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Lecture 2

Theories of
Economic Policy Analysis
Dr Dragana Radicic
Social welfare functions

• If we allow interpersonal comparison of utility, in

order to overcome Arrow’s impossibility theorem, we
still have to define the aggregation rule.
• The most important social welfare functions (SWFs):
• Utilitarian SWFs
• Bernoulli-Nash SWFs
• The Rawls SWF
• The Bergson-Samuelson SWF
Utilitarian social welfare
• Simple utilitarian SWF

𝑊 𝑥 = ෍ 𝑢𝑖 (𝑤)

• Generalised utilitarian SWF

𝑊 = ෍ 𝑎 𝑖 𝑢𝑖
Utilitarian social welfare
• Social indifference curves or isowelfare curves 𝑊1 < 𝑊2 < 𝑊3
Bernoulli-Nash social welfare
• Simple Bernoulli-Nash SWF

𝑊 = ෑ 𝑢𝑖
• Generalised form

𝑊 = ෑ(𝑢𝑖 )𝑎𝑖

• Multiplication accentuates the egalitarian nature of the

aggregation rule, since a more equal income distribution produces
greater social welfare.
Bernoulli-Nash social welfare functions
Rowls’ social welfare function
𝑊 = min 𝑢𝑖 , 𝑖 = 1,2, … , 𝐻
• The welfare of society increases only if the minimum utility
• There is no trade-off between the utility of one person and that
of another; they are perfectly complementary.
Bergson-Samuelson social
welfare function
𝑊 = W 𝑢1 , 𝑢2 , … 𝑢𝐻

• The function has the following properties

• It is defined with respect to individual utilities
• Individual utilities are comparable
• The strong Pareto criterion is satisfied
• Social preferences are convex
Bergson-Samuelson social
welfare function
Choosing the social optimum
• The SWF is maximised subject to the constrained faced by a
society, which is given by the utility possibilities frontier.
• In figure below, the social optimum is at point a, where the slope
of the UPF is equal to the slope of the social indifference curve,
i.e. the marginal rate of social substitution.
Utilitarianism of Pigou
• Total (or aggregate) welfare is the sum of utilities of the
members of society obtained from various sources of
• Pigou postulated that individual utilities were cardinally
measurable and fully comparable.
• Total welfare can be expressed by the simple utilitarian

𝑊 = ෍ 𝑢𝑖 (𝑥)
• Economic welfare = x includes only monetary sources
Pigou’s propositions about
economic welfare

• Two propositions of Pigou which are the sufficient

conditions for an increase in economic welfare:
• Economic welfare increases if the size of national
income increases without ‘worsening’ the
distribution, i.e. reducing the income of the poor
(efficiency condition).
• Economic welfare increases if the distribution
‘improves’ and the size of national income does not
decline (equity condition).
Rawls’ theory of justice

• Two principles of justice

• Each person is to have equal right to the most
extensive total system of equal basic liberties
compatible with a similar system of liberty for all.
• Inequalities in life prospects are justifiable only if
we can associate them with a benefit for the worst-
off individual (the difference principle).
Rawls’ theory of justice
Rawlsian SWF vs other SWFs
Nozick’s theory of justice
• Nozick’s rejects ethical individualism and develops the
entitlement theory.
• The theory assesses distributive justice not with regards
to results, but rather with regard to procedures
(procedural or formal justice).
• Any distribution is considered just if individuals’
fundamental rights have been respected.
• The right to life, freedom of choice and the right to
the products of one’s labour
• This theory aims only to guarantee liberty and the
exercise of rights, not to satisfy preferences.
Sen’s theory of justice
• Both the quantity and the utility generated by its use are inadequate
indicators of the welfare of an individual or a society.
• Goods have characteristics that people may use to perform certain
functionings and it is the achievement of these functionings that
indicates the benefit enjoyed by people, allowing them to exercise
positive liberty.
• It is not only the performance of certain functionings that is
important, but also the very possibility (the ‘capability’) of
performing them, even if they are not actually performed.
• Applications
• Studies on poverty and human development indicators
• E.g. purchasing power, education and health are proxies of
capabilities used to construct indicators of human development.
Summary of correspondence between postulates,
types of ordering and specific SWFs