower level than possible under the given production conditions. Thus,
monopoly has caused misallocation of resources.
15.2.3 Natural Monopoly
A natural monopoly is referred to a market structure, where a single firm is
the only supplier of a particular kind of product or service due to the
fundamental cost structure of the industry that precludes another entry.
Natural monopolies are often contrasted with coercive monopolies, in which
competition would be economically viable if allowed but potential
competitors are barred from entering the market by law or by force.
Natural monopolies arise where the largest supplier of an industry, or the first
supplier to a local area, has an overwhelming cost advantage over other actual
or potential competitors. This tends to be the case in industries where capital
costs predominate creating economies of scale, which can be reaped at an
output level large enough in relation to the size of the market. Such high costs 45
Welfare Economics create barriers to entry. Examples of these types of industries include water
services and electricity. It may also depend on control of a particular natural
resource. Companies that grow to take advantage of economies of scale often
run into problems of bureaucracy; these factors interact to produce an “ideal”
size for a firm at which its average cost of production is minimised. If that
ideal size is large enough to supply the whole market, then that market is a
natural monopoly.
Fig. 15.2: Long Run Decreasing Average Cost in the case of Natural Monopoly
A natural monopoly occurs in a market where the average cost curve is
decreasing over the entire relevant range of outputs. In Figure 15.2, a typical
“U” shaped long-run average cost curve (LRAC) is shown. It reflects the
common tendency for average costs to first fall then rise as output increases.
In the case of a natural monopoly, the entire relevant part of the LRAC curve
(that is, the range of outputs where demand for the product exists) is
downward sloping.
If a single company supplies the entire market, the output it produces will
correspond approximately to the amount Q. If two firms supply the market,
each firm will produce approximately Q/2, and if there are three firms, each
will produce Q/3. The more firms in the industry, the less each firm will
produce, and the greater will be the cost structure for each firm.
46 Fig. 15.3: Price and Output Determination Under Natural Monopoly

If a natural monopolist were free to set prices or output levels, it would tend to Imperfect Market Externality
produce approximately Q1 units of output and charge a price of about P1 and Public Goods
(Figure 15.3). This price and quantity combination is considered sub optimal
by most economists: as the diagram suggests, it creates windfall profits for the
monopolist and also generates less than socially optimal quantities of the good
(that is, less product than would be demanded if the price was lower). It also
creates what economists call a “dead-weight loss” to society. For these
reasons, governments tend to restrict the prices that a natural monopolist can
charge. Typically, governments set the price at P2 (determined by the largest
quantity of output that the market demands and that can be produced
profitably).
15.2.4 Imperfect Knowledge, Uncertainty, Non-existent and
Incomplete Market
It is to be noted that though the assumption of perfect knowledge about
relevant prices seems very strong, it is possible to believe that some real world
situations would approximate it sufficiently for a more or less unique
equilibrium price for more or less identical products to emerge. But it is also
possible to conceive of real world situations where the assumption of perfect
knowledge is far too strong. In other words, even an economy solely
consisting of perfectly competitive industries, at least some of which are not
in equilibrium will not have allocation, which is Paretian optimal. Moreover,
if perfect knowledge is not assumed, there is no necessary reason why each
perfectly competitive industry should be in equilibrium.
The recognition of imperfect knowledge has important implication that the
price mechanism. Working on its own it may not be sufficient to bring about
the necessary conditions for technological efficiency which is likely to be
relevant to most kinds of social welfare functions. One important reason for
this is the recognition of the possibility of uncertainty introducing information
as a good into the analysis. The marginal cost of transmitting certain kinds of
information is often low or even zero. To the extent that some information
(e.g., about improvements in techniques and designs etc.) is a factor of
production, technological efficiency requires its price be the same for all
producers. This requires that the information should be available to all its
potential users at the very low or zero marginal cost, at which it is available to
its original possessor or discoverer. But if information once gained has to be
transmitted so cheaply, there may be very little incentive for firms and
individuals to engage in information seeking activity, i.e., research. On the
other hand, with the grant of legal rights for restricting the use of newly
discovered knowledge, the necessary conditions for reaching the economy’s
production frontier are violated; one might say this is because less than the
‘maximum’ use is made of the new knowledge. There is then a dilemma here.
Moreover, even the free or low cost availability of information about new
techniques of a kind, which would pass a reasonable investment criterion
sometimes, does not ensure that entrepreneurs will in fact utilise that
information. If that were certain, governments would have given extra
inducements to bring this about. Attempts to look at the underlying reason
behind such a tendency involve ethical assessments. For, if entrepreneurs
prefer a ‘quiet life’ and, according to the adopted social welfare functions of
the society concerned are entitled to follow their own judgment in such things,
then the technological efficiency for such an economy would have to be
modified to include the constraint of a ‘quiet life’ among the other constraints.
If we ignore this rather special possibility, we have here an important reason 47
Welfare Economics for doubting the ability of the market mechanism working entirely on its own
to take the economy to its production frontier or consequently, its Paretian
utility frontier.
Let us now examine the other way in which the existence of uncertainty might
prevent the attainment of the economy’s production frontier. An example may
be helpful at this stage. Suppose the welfare function of some society and its
economic circumstances are such that it is considered desirable to have an
annual amount of a good called X1. So far, this good has been imported by
some firms. Assume that X2 is an important component of X1. X2 is not
produced at present at home because X1, its sole or main user, is produced
abroad; and because transport costs prevent competitive sale of X2 abroad.
Hence, if any firm is to undertake the manufacture of X2 at home it must know
that X1 will also begin to be produced at home. Now it may be that it would be
more profitable to manufacture X1 at home rather than to import if X2 were
available at home. Hence, if it were known that X2 was going to be produced
at home, then X1 would also be produced at home. If both X2 and X1 were
produced at home, then the society would get X1 cheaper by at least the
transport costs. If there also happens to be some unemployment in the
economy-structural or involuntary, whether it is disguised or not- then there is
also a favorable employment effect.
The example could be slightly altered by assuming that X1 is neither produced
nor imported; but that if X2 were produced at home, then it would become
profitable for some firms to produce X1 and that X2 is profitable only if X1 is
also being produced.
Normally when the mutual repercussions on the profitability of any two (or a
group of) industries are so strong we should expect integration between them
or exchange of information through trade journals (or even monopolistic
collusion-if the repercussions are along a horizontal relationship rather than a
vertical one as in our example). But vertical integration is sometimes
uneconomical when a region is adopting a certain kind of industry for the first
time: the necessary entrepreneurial and managerial skill for quite so large an
enterprise may be lacking; and- to introduce an imperfection in the market- it
might be difficult to raise the necessary finance for a large integrated
undertaking, even it would otherwise be economically viable. As for tacit or
overt monopolistic collusion, there may be legal prohibition to prevent that.
Exchange of information is the other possibility as mentioned above. Such
exchange of information may actually take place. Assuming perfect
knowledge implies that it may actually take place. But in fact, there is no
absolute necessity about it, and it is possible that in economies with relatively
few entrepreneurs, trade journals, or clubs where businesspersons might meet,
such exchange of information often fails to take place. Such conditions of
imperfect dissemination of commercial information then constitute another
reason why the market working on its own may not be able to take the
economy to its production frontier to attain optimum welfare.
Moreover, even if competition were almost perfect in some economy,
knowledge about changes in technology and about mutual profitability
relationships would not necessarily be perfect. Indeed, the newer a certain
kind of industry is to a region, and the less developed a region is the more
important are the imperfections in business knowledge likely to be.
It is worth mentioning that in situation of the kind discussed in our foregoing
example, a mere provision of information about the mutual profitability
48 relationships of X1 and X2 may not always be sufficient to ensure that the two
industries would get started. Depending on the kind and degree of risk- Imperfect Market Externality
aversion prevalent among the entrepreneurs, it may sometimes be necessary, and Public Goods
provided it is not overruled by some other considerations laid down by the
social welfare function-also to provide some assurance to the entrepreneurs in
each industry that the industry would also be starting. The assurance might
take the form of subsidies and guarantees by an outside agency, in other
words, it calls for government intervention.
However, even government-assisted coordination can ever abolish another
kind of uncertainty, which concerns possible changes in tastes, technology,
weather and so on. Uncertainty from these sources can never be abolished, no
matter what amount of coordination takes place. This kind of uncertainty
makes it impossible to be sure that any pattern of allocation, which is
presently considered desirable, will still be considered so by the time it has
been achieved. This is a kind of uncertainty conditioning human existence,
which is another, factor causing the inability to attain optimum.
Another field where there may be an important degree of uncertainty through
the market interdependence is the consumers’ saving decisions. A consumer’s
regarding the form and size of her savings is likely to be affected by her
estimate of the future changes in the absolute price level and in relative prices;
but what these changes will be, depends, to some extent, on others’ saving
decision which the consumer acting on her own has no way of knowing.
1) Why is it not possible to obtain optimum welfare always?
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
2) How a natural monopoly leads to produce a sub optimal price-quantity
combination?
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
3) What do you mean by market failure? What are its causes?
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
15.3 EXTERNALITY
The existence of externality prevents the achievement of Pareto optimality
even when perfect competition prevails. An externality occurs in when a
decision (for example, to pollute the atmosphere) causes costs or benefits to
individuals or groups other than the person making the decision. In other
words, the decision-maker does not bear all of the costs or reap all of the gains
from her action. As a result, in a competitive market too much or too little of 49
Welfare Economics the good will be consumed from the point of view of society. If a company
making the decision benefits more than it does (education, safety), then the
good will be under-consumed by other. On the other hand, if the costs to the
world exceed the costs to the individual making the choice (pollution, crime),
then the good will be over-consumed from society's point of view.
15.3.1 Types of Externalities
Examples of externalities include:
• Pollution by a firm in the course of its production which causes nuisance
or harm to others. This is an example of a negative externality, external
cost, or external diseconomy.
• The harvesting by one fishing company in the open sea depletes the stock
of available fish for the other companies. Over-fishing may result. This is
an example of a common property resource, sometimes referred to as the
Tragedy of the commons.
• An individual planting an attractive garden in front of her house may
benefit others living in the area. This is an example of a positive
externality, beneficial externality, external benefit or external economy.
• An individual buying a picture-phone for the first time will increase the
usefulness of such phones to people who might want to call her. This may
lead to the general acceptance of these phones. This is an example of a
network externality.
In contrast; a property tycoon buying up a large number of houses in a town,
causing prices to rise and therefore making other people who want to buy the
houses worse off (perhaps by excluding them from the housing market), is not
causing an externality, because the effect is through prices, and is considered
part of the normal functioning of the market. Alternatively, these effects are
sometimes called “pecuniary externalities”, with externalities as defined
above called “technological externalities.”
Externalities are important in economics because they may lead to
inefficiency. Because the producers of externalities do not have an incentive
to take into account the effect of their actions on others, the outcome will be
inefficient. There will be too much activity that causes negative externalities
such as pollution, and not enough activity that creates positive externalities,
relative to an optimal outcome.
15.3.2 Externalities in Supply and Demand
The usual economic analysis of externalities can be illustrated using a
standard supply and demand diagram if these can be monetised (valued in
terms of money). An extra supply or demand curve is added, as in the
diagrams below. One of the curves is the private cost that consumers pay as
individuals for additional quantities of the good (in competitive markets, the
marginal private cost) and the other curve is the true cost that society as a
whole pays for production and consumption of increased production the good
(the marginal social cost).
Similarly, there might be two curves for the demand or benefit of the good.
The social demand curve would reflect the benefit to society as a whole, while
the normal demand curve reflects the benefit to consumers as individuals and
is reflected as effective demand in the market.
50
15.3.3 Negative Externalities Imperfect Market Externality
and Public Goods
Figure 15.4 below shows the effects of a negative externality. For example,
the steel industry is assumed to be selling in a competitive market – before
pollution-control laws were imposed and enforced. The marginal private cost
is less than the marginal social or public cost by the amount of the external
cost, i.e., the cost of the smoking stacks and water pollution. This is
represented by the vertical distance between the two supply curves. It is
assumed that there are no external benefits, so that social benefit equals
individual benefit.
Fig. 15.4: Effects of Negative Externality

Supply and Demand with external costs
If the consumers take into account their own private cost only, they will end
up at price Pp and quantity Qp, instead of the more efficient price Ps and
quantity Qs. The latter price and quantity reflect the idea that the marginal
social benefit should equal the marginal social cost, i.e., production should be
increased only as long as the marginal social benefit exceeds the marginal
social cost. The result in an unfettered market is inefficient since at the
quantity Qp, the social benefit is less than the societal cost, so society as a
whole would be better off if the goods between Qp and Qs had not been
produced. The problem is that people are buying and consuming too much.
This discussion implies that pollution is a problem where the disjuncture
between marginal and social costs that is not solved by the free market.
15.3.4 Beneficial Externalities
The example of industry supplying smallpox vaccinations is assumed to be
selling in a competitive market may be cited to appreciate the efforts of
positive or benefited externality. See that the marginal private benefit of
getting the vaccination is less than the marginal social or public benefit by the
amount of the external benefit, i.e., the fact that if one person gets the
vaccination, others are less likely to get the smallpox even if they themselves
are not vaccinated. Figure 15.5 below shows the effects of a positive or
beneficial externality. The marginal external benefit of getting a smallpox shot
is represented by the vertical distance between the two demand curves.
Assume that there are no external costs, so that social cost equals individual
cost.
51
Welfare Economics
Fig. 15.5: Effects of Positive Externalities

If consumers only take into account their own private benefits from getting
vaccinations, the market will end up at price Pp and quantity Qp as before,
instead of the more efficient price Ps and quantity Qs. These latter price
quantity combination reflects the idea that the marginal social benefit should
equal the marginal social cost, i.e., production should be increased as long as
the marginal social benefit exceeds the marginal social cost. The result in an
unfettered market is inefficient since at the quantity Qp, the social benefit is
greater than the societal cost. So the society as a whole would be better off if
more goods had been produced. The problem is that people are buying too few
vaccinations.
The issue of external benefits is related to of public goods, i.e., goods where it
is difficult, if not impossible, to exclude people from benefits.
15.3.5 Externality and Coase Theorem
Ronald Coase asserted that under perfect competition private and social cost
will be equal and addressed a well-known problem of market externalities,
known as the ‘Spillover Effect’. This occurs when someone other than the
buyer must share the benefits or costs of a product. The classic example of
such a perception is pollution. Factories can either treat pollution - which
costs money – or dump it into the air or water for free. If they choose to dump,
they may save their customers some money, but citizens who live near the
factory will also pay a price in higher death and disease rates, less fertile land,
environmental catastrophes, etc. Sometimes the spillover effect is both
positive and negative. An airport obviously benefits its customers, but it also
subjects the local neighborhood to various externalities. Positive ones include
increased local business; negative ones include noise pollution.
Coase argued that individuals could organise bargains so as to bring about an
efficient outcome and eliminate externalities without government intervention.
The government should restrict its role to facilitating bargaining among the
affected groups or individuals and to enforcing any contracts that result. This
result, often known as the “Coase Theorem,” requires that:
52
• property rights are well defined; Imperfect Market Externality
and Public Goods
• the number of people involved is small; and
• bargaining costs are very small.
Only if all three of these conditions apply then individual bargaining will
solve the problem of externalities.
The main implication of the theorem is that if remedies are considered in the
unrealistic world in which competitive markets are normally considered, a
world of zero transactions costs, the Pigovian remedies said to be necessary
for an efficient resolution of externality problems are not, in fact, necessary.
All that is needed is a common law or statutory rule, which assigns rights over
the externality to one party or another. The market/pricing mechanism will
then function in the same way as it does for the ordinary goods and services
over which rights clearly defined. Furthermore, if rights are well defined, the
observed situation will be efficient (the parties having taken all Pareto-
improving steps) and any further intervention (for example, Pigovian
remedies) will make matters worse rather than the better.
However his theorem has been severely criticized on many grounds. It can be
mentioned the three initial reasons why the Coase Theorem, as specifically
formulated above, is wrong. These are based on the inadequacy of zero
transaction costs as a proxy for perfect competition. First, monopolies, such as
a typical railway company, are unlikely to act like competition despite
Coase’s claim to the contrary. Secondly, Arrow demonstrated a priori that the
characteristics of many externalities make unfeasible a competitive market in
them. Consider a market in rights to produce a negative externality, which
affects the whole public. Each person has a permit, which she may sell to a
firm, allowing the production of a certain amount of the externality. But her
selling of that permit creates a negative externality for other members of the
public. Many externalities are impossible to internalise. Thirdly, imperfect
information will thwart the bargaining process for legal entitlements, leading
to Prisoners Dilemma type situations.
Regardless of the inadequacies of the zero transaction costs approximation,
the initial allocation of entitlement always has distribution consequences for
wealth. As a result, demand for other goods and services will be dependent on
the initial allocation of property rights. The shapes of our aggregate marginal
willingness to pay and marginal cost curves will then change, being dependent
on the demand for other goods and services. Consequently, the efficient
outcome is dependent on the initial legal decision. This amounts to outright
theoretical falsification of the theorem.
Varian has noted, however, that in the very special circumstances, where
preferences are quasilinear, the strict version of the theorem may hold.
Quasilinear preferences suggest the absence of income effects, implying
demands for the emission permits are independent of the income distribution.
This is seen in the form of a horizontal contract curve yielded in an Edgeworth
Box analysis of the situation.
Varian does not acknowledge Arrow’s aforementioned objection, however,
which would deny the theorems veracity even in this special case.
A final objection to the theorem is that the notable externalities of our age,
such as ozone depletion and nuclear pollution, affect a large number of
people, implying large transaction costs. This further consolidates the political
irrelevance of the theorem.
53
Welfare Economics Thus, it can be concluded that though Coase’s theorem is subject to serious
criticisms and controversies due to its inadequate empirical relevance, yet at
the same time, it has helped in the emergence of numerous policy
formulations in the welfare imperatives of societies.
1) Why externalities in demand and supply give rise to inefficient
outcome?
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
2) What are the recommendations of Coase to the problem of externality?
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
3) What are externalities? Distinguish between positive and negative
externalities with suitable examples from your day-to-day life.
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
15.4 PUBLIC GOODS AND MARKET FAILURE

The market economy, when certain conditions are met, serves to secure an
efficient use of resources in providing for private goods. Consumers must
bid for what they wish to buy and must thus reveal their preferences to
producers. Producers, in trying to maximise their profits, will produce what
consumers want to buy and will do so at least cost. Competition will ensure
that the mix of goods produced corresponds to consumers' preferences. This
view, of course, is a highly idealised picture of the market system. In reality,
various difficulties arise. Markets may be imperfectly competitive,
production may be subject to decreasing cost, consumers may lack sufficient
information or be misled by advertising, and so forth. For these reasons, the
market mechanism is not as ideal a provider of private goods as it might
be. But even so, it does a good job and a better one than can be done
otherwise.
At the same time, the market cannot solve the entire economic problem.
First, and most important in the present context, it cannot function effectively
if there are “externalities,” by which we mean situations where
consumption benefits are shared cannot be limited for particular consumers
where “economic activity results social cost which are not paid for by the
producer or the consumer who causes them. Second, the market can respond
only to the effective demands of consumers as determined by the prevailing
state of income distribution, but society must also judge whether this is the
54
distribution it wants. Third, there re problems of unemployment, inflation, Imperfect Market Externality
and economic growth which do not take care of themselves automatically. and Public Goods
Thus, a public good is difficult to produce for private profit, and it is difficult
to get people to pay for its beneficial externalities. By definition, a public
good possesses two properties:
• It is non-rivalrous, meaning that its benefits do not exhibit scarcity of
consumption; once it has been produced, each person can benefit from it
without diminishing anyone else's enjoyment.
• It is non-excludable, meaning that once it has been created, it is impossible
(or at least very difficult) to prevent people from gaining access to the
good.
Public goods are “pure” when they possess these properties absolutely. There
are impure public goods those confined to particular localities (for example,
‘A’ congested road). The problem with public good is that a free market is
unlikely to produce its optimum amount. Important public goods such as
national defense will be under-produced due to the free-rider problem. In
practice, this problem has been solved through government intervention and
the provision of public goods by the state. These solutions are not without
critics, however, since there are some who have argued that such interventions
can lead to too many resources being allocated to a public good's production.
In the case of national defense, this is the alleged problem of the military-
industrial complex. Also, the centralized governments are not the only
substitute for markets. In theory, tradition and decentralised democracy might
play a role of the government.
A public good is the opposite of a private good, i.e., a good that can be sold in
the market. A loaf of bread, for example, is a private good. Its owner can
exclude others from using it, and once it has been consumed, it cannot be used
again.
Fig. 15.6: Scitovsky Contour

What constitutes an efficient production of public goods? Suppose there is a
single private good, a single public good and the society consists of two
individuals, Joe and Percy. There is a production possibility frontier such that
we cannot produce more public goods without diverting resources from
production of private goods (see Figure15.6). We now want to derive the
Scitovsky contour and look for a condition of its tangency with the PPF. 55
Welfare Economics 15.4.1 Scitovsky Contour for Public Goods
Suppose we have certain amount of the public good (see in Figure 15.7). To
derive a Scitovsky contour, we add vertically Joe's and Percy's indifference
curves. The slope of the PPF (the rate of product transformation) should be
equal to the slope of the Scitovsky contour. With private goods, the slope of
the contour was the common MRS of a single individual. With public goods,
its slope is the summation of the MRS (summed over all people). So, for
public goods:
RPT = MRS
This makes sense because the opportunity cost of producing the public good is
the RPT. Since we all get to consume that unit of the public good, its value to
different consumers from consuming that unit should be equal to the value of
the resources that went into producing that unit. For a private good, because
one uses up the resources that went into producing it, it has to be worth it to
her to pay for all the resources that went into producing it. With a public good,
because all get to use it simultaneously, it has to be worth it for all collectively
to pay for the resources that went into producing it.
Fig. 15.7: Distribution of Public School Education

15.4.2 Inefficient Provision of Public Goods
Suppose we have a public good but we can exclude people from using it.
Remember that it does not involve extra cost to let someone use a public good
(e.g., a park). If we try to charge people to let them in and set the price higher
than what is worth to the least park-liking person, then we end up with an
inefficient outcome. Any price that results in the exclusion of a visitor is too
high since all people benefit from the park. Since we cannot charge an entry
fee, and therefore, we have to collect the resources for it in some way that
does not discourage its use. We can charge different prices to different people,
but that is there is a need to devise some pricing scheme where people would
correctly reveal how much the park is worth to them. However, it is very
difficult to get people to reveal what a public good is worth them.
The non-rival nature of public good consumption has important bearing on (1)
what constitutes efficient resource allocation, i.e., allocation of resources to
produce at least cost what consumers want most, and (2) the procedure by
which their provision is to be achieved. These implications will now be
examined more carefully when we compare it with the provision of private
56 goods as shown in the figure below.
and Public Goods
Fig. 15.8: Demand and Supply of Public Goods

To explore problem 1, it is helpful to compare the familiar demand and
supply diagram for private goods with a corresponding construction for
public goods, as they would compare in a hypothetical market setting. The
latter, as we will see presently, is unrealistic, but it is nevertheless useful in
noting essential differences between the two situations. The left side of Figure
15.8 shows the conventional market for a private good. DA and DB are A's and
B's demand curves, based on a given distribution of income and prices for
other goods. The aggregate market demand curve DA + B is obtained by
horizontal addition of DA and DB, adding the quantities which A and B
purchase at any given price. SS is the supply schedule, and equilibrium is
determined at E, the intersection of market demand and supply. Price equals
OC and output OH, with OF purchased by A and OG by B, where OF
+ OG = OH.
The right side of the figure shows a corresponding pattern for a public
good. We assume for this purpose that consumers are willing to reveal
their marginal evaluations of the public good—say, weather forecasting
installations—it being understood that daily reports will be available free of
charge. As before DA and DB are A's and B's respective demand curves,
subject to the same conditions of given incomes and prices for other goods.
Since it is unrealistic to assume that consumers volunteer their preferences,
such curves have been referred to as “pseudo-demand curves.” But suppose
for argument's sake that consumer preferences are revealed. The critical
difference from the private-good case then arises in that the market demand
curve DA + B is obtained by vertical addition of DA and DB, with DA + B
showing the sum of the prices which A and B are willing to pay for any given
amount. This follows because both consume the same amount and each is
assumed to offer a price equal to his or her true evaluation of the marginal
unit. The price available to cover the cost of the service equals the sum of
prices paid by each. SS is again the supply schedule, showing marginal cost
(chargeable to A and B combined) for various outputs of the public good.
The level of output corresponding to equilibrium output OH in the private-
good case now equals ON, which is the quantity consumed by both A and B.
The combined price equals OK, but the price paid by A is OM whereas that
paid by B is OL, where OM + OL = OK
Returning to the case of the private good, we see that the vertical distance
under each individual's demand curve reflects the marginal benefit, which
derives from its consumption. At equilibrium E, both the marginal benefit
derived by A in consuming OF and the marginal benefit derived by B in 57
Welfare Economics consuming OG equals marginal cost HE. This is an efficient solution
because marginal benefit equals marginal cost for each consumer. If output
falls short of OH, marginal benefit exceeds marginal cost and individuals
will be willing to pay more than is needed to cover cost. Net benefits will be
gained by expanding output so long as the marginal benefit exceeds the
marginal cost of so doing, and net benefits are therefore maximised by
producing OH units, at which point marginal benefit equals marginal cost.
Welfare losses would occur were output expanded beyond OH, for marginal
cost would thereby exceed marginal benefits.
Let us now compare this solution with that for public goods. While the
vertical distance under each individual's demand curve again reflects the
marginal benefits obtained, the marginal benefit generated by any given
supply is obtained by vertical addition. Thus, the equilibrium point E now
reflects the equality between the sum of the marginal benefits and the
marginal cost of the public good. If output falls short of ON, it will again be
advantageous to expand because the sum of the marginal benefits exceeds
cost. An output in excess of ON, on the contrary, would imply welfare
losses, since marginal costs outweigh the summed marginal benefits.
Thus the two cases are analogous but with the important difference. For the
private good, efficiency requires equality of marginal benefit derived by each
individual with marginal cost. In the case of the public good, on the other
hand, the marginal benefits derived by the two consumers differ and it is the
sum of the marginal benefits (or marginal rates of substitution) that should
equal marginal cost.
The figure also shows that an application of the same pricing rule where the
price payable by each consumer equals the individual's marginal benefit yields
different results for public and private goods. In the private-good case, A and
B pay the same price but purchase different amounts, whereas in the public
good case, they purchase the same amount but pay different prices. Yet in
both cases, the same pricing rule is applied. Each consumer pays a single price
for successive units of the good purchased, with the price equal to the
marginal benefit that the purchaser derives.
15.4.3 The Lindahl Formula

Erik Lindahl developed a price system that will support the efficient allocation
of public goods. For that purpose, he viewed the sharing of costs by two
customers of the public good as a supply-demand relationship, and worked out
a pricing rule. We discuss his results in the following diagram (Figure 15.9).
Assume that the vertical axis measures K or the fraction of unit cost
contributed by A. Given the unit cost C and assuming it to be constant, kC is
the price paid by A, and DA is her demand schedule for the public good S.
Since B's price equals (1 — k)C, and since both share the same quantity of S,
B's demand curve drawn with regard to k is given by DB. Individual A may
then look upon DB as showing the price at which various quantities of S are
available to her i.e., as a supply schedule for the public good which confronts
her. B similarly may regard DA as her supply curve. The fraction of the price
which both are willing to pay [k for A and (1 — k) for B] adds to I at the
intersection of DA and DB, at output OM.
58
and Public Goods
K=100%
DB
K=0%
M Qs
Amount of public good
Fig. 15.9: Lindahl Pricing for Public Goods
1) Which characteristic of public goods leads to inefficient resource
allocation? Explain its operation.
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
2) Describe the meaning of market failure in public goods.
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
3) Discuss the Lindahl Formula for efficient allocation of public goods.
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
15.5 LET US SUM UP

The competitive market provides an efficient outcome. However, we face to
imperfect markets, information asymmetry, externalities and presence of
public goods, which contribute to non-attainment of such a position. In case
imperfect competition, price and marginal cost equality required for Pareto
optimality is violated. Again, between a pair of goods, the ratio of shadow
price is not equal to their ratio of market price.
Externalities give rise to market inefficiencies whereby the consumption and
production quantities do not match. Pollution is a common example of 59
Welfare Economics externality, where market fails to provide solution. It necessities collective
solutions such as government intervention. When there is uncertainty about
costs and benefits, shapes of marginal cost and marginal benefit may have to
be taken into account for adopting one of the collective solutions.
Inefficiencies due to market failure may be tackled through bargaining among
the affected parties. Coase theorem offers a solution to include clearly defined
property rights, when transaction costs are zero.
Public goods, because of their non-rival or non-exclusive features, are not
produced efficiently by the market. To bring in efficiency to public goods
provision, the vertical sum of the individual demands must be made equal to
the marginal cost of their production.
15.6 KEY WORDS

Common Property Resource: A Common Property Resource or Common
Pool Resource (CPR) is produced by a sufficiently large resource system that
makes it costly but not impossible to exclude potential beneficiaries. A
resource system can be regarded as a stock variable that is under favorable
conditions capable of producing a maximum quantity of a flow variable,
without harming the stock or the resource system itself. Examples are: Fishing
grounds, vast and open pastures.
Externality: An externality occurs in economics when a decision (for
example, to pollute the atmosphere) causes costs or benefits to individuals or
groups other than the person making the decision.
Free Rider Problem: In the analyses of economics, free riders are actors who
take more than their fair share of the benefits or do not shoulder their fair
share of the costs of their use of a resource, involvement in a project, etc. The
free rider problem is the question of how to prevent free riding from taking
place, or at least limit its effects.
Imperfect Competition: In economic theory, imperfect competition is the
competitive situation in any market where the conditions necessary for perfect
competition are not satisfied.
Information Asymmetry: Information asymmetry occurs when one party to a
transaction has more or better information than the other party. (It has also
been called asymmetrical information and markets with asymmetrical
information). Typically it is the seller that knows more about the product than
the buyer; however, it is possible for the reverse to be true -- for the buyer to
know more than the seller. Examples of situations where the seller usually has
better information than the buyer are numerous but include used-car
salespeople, stockbrokers, real estate agents, and life insurance transactions.
Examples of situations where the buyer usually has better information than the
seller include estate sales as specified in a last will and testament.
Market Failure: A market failure is a case in which a market fails to
efficiently provide or allocate goods and services.
Public Good: A good that has the property that all consumers can enjoy it
jointly, without any one individual's consumption reducing others' ability to
consume. Thus no one need be excluded from consuming it.
Tragedy of Commons: The tragedy of the commons is a metaphor used to
illustrate the conflict between individual interests and the common good.
Hardin uses the example of English Commons, shared plots of grassland used
60 in the past by all livestock farmers in a village. Each farmer keeps adding
more livestock to graze on the Commons, because it costs him nothing to do Imperfect Market Externality
so. In a few years, the soil is depleted by overgrazing, the Commons becomes and Public Goods
unusable, and the village perishes.
The cause of any tragedy of the commons is that when individuals use a public
good, they do not bear the entire cost of their actions. If each seeks to
maximise individual utility, he ignores the costs borne by others. This is an
example of an externality. The best (non-cooperative) short-term strategy for
an individual is to try to exploit more than his or her share of public resources.
Assuming a majority of individuals follow this strategy, the theory goes, the
public resource gets overexploited. The tragedy of the commons is a source of
intense controversy, precisely because it is unclear whether individuals will or
will not follow the overexploitation strategy in any given situation.

Gareth D. Myles, (1995) Public Economics, Cambridge: Cambridge
University Press.
Richard A. Musgrave and Peggy B. Musgrave, (1989), Public Finance in
Theory and Practice, Singapore: McGraw-Hill International

PROGRESS
1) See Section 15.2
2) See Sub-section 15.2.3
3) Market failure is a case in which market fails to efficiently provide or
allocate goods and services. The two main reasons of market failure are,
sub-optimal market structures and the lack of internalisation of costs or
benefits in prices.
1) See Sub-section 15.3.2 and 15.3.3
3) An externality occurs when a decision causes costs or benefits to
individual groups other than the person making the decision.
2) See Section 15.4
15.9 EXERCISES
1) Explain the conditions of inability to obtain optimum welfare.
2) What is market failure? Account for its causes.
3) What is Externality? Explain different types and their causes.
4) Explain the difficulty in the provision of public goods.
61
Welfare Economics
UNIT 16 SOCIAL CHOICE AND WELFARE
Structure
16.0 Objectives
16.1 Introduction
16.2 Theory of Second Best
16.3 Arrow’s Impossibility Theorem
16.4 Rawls’ Theory of Justice
16.4.1 Original Position
16.4.2 Two Principles of Justice
16.4.3 An Appraisal
16.5 Equity-Efficiency Trade-off
16.6 Let Us Sum Up
16.7 Key Words
16.10 Exercises
16.0 OBJECTIVES
After going through this unit, you will be able to explain:
• choices available to a society when optimal welfare is not achievable;
• reason for not looking at second best options when first best is violated;
• Arrow’s impossibility theorem on social welfare;
• Rawl’s’ views on organising and governing a society; and
• equity-efficiency trade off as limits to redistribution.
16.1 INTRODUCTION
In the previous unit, we have seen the prevalence of imperfect asymmetric
information, transaction costs, presence of externalities and public good,
which prevent attainment of optimal social welfare conditions. The present
unit discusses the available choice. We start with the theory of second best
and proceed to look into the difficulties of constructing a social welfare
function. By bringing in the theory of justice, it is tried to assess the available
choice for imparting the social welfare. The unit concludes with the equity
efficiency trade off in distribution mechanism.
16.2 THEORY OF SECOND BEST

The theory of second best refers to ‘what is the optimal policy when the true
optimum (the first best) is unavailable due to constraints on policy choice’. It
says, ‘a policy that would be optimal without constraints (such as a zero tariff
in a small country) may not be second-best optimal if other policies are
constrained’.
Earlier we have explained that due to the existence of imperfections in some
markets or in case of externalities and public goods all marginal conditions or
Pareto optimality are not fulfilled. In their theory of second best, Lipsey and
Lancaster assert that the second best solution will not lead to an increase in
social welfare. For example, suppose a monopoly exists in one market and
62
Government takes steps to make this market competitive, it would appear that Social Choice and
social welfare would increase (as price and marginal cost will be equated in Welfare
this market) irrespective of whether in some other markets competition cannot
be enforced and therefore in them Pareto optimality conditions cannot be
satisfied. The second best theory holds that, this will not lead to the increase in
social welfare. In other words, the second best solution is not desirable.
Although a formal proof of the theory of second best is bit complicated, it can
be represented graphically in the Figure 16.1 below.
Fig. 16.1: Theory of Second Best

In the Figure 16.1, PP’ is the production possibility curve and all points on the
curve are Pareto efficient. According to Lipsey and Lancaster, it is sometimes
better to move inside PP’ to achieve a higher level of social welfare in case all
marginal conditions are not satisfied. To demonstrate this, social welfare
curves or community indifference curves are drawn in the figure like
individual indifference curves. These social welfare curves represent
combinations of two products X and Y, which yield the same level of social
welfare. Further, the higher the level of social welfare curve denotes higher
level of welfare. It will be seen from the figure that point H at which social
welfare curve is tangent to PP’ shows maximum social welfare point
satisfying all the marginal conditions of Pareto optimality. Now, suppose due
to the existence of monopoly in the markets of the two goods, X and Y, the
socially best point H is unattainable. Further, suppose that under such
circumstances, combinations lying on the line CC’ are attainable. Suppose the
economy is at present at point L on the attainable line CC’. If Pareto
optimality is to be achieved, we can move from a point L, which is inside PP’
to point A or B which are also on the attainable line CC’. However, as will be
seen from the figure, moving to point A or B on PP’ would put us in a lower
welfare curve W1. If instead from point L, we move the point E, which is
inside PP’ and is therefore Pareto inefficient and yields a higher level of
welfare as indicated by W2. Thus, the theory of second best asserts that when
one of the marginal conditions of Pareto optimality is not satisfied due to
63
Welfare Economics some or other reasons, it may be better to violate other marginal conditions of
Pareto optimality to achieve maximum possible social welfare.
The theory of second best has been applied to question, the desirability of
advocating competitive pricing in some particular markets when it is known
that Pareto conditions do not hold in other markets. However, the advocates of
such policies in making some markets more competitive in achieving Pareto
optimality argue that as the markets in question are unrelated, it does not
matter for attaining maximum social welfare that in other market conditions
for Pareto efficiency are not fulfilled. Advocates of the latter policy argue that
when markets are relatively independent or unrelated, marginal cost pricing
increase social welfare. Thus, in the words of Prof. S. Charles Maurice and
Own. R. Phillips, “the theory of second best applies most strongly when
markets are closely related: that is, they either produce complementary goods
like bread and butter, or one market is an intermediate supplier of another as
in the case of tyre makers supplying automobile producers”.
16.3 ARROW’S IMPOSSIBILITY THEOREM

In an attempt to construct a consistent social ranking of a set of alternatives on
the basis of individual preferences over this set, Arrow obtained:
1) an impossibility theorem;
2) a generalisation of the framework of welfare economics, covering all
collective decisions from political democracy and committee decisions to
market allocation; and
3) an axiomatic method which sets a standard of rigour for any future
endeavour.
Prof. Arrow pointed out that the construction of social welfare function, which
reflects the preferences of all individuals comprising the society, is an
impossible task. His main contention is that it is very difficult to set up
reasonable democratic procedure for the aggregation of individual preferences
into a social preference for making a social choice. Arrow has proved a
general theorem according to which it is impossible to construct a social
ordering which will in some way reflect the individual ordering of all the
members of society.
While constructing his argument, Arrow has maintained that individual’s
ordering of social states does not depend exclusively upon the commodities
consumed but also on the amounts of various types of collectives such as
municipal services, parks, sanitation, erection of statues of famous men, etc.
In other words, an individual solely on the basis of her consumption cannot
evaluate welfare results of collective activity; instead, individual ordering of
social states will depend on her own consumption as well as on the
consumption of others in a society. Individual ordering of alternative social
states reflects her value judgments, which are also called simply ‘values’ by
Arrow. According to him, it is ordering of social states according to the values
of individuals as distinct from the individual tastes, which should be
determined for the construction of valid social welfare function.
The theorem’s content, somewhat simplified, is as follows: A society needs to
agree on a preference order among several different options. Each individual
in the society has a particular personal preference order. The problem is to
find a general mechanism, called a social choice function, which transforms
the set of preference orders, one for each individual, into a global societal
64
preference order. This social choice function should have several desirable Social Choice and
(“fair”) properties: Welfare
• Unrestricted domain or universality: the social choice function should

create a deterministic, complete societal preference order from every
possible set of individual preference orders. (The vote must have a result
that ranks all possible choices relative to one another, the voting
mechanism must be able to process all possible sets of voter preferences,
and it should always give the same result for the same votes, without
random selection.)
• Non-imposition or citizen sovereignty: every possible societal preference
order should be achievable by some set of individual preference orders.
(Every result must be achievable somehow.)
• Non-dictatorship: the social choice function should not simply follow the
preference order of a single individual while ignoring all others.
• Positive association of social and individual values or Monotonicity: if an
individual modifies her preference order by promoting a certain option,
then the societal preference order should respond only by promoting that
same option or not changing, never by placing it lower than before. (An
individual should not be able to hurt an option by ranking it higher.)
• Independence of relevant tenatives: if we restrict attention to a subset of
options, and apply the social choice function only to those, then the result
should be compatible with the outcome for the whole set of options.
(Changes in individuals’ rankings of “irrelevant” alternatives [i.e., ones
outside the subset] should have no impact on the societal ranking of the
“relevant” subset.)
Arrow examined the problem rigorously by specifying a set of above
requirements that should be satisfied by an acceptable rule for constructing
social preferences from individual preferences, which can be simplified as the
conditions of social choice as follows:
• Social preferences should be complete in that given a choice between
alternatives A and B, it should say whether A is preferred to B, or B is
preferred to A or that there is a social indifference between A and B.
• Social preferences should be transitive, which implies, if A is preferred to
B, and B is preferred to C, then A is also preferred to C.
• If every individual prefers A to B, then socially A should be preferred to
B.
• Social preferences should not depend only upon the preferences of one
individual; i.e., the dictator (not in the pejorative sense of the word).
• The last condition asserts that the social preference of A compared to B
should be independent of preferences for other alternatives.
According to Arrow, “if we exclude the possibility of interpersonal
comparisons of utility, then the only method of passing from individual tastes
to social preferences which will be satisfactory and which will be defined for
a wide range of sets of individual ordering are either imposed or dictatorial”.
The democratic procedure for reaching a social choice or group decision is the
expression of their preferences by individuals through free voting. Social
choice will be determined by the majority rule. But Arrow has demonstrated
through his impossibility theorem mentioned above that consistent social
65
Welfare Economics choices cannot be made without violating the consistency or transitivity
condition. The social choice on the basis of majority rule may be inconsistent
even if individual preferences are consistent. Arrow first considers a simple
case of two alternative social states and proves that in this case group decision
or social choice through a majority rule yields a social choice, which can
satisfy all the five conditions. But when there are more than two alternatives,
majority rule fails to yield a social choice without violating at least one of the
five conditions. Thus, Arrow’s theorem says that if the decision-making body
has at least two members and at least three options to decide among, then it is
impossible to design a social choice function that satisfies all these conditions
at once.
Various economists have tried to explain Arrow’s impossibility theorem in
very different ways, but we will illustrate the proof of the theorem with the
help of the table given below.
Table 16.1: Ranking of Alternatives by Individuals and Social Choices
Alternative Social States
X Y Z
A 3 2 1
B 1 3 2
C 2 1 3
In this table three individuals A, B and C who constitute the society have been
shown to have voted for three alternative social states, X, Y and Z by writing
3, against the most preferred alternative, 2 for the next preferred alternative
and 1 for the least preferred alternative. As shown in the table, individual A
prefers X to Y, Y to Z and therefore X to Z. Individual B prefers Y to Z, Z to
X and therefore Y to X. and individual C prefers Z to X, X to Y and therefore
Z to Y. It is clear that two individuals A and B prefer Y to Z and also two
individuals A and C prefer Z to X. Thus, the majority (two of the three
individuals) prefers X to Y and also Y to Z, and therefore, Z to X. But
majority also prefers Z to X. Thus, we see that majority rule leads to
inconsistent social choices because on the one hand, X has been preferred to Z
by the majority and on the other hand, Z has also been preferred to X by
majority, which is contradictory or inconsistent.
On the basis of five conditions as mentioned above, Arrow has derived three
consequences to explain his impossibility theorem. Let us analyze these
consequences in the case of three alternatives X, Y and Z available to the two
individuals, A and B. According to Consequence I, whenever the two
individuals prefer X to Y, then irrespective of the rank of the third alternative
Z, society will prefer X to Y. According to Consequence II, if in a given social
choice, the will of individual prevails against the opposition of individual B,
then the will of A will certainly prevail in case individual B is different or
agrees with A. According to Consequence III, if individuals A and B have
exactly conflicting interests in the choice between two alternatives X and Y,
then the society will be indifferent between X and Y. It is interesting to note
that the simple proof of the impossibility theorem follows from Consequence
III. For instance, if individual A prefers X to Y and individual B prefers Y to
Z and if society opts for X, then A will be a dictator inasmuch as her choice
will always be a social choice. Thus, Arrow’s theorem says that ‘if the
66
decision-making body has at least two members and at least three options to Social Choice and
decide among, then it is impossible to design a social choice function that Welfare
satisfies all these conditions at once’. Arrow, therefore concludes that it is
impossible to derive a social ordering of different conceivable alternative
social states on the basis of the individual ordering of those social states
without violating at least one of the value judgments as expressed in the five
conditions of social choices. This is in essence his impossibility theorem.
1) Point out the theory of second best with suitable present economy
examples.
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
2) How individual ordering of social states is made according to Arrow’s
impossibility theorem?
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
3) What do you mean by social choice function?
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
16.4 RAWLS’ THEORY OF JUSTICE

Rawls’ most famous work, A Theory of Justice (1871), provides an
introduction to this body of thought as well as some of its implications for
ethics. Like many philosophers before him, Rawls focused upon justice
because of its substantive importance for organising and governing society.
The problem, however, involves defining what that term means theoretically
(i.e., speculatively about organising and governing society) and practically
(i.e., the consequences for people and their lives).
Generally speaking, justice can be defined in one of two ways. One definition
emphasises an individual’s merit or lack of it. According to this definition,
each individual must be treated exactly as one deserves. This “merit theory”
of justice, reflecting utilitarian ethics, uses merit to determine just how
individual members of society will be rewarded or punished based solely upon
whether one's conduct is useful or harmful to a society. The “need theory” of
justice, who assumes that individual members of the society should help those
other members who are most in need so as to redress their disadvantages,
reflects the influence of natural law theory. In this view, “doing good”
dictates that every member of society recognise that need entitles the most
disadvantaged to some sort of special consideration and that the more
67
Welfare Economics advantaged must compensate the disadvantaged with the goal of bringing
them up to an acceptable level of advantage.
Attempting to balance the demands posed by these rival theories, Rawls
maintained that inequalities in society can only be justified if they produce
increased benefits for the entire society and only if those previously the most
disadvantaged members of society are no worse off as a result of any
inequality. An inequality, then, is justified if it contributes to social utility, as
the merit theory asserts. But, at the same time, Rawls asserted, priority must
be given to the needs of the least advantaged, as the needs theory asserts.
Thus, differential rewards are allowed to the advantaged members of society
but not because of any merit on their part. These rewards are tolerated
because they provide an incentive for the advantaged, which ultimately will
prove beneficial to society (e.g., taxing the advantaged with the goal of
redistributing the wealth to provide for the least advantaged).
16.4.1 Original Position
Using a thought experiment Rawl’s called “the original position” from which
agents behind a “veil of ignorance” select principles of justice to govern the
society. Two principles serve to organise society, are the “liberty principle”
and the “difference principle.” He rooted the original position in and
extended the concept of “social contract” previously espoused by Hobbes,
Rousseau and Locke, which made the principles of justice the object of the
contract-binding members of society together.
According to Rawls, a society is a cooperative venture between free and equal
persons for the purpose of mutual advantage. Cooperation among members
makes life better because of the “primary goods” which include among others:
health, rights, income and the social bases of self-respect. All social primary
goods – liberty and opportunity, income and wealth, and the bases of self-
respect – are to be distributed equally unless an unequal distribution of any or
all of these goods is to the advantage of the least favored.
The problem every society must confront, Rawls noted, is that the members
will often disagree on what constitutes the good and how the benefits and
burdens within society will be distributed among its members. Some believe,
for example, that the good consists in virtuous conduct while others believe
that the good is discovered in the pursuit of individual happiness, at least in so
far as the members of society define these terms. Some members believe that
an individual’s merit should determine how one would participate in society’s
benefits while others believe that society must provide the least advantaged
extra assistance so that they will be able to share equally in society’s benefits.
If society is to exist and to endure despite these and other such differences, its
members must derive a consensus regarding what minimally constitutes the
good.
What consensus requires in actual practice is that the members agree upon the
rules which will govern them as a society and that these rules will be applied
consistently. But, Rawls asked, just how would a society and its members
know what constitutes a “fair” principle? And, how would it be possible to
determine what is “reasonable” for every member to agree with? Thompson
cites the example of welfare to make this point:
The growth of the welfare state has often been explained and defended as a
progressive recognition that government should provide certain benefits
(positive rights) in order to prevent certain harms to citizens (negative rights).
68
Yet, its opponents claim that the welfare state violates the negative rights of Social Choice and
other citizens (property owners, for example). Welfare
Rawls responded to this challenge by invoking the original position, in which

representative members of a society would determine the answers to these
difficult questions. That is, absent any government, the representatives would
rationally discuss what sort of government would be supported by a social
contract, which will achieve justice among all members of society. The
purpose for this discourse would not be to justify governmental authority but
to identify the basic principles that would govern society when government is
established. The chief task of these representatives would not be to protect
individual rights but to promote the welfare of society.
To this end, the representatives do not know, which place in society they will
occupy. In addition, every factor, which might bias a decision (e.g., one’s
tastes, preferences, talents, handicaps, conception of the good) is kept away
from the representatives. They, however, do possess knowledge of those
factors, which will not bias one’s decision (e.g., social knowledge, scientific
knowledge, knowledge identifying what human beings need to live). From
this original position and shrouded by a veil of ignorance about their place in
society, Rawls argued the representatives ultimately would select the principle
of justice rather than other principles (e.g., axiological virtues, natural law,
utilitarian principles) to organise and govern the society.
While individual members of the society oftentimes do act in their self-
interest, this does not mean that they cannot be rational about their self-
interests. Rawls argued that this is precisely what would occur in the original
position when the representatives operated from behind the veil of ignorance.
Freed from focusing upon one’s self-interest to the exclusion of others’ self-
interests, the society which the representatives would design determines what
will happen to its members and how important social matters like education,
health care, welfare and job opportunities will be distributed. The idea is that
the representatives operating from behind the veil of ignorance would design a
society that is fair for all of its members because no individual member would
be willing to risk up ending in an intolerable position that one created for
others but had no intention of being in oneself.
Rawls claimed that the representatives to the original position would invoke
the principle of rational choice, the so-called “max-min decision rule.” This
rule states that an agent, when confronted with a choice between alternative
states of the world with each state containing a range of possible outcomes,
would choose the state of affairs where the worst outcome is that state of
affairs which is better than the worst outcome presented by any other
alternative.
Rawls’ example of two persons sharing a piece of cake demonstrates how the
max-min decision rule works in actual practice:
Suppose there is one piece of cake that two persons want to eat. They equally
desire to eat the cake and each wants the biggest piece possible. To deal with
this dilemma, both agree that one will cut the cake while the other will choose
one of the two pieces. The consensus derived guarantees that the cake will be
shared fairly, equating “justice” with “fairness.”
Refer to the analysis of social welfare function where we have already
explained Rawlsian social welfare function through his Max-Min criteria.
According to it ‘welfare is maximised when the utility of those society
members that have the least is the greatest’. No economic activity will
69
Welfare Economics increase social welfare unless it improves the position of the society member
that is the worst off. Most economists specify social welfare functions that are
intermediate between these two extremes. This has been explained graphically
as in the Figure 16.2 below.
Under this criterion unequal distribution position Q in Figure 16.2 should be
chosen only when achievable positions of equal distribution of welfare along
the 450 line are below point D. Further, according to him, positions of equal
distribution of welfare lying between D and E are socially preferable to
efficient position Q with unequal distribution. In order to achieve justice in the
distribution of welfare, he proposes that equal distribution position should be
socially preferred to the more efficient allocations such as position Q in the
GUPF. Thus according to Rawls, to promote welfare of the poor and
underprivileged sections of the society, some efficiency in resource allocation
should be sacrificed.
Y
V T
Q
B’s Utility
E
UB
W3
D
W2
W1
450
O UA V'
A’s Utility
Fig. 16.2: Rawlsian Theory of Justice
16.4.2 Two Principles of Justice

By equating the principle of justice with fairness, the representatives in the
original position and operating from behind the veil of ignorance would elect
to organise society around the liberty and difference principles.
The liberty principle dictates that each member of society has an equal right to
the most extensive scheme of equal basic liberties compatible with a similar
system of equal liberty for all. Accordingly, each member of society should
receive an equal guarantee to as many different liberties and as much of those
liberties as can be guaranteed to every member of society. The liberties,
Rawls discussed include: political liberty (the right to vote and to be eligible
70
for public office); freedom of speech and assembly; liberty of conscience and Social Choice and
freedom of thought; freedom of the person along with the right to hold Welfare
personal property; and, freedom from arbitrary arrest and seizure. In contrast
to some libertarian interpretations of utilitarianism, Rawls did not advocate
absolute or complete liberty, which would allow members of the society to
have or to keep absolutely anything.
The difference principle requires that all economic inequalities be arranged so
that they are both a) to the benefit of the least advantaged and b) attached to
offices and positions open to all members under conditions of fair equality of
opportunity. If this is to occur, Rawls argued,
…each generation should “preserve the gains of culture and civilisation, and
maintain intact those just institutions that have been established” in addition to
putting aside “in each period of time a suitable amount of real capital
accumulation.”
Rawls is willing to tolerate inequalities in a society but only if they are
arranged so that any inequality actually assists the least advantaged members
of society and that the inequalities are connected to positions, offices or jobs
that each member has an equal opportunity to attain. In the United States, this
scheme is oftentimes called “equal opportunity.”
The inequalities Rawls discussed include: inequalities in the distribution of
income and wealth as well as inequalities imposed by institutions that use
differences in authority and responsibility or chains of command.
The reason the representatives in the original position and operating from
behind the veil of ignorance would agree upon the difference principle is not
due to the existence of a social contract but to ethics. That is, members of
society do not deserve either their natural abilities or their place in a social
hierarchy. Where and when one was born and the privileges and assets
afforded by one’s birth is a matter of sheer luck. It would be unfair, Rawls
contended, were those born into the least advantaged of society to remain in
that place if all members of society could do better by abandoning (or
redistributing) initial differences. According to Rawls, this is what ethics
according to the standard of justice demands.
The representatives would agree, however, that the liberty principle must
always take precedence to the difference principle so that every member of
society is assured of equal basic liberties. Similarly, the second part (b) of the
difference principle cited above must take priority to the first part (a), so that
the conditions of fair equality of opportunity are also guaranteed for
everyone. Thus, the two principles of justice, the liberty principle and the
difference principle are ordered because society cannot justify a decrease in
liberty by increasing any member's social and economic advantage.
Reflecting Rawls’ interest in political philosophy, the liberty principle and the
difference principle apply to the basic structure of society (what might be
called a “macro view”)―society's fundamental political and economic
arrangements rather than to particular conduct by governmental officials or
individual laws (what might be called a “micro view”). The liberty principle
requires society to provide each citizen with a fully adequate scheme of basic
liberties (e.g., freedom of conscience, freedom of expression and due process
of law). The difference principle requires that inequalities in wealth and
social position be arranged so as to benefit society’s most disadvantaged
group. In cases where the two principles conflict, Rawls argues, the liberty
principle must always take precedence over the difference principle.
71
Welfare Economics According to Maclagan, the issue of equitable pay also provides a practical
example that clarifies how Rawls’ theory of justice can be applied.
Noting that the principle “equal pay for equal work” is eminently fair in
concept, Maclagan notes that not all work is equal. What is really needed in
society is some rational basis to compare what sometimes are very different
occupations and jobs, especially when this involves comparing “men’s work”
and “women’s work.” Typically, the criteria used to compare dissimilar jobs
quantify work requirements as well as the investment individuals must make
to attain these positions. In addition, the amount of skill and training required
the potential for danger and threat to one's life, the disagreeableness involved
in the work as well as the degree of responsibility associated with a job figure
prominently when making such calculations. In actual practice, however,
making comparisons between dissimilar jobs is an immensely difficult
undertaking, as Maclagan notes, citing as an example the difficulties between
the management and labor both of which confront in the process of collective
bargaining.
Collective bargaining involves ethics because each party declares what the
other ought to do. When these differences are resolved through a consensus, a
“contract” provides the basic structure by which the members of that society
(called the “corporation”) will organise and govern themselves for a specific
period of time. Coming to agreement upon a contract—like Rawls’ concept
of reflective equilibrium—requires both parties to the collective bargaining
process to align their principles and intuitions through the process of
considered dialogue and mutual judgment. Furthermore, the contract, like
Rawls’ difference principle, tolerates inequalities in pay but only as long as
the least advantaged enjoy equal opportunity and their situation is protected if
not improved.
What is noteworthy about Maclagan’s example is that the parties are neither in
the original position nor do they operate from behind a veil of ignorance.
Instead, they have to move towards those positions if they are to adjudicate
their differences amicably and for the benefit of both.
16.4.3 An Appraisal
In the formulation of Rawls, some have asked which members of society
constitute the “least advantaged”? For his part, Rawls identified these people
generally as unskilled workers and those whose average income is less than
the median income. What Rawls failed to address, however, is the plight of
those who may be the truly least advantaged members of society, namely,
those citizens of some permanently unemployed class, who depend entirely
upon government largesse (e.g., welfare) to subsist, or whose racial or ethnic
origins condemn them to permanent disadvantage. The critics ask, should not
their plight be considered more important than those who possess more of
society’s benefits?
Furthermore, in so far as Rawls states the difference principle, it appears that
inequalities are permissible but only if they better the lot of the least advantaged
members of society. However, critics note, that position is inconsistent with
Rawls’ claim that the representatives to the original position must not take an
interest in anyone’s particular requirement. The logic fails if preference must
be given by those in the original position to the least advantaged.
Lastly, Rawls’ critique of utilitarianism, his embrace of egalitarianism and the
actual effects of the difference principle combine in such a way that his
philosophy becomes a political agenda with Marxist overtones. That is,
72
Rawls' theory, in actual practice, would redistribute society’s benefits away Social Choice and
from the “haves” to the “have-nots” with little or no concomitant bearing of Welfare
society’s burdens. Economists, for example, note that Rawls has neglected to
consider the market forces unleashed in a capitalist society where seeking
one’s self-interest is arguably the primary motivating principle. These critics
argue that even the least advantaged, if they so choose, can take advantage of
the minimal benefits society offers them by virtue of citizenship. Through
education, persistence, and hard work, the least advantaged (or, their children
in the next generation) will be able to participate more fully in enjoying the
benefits as well as in bearing the burdens of membership in a society.
Thus, Rawls in his theory of justice has explained that the difficulty in setting
distributional policy can be avoided by maximising income at the bottom of
the scale. This rule as suggested by Rawls, permits income inequality to the
extent that it contributes to a higher level of income at the bottom. Rawls
obtains such a solution from his rule of fairness by which individuals are
placed into an ‘initial position’ where they do not know what their earnings
will be. They then render an ‘impartial’ choice as to what the state of
distribution should be. Knowing that equalisation will reduce the level of
income available for distribution but not knowing what their own position on
the income scale will be, they will stop short of demanding equalisation.
Assuming people to be highly risk averse, they will vote for that degree of
redistribution, which maximises the lowest income.
16.5 EQUITY-EFFICIENCY TRADE-OFF

The problem of just distribution, along with that of efficiency, is an essential
part of the broader problem of optimal resource use, which involves two
issues. The first is to secure efficient satisfaction of demands that arise from a
given state of distribution. Defined in terms of Pareto efficiency, the
proposition that there is a welfare gain when the position of any one
individual is improved without hurting that of another-this objective is
generally accepted as a policy goal. Only jealousy is ruled out thereby. The
second issue is how to secure a state of just or fair distribution. Since there
exists an efficient solution corresponding to each and every state of welfare
distribution, a question remains: which state should be chosen as equitable or
just? Here the concept of Pareto efficiency helps little. The problem of
distribution is one of evaluating a change in which someone gains while
someone else loses.
The distribution of income as determined in the market depends on factor
endowments and prices, which the services of these factors will fetch. This
process has important bearing on efficient resource use, but it does not
constitute a theory of distributive justice. The distribution as determined by
factor incomes need not coincide with what is considered socially desirable,
thus calling for adjustment by fiscal and other policy measures.
Various approaches to distributive justice have been distinguished and their
implications for the distribution of income have been considered. First, the
Endowment-based View, which sanctions that sanction the distribution of
income as determined by factor ownership and returns. Second, Utilitarian
View that calls for a distribution of welfare so as to maximise the total
satisfaction. An equal distribution of income is required if individuals are
assumed to have similar utility functions. Third, Egalitarian View according
to which would distribute income is to equalize the welfare position of all
individuals so as to maximise that of the lowest. Moreover, equity
73
Welfare Economics considerations may be applied across generations as well as across
individuals.
However, the issue before the practical policy is not so much on how to
establish a fair society and its de novo state of distribution, but to consider
whether and how to address the problem of redistribution. The question,
therefore, is to what extent and how the existing state of distribution, as
determined by the market and prevailing social institutions, needs to be
amended. To some extent, this may be accomplished by way of voluntary
actions of the members but such transfers carry minor weight as compared
with policies of redistribution decided upon by the process of budget. Such
policies will then be met by the responses of individuals who stand to lose or
gain in the process. This may in turn affects the size of the pie available for
redistribution and imposes costs, which must be allowed for. Here comes the
issue of efficiency-equity trade-off.
Redistribution involves costs as well as benefits, and both must be considered
in policy making. Policies to redistribute, to begin with, can shrink the size of
the pie available for distribution. This is shown here with regard to effects on
labor supply, but similar problems arise with regard to saving, investment and
economic growth.
Let us take up the analytical framework of efficiency-equity trade-off.
Consider two individuals, H with high and L with low earning capacity. To
simplify, suppose L’s earning capacity is, in fact zero. In the absence of
intervention, H has a substantial positive income and L has none. Now a tax is
imposed on H and the yield is transferred to L. As a result of the tax, the new
wage rate of H (the return in goods which H can obtain for selling leisure) is
reduced. Initially, H may respond by working more (H’s labour supply
schedule slopes backward over a range of high wage rates), but thereafter a
further increase in the tax rate will induce her to retain more leisure. As a
result, the revenue obtainable from a given tax is not unlimited. As the tax rate
is increased further, revenue will rise for some time until a point is reached
beyond which further increases in the tax rate will result in declining
revenues. Hence, a reduction in funds available for transfers to L becomes
inevitable. This relationship is illustrated in the following table, showing H’s
responses to rising rates of tax with a wage rate of Rs. 10.
Tax
Revenue
from H
H’s income Transferred H’s income
Tax Rate H’s Hours Before tax to L (Rs) After tax L’s income
(percentage) worked (Rs.)
(i) (ii) (iii) (iv) (v) (vi)
0 6.0 60.0 0 60.0 0
15 7.0 70.0 10.5 59.5 10.5
30 5.0 50.0 15.0 35.0 15.0
50 2.5 25.0 12.5 12.5 12.5
80 1.0 10.0 8.0 2.0 8.0
100 0 0 0 0 0
74
As the tax is introduced, H increases his working hours initially so as to Social Choice and
recoup some of her lost income. She does so until a tax rate of 15 percent is Welfare
reached, above which her working hours will be reduced. In moving from 15
percent to 30 percent, revenue still rises as the increase in tax rate more than
offsets the decline in the taxable base. However, as the tax rate is increased
further, revenue begins to fall. Whereas the goal of Max-Min would be served
by stopping at 30 percent, a 50 percent rate would be needed for full
equalisation.
The potential scope for redistribution may thus be limited because a further
increase in tax rates eventually hits a revenue ceiling. But this is not the entire
story. There is another and more subtle cost to redistribution, which becomes
effective from the outset. This arises because withdrawing one rupee of
income tax from H leaves her with a welfare loss in excess thereof, and
because receipt by L also imposes a deadweight loss that must be taken into
consideration. As noted below, this factor poses a major problem in the design
of welfare programs.
The fact that the donor loses more than the recipient gains, however, does not
mean that the transaction must involve a social loss. Much depends on the
weight to be attributed per Rupee of loss and gain, so that a low-income gain
of 90 paisa may, as placed under a social weight, more than outweigh a loss of
Rs.1.10 for the higher up.
The nature of efficiency-equity tradeoff is illustrated in the Figure 16.3 below
for an economy consisting of two persons, A and B. As shown, the vertical
and horizontal axes measure A’s and B’s utility levels, with utility rising when
moving from O to C or from O to D. CD is the utility frontier and is1, is2,
is3…are social indifference curves reflecting the distributive judgment of the
community. B* is the point of bliss, reflecting the best of all possible solutions.
Index of
A’s Utility
E G
Z
B*
is 5
is 4
is 3
is 2
is1
O D Index of
B’s Utility
Fig. 16.3: Equity-Efficiency Tradeoff
75
Welfare Economics If prevailing arrangements place the economy at E, movement to points below
F and G on the utility frontier is efficient (Pareto optimal), since at least one
gains and no one loses. But the Pareto criterion of efficiency does not tell us
how to choose among points between F and G. From the social point of view,
however, G is the best, since it reaches the highest possible social indifference
curve, is4. Now suppose that the functioning of the market leads to the point F.
Given the is curves in the figure, a social gain results by moving from F to B*,
raising social welfare from is2 to is5. This gain results even though A loses, so
that the move is not sanctioned by the criterion of Pareto efficiency.
Moreover, moving to a point off the utility frontier, such as K, may be
superior from the social point of view to remaining at F. Introduction of a
social welfare function, as reflected in is1, is2, is3 thus suggests a broadened
concept of efficiency, i.e., one by which the outcome is assessed and ranked in
terms of social welfare weights.
To see how this bears on the efficiency cost of redistribution, we might
imagine CBD to trace the utility frontier, as it would look if redistribution
could be achieved without an efficiency cost. But given this cost, and
beginning at F, the actually available frontier may be given by the dotted line
FKZ. By moving from F to K (but not further!), redistribution still pays in
social welfare terms, but the gain is less (involving a shift from is2 to is3 only)
than it would be without an efficiency cost of redistribution. Although society
may thus accept some efficiency loss to obtain an equity gain, distributional
adjustments should be made so as to minimise this cost.
1) What are the two principles of justice as mentioned by the philosopher
Rawls?
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
2) What is equity-efficiency trade-off?
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
…………………………………………………………………………..
16.6 LET US SUM UP

In this unit, we discussed how the non-feasibility of Pareto Optimum gives
rise to the next best alternative, the second best and analyzed some alternative
theories such as Arrow’s impossibility theorem and Rawls’ theory of Justice.
We also explained how there is a limit to redistribution through its costs and
benefits in the perspective of equity-efficiency trade off.
16.7 KEY WORDS

Monotonicity Criterion: A voting system is monotonic if it satisfies the
following so-called monotonicity criterion given below. In mathematics,
monotonicity usually refers to the different concept of a monotonic function.
The monotonicity criterion for voting systems is the following statement: If an
76
alternative X loses, and the ballots are changed only by placing X in lower Social Choice and
positions, without changing the relative position of other candidates, then X Welfare
must still lose.
Rawls Theory of Justice: Each person possesses an inviolability founded on
justice that even the welfare of society as a whole cannot override. Therefore,
in a just society the rights secured by justice are not subject to political
bargaining or to the calculus of social interests.
Social Choice Function: A function that transforms the set of preference
orders, one of each individual, into a global societal preference order.
Theory of Second Best: The Theory of Second Best says that ‘a policy that
would be optimal without constraints (such as a zero tariff in a small country)
may not be second-best optimal if other policies are constrained’.

Abba P. Lerner (1944), The Economics of Control: Principles of Welfare
Economics, New York: Macmillan.
J. De V. Graff (1963), Theoretical Welfare Economics, Cambridge
University Press.
J.K.Mehta and Mahesh Chand (1970), A Guide to Modern Economics,
Bombay: Somaiya Publications.
John A. Edgren (1995), On the Relevance of John Rawls theory of Justice to
Welfare Economics, Review of Social Economy, Vol. 53.
S. K. Nath (1969), A Reappraisal of Welfare Economics, London: Routledge
and Kegan Paul Ltd.
W. J. Baumol, (1952), Welfare Economics and the Theory of the State,
Harvard University Press.

PROGRESS
1) The theory of Second Best stated that a policy that would be optimal
without constraints may not be the second-best optimal if other policies
are constrained.
2) According to Arrow’s theorem, individual ordering of social states does
not depend solely on the consumption of his/her goods and services
alone but also includes on the amounts of collectives such as municipal
services, health care facilities, etc. In other words, an individual solely
on the basis of his/her consumption cannot evaluate welfare results of
collective activity, instead, individual ordering of social states will
depend on his/her own consumption as well as on the consumption of
others in society.
3) Social choice function is a function that transforms the set of preference
orders, one of each individual, into a global societal preference order.
1) The two principles of justice mentioned by Rawls are the liberty
principle and the difference principle.
77
Welfare Economics 2) The equity-efficiency trade-off which poses major problem in the design
of welfare programmes states that there is a limit to redistribution in an
economy. This means that there is a limit to amend the existing state of
distribution as determined by the market and prevailing social
institutions to establish fair society.
16.10 EXERCISES
1) Discuss the relevance of Rawls theory of Justice for third world
countries.
2) Briefly explain equity-efficiency tradeoff.
3) Critically examine Arrow’s Impossibility theorem.
4) What is the Theory of Second Best? Prove the theorem with the help of
a diagram.
78

Welfare Economics

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Welfare Economics

Uploaded by

Copyright:

Available Formats

MEC-101

Course Editor : Prof. Gopinath Pradhan

In this block we discuss welfare economics that uses microeconomic techniques to

13.2 PIGOVIAN APPROACH

Pigou had assumed measurability and interpersonal comparison of utility, and

14.2.1 Pigovian Analysis

Pigou was concerned about the channeling of “real” factors of production to

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

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

Obstacles to free movement are composed of ‘costs of movement and

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

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

13.2.2 Case for the Market

13.2.3 Case for Improving upon the Market System

individual ownership and control of resources by self-interested agents.

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

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

13.3 PARETO OPTIMAL CONDITIONS

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

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

a) Consumption Efficiency: MRSAXY = MRSBXY for any pair of households,

b) Production Efficiency: MRTSXKL = MRTSYKL for any pair of outputs, X,

These marginal conditions are based on the following important assumptions:

• Goods are perfectly divisible.

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

• Every individual wants to maximise his/her satisfaction.

• Every individual purchases some quantity of all goods.

• All factors of production are perfectly mobile.

We shall explain each condition in detail.

The marginal condition of production efficiency requires that the available

Fig. 13.1: Movement from Inefficient to Efficient Allocation

Though the equality of the MRTS is the central production efficiency

This efficiency condition is applied in analysing the theory of comparative

This production efficiency condition can be explained with the help of

∂xif/∂xjf = ∂xig/∂xjg for any i, j = 1, 2, .., n+m.

The second main marginal condition for Pareto-optimality is consumption

Fig. 13.2: Consumption Edgeworth-Bowley Box

As evident from Figure 13.2, D is Pareto-superior to E, but it is not the case

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

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

Fig. 13.3: Construction of the CIC

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

dY0/dX0 = MRSAXY = MRSBXY.

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

Fig. 13.4: Intersecting CIC Curves

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

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

a new, higher level of aggregate utility, CICD’.

Fig. 13.5: Intersecting CIC Curves

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

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

Check Your Progress 2

2) Distinguish between strongly Pareto optimal and weakly Pareto optimal

13.4 TWO FUNDAMENTAL WELFARE

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

Check Your Progress 3

13.5 LET US SUM UP

purely cardinal and subject to value laden.

13.6 KEY WORDS

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

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

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