Module-3
Welfare Economics
Welfare economics
Welfare economics is that branch of economic theory which evaluates alternative pattern of
resource allocations from the point of view of maximising economic welfare of the society as
a whole. In other words, the function of welfare economics is to evaluate alternative
economic situations and determine whether one economic situation yields greater economic
welfare than others.
Objectives of welfare economics
1. The most fundamental objective of welfare economics is the measurement of social
welfare.
2. Welfare economics aims the evaluation of social desirability of alternative economic
situations
3. Welfare economics attempt to evaluate alternative policy options before the
authorities.
4. Welfare economics analyses the optimum allocation of resources and thereby leads to
the maximisation of social welfare.
Different Criteria used to Measure Social Welfare
To measure social welfare, various criteria have been suggested by economists at different
times. They are:
1. Growth of GNP as a criterion for social welfare
Adam smith developed this criterion to measure social welfare. He implicitly accepted
that the growth of wealth of a society, that is the growth gross national product as a
welfare criterion. He believed that economic growth increases social welfare because
growth increases employment and the goods available for consumption to the community.
Growth criterion implies the acceptance of ethical distribution of income and importance
of economic efficiency in social welfare. Thus according to this criterion the maximum
social welfare depends of production and distribution efficiency. However, critics of this
criterion pointed out that efficiency is a necessary condition but is not a sufficient
condition of the maximisation of social welfare.
2. Bentham’s criterion
Jeremy Bentham an English economist in his social welfare criterion argued that welfare
is improved when the greatest goods (is secured) for the greatest number. He assumed the
total welfare of a society is the sum of the utilities of the individuals of the society. To
illustrate the pitfalls in Bentham’s criterion assumes that a society consists of three
individuals A, B and C, so that
W= UA+ UB + UC
According to Bentham ∆ 𝑊 > 0 if (∆𝑈𝐴 + ∆𝑈𝐵 + ∆ 𝑈𝐶) > 0. However, if a change
which resulted change in the individual utilities is such way that individual A and
individual B’s utilities are increase while C’s utility decreases, but if (∆ 𝑈𝐴 + ∆𝑈𝐵) >
∆𝑈𝐶. In other words two individuals are better off while the third is worse off after a
Dr Ratheesh C, Assistant Professor, Department of Economics, FMNC, Kollam Page 1
, change, but the sum of utilities of A and B is greater than the decrease in the utility of
individual C, the change will lead to increase social welfare. This implies Bentham’s
criterion involves interpersonal comparison. Another difficulty of Benthams criterion is
that it cannot be applied to compare situations where the greatest good and the greatest
number exist simultaneously.
3. Cardinalist criterion
The cardinalist criterion was proposed the use of diminishing marginal utility as a
criterion of welfare. The cardinalist criterion can be illustrated with the help of the
following example. Assume the society consists of three individuals A, B and C.
Individual A has an income of Rs 1000, while B and C have an income of Rs.500 each.
The example indicates that consumer A can purchase double quantities of goods with his
income as compared to individuals B and C. However, given the diminishing marginal
utility, A’s total utility is less than the total utility of either B or C because A’s marginal
utility of money is lower than that of B or C. Thus to increase welfare the income should
be redistributed equally among all members in a society.
The important limitations of this criterion are, firstly it assumes that all individuals have
identical utility functions of money, so that with an equal income distribution all would
have the same marginal utility of money. It is an unrealistic assumption. Secondly, the
welfare effects of an equal distribution of income cannot be examined in isolation from
the effects of resource allocation.
4. The Pareto optimality criterion
This criterion was developed by Wifredo Pareto (1848-1923). This criterion refers
economic efficiency can be objectively measured. According to this criterion any change
that makes at least one individual better off and no one worse off is an improvement in
social welfare. Conversely a change that makes no one better off and at least one worse
off is a decrease in social welfare. Thus a situation is Pareto efficient, if it is impossible to
make anyone better off without making some one worse off is said to be Pareto efficient
or Pareto optimal.
The important limitations of this criteria are (1) The Pareto criterion cannot evaluate a
change that makes some individuals better off and others worse off.(2) A Pareto efficient
situation does not guarantee the maximisation of the social welfare.
5. The Kaldor Hicks compensation criterion
Nicholas Kaldor and John Hicks suggested the compensation criteria to establish social
welfare. Assume that a change in the economy being considered which will benefit some
(gainers) and hurt others (losers). One can ask the gainers how much money they would
be prepared to pay in order to have the change and the losers how much money they
would be prepared to pay to prevent the change. If the amount of money of the gainer’s
would be prepared to pay for the change is greater than the amount of money of the losers
prepared to pay in order to prevent the cahange, the change constitutes an improvement in
social welfare because the gainers could compensate the losers and still some net gain.
The limitations of Kaldor Hicks compensation criterion are (1) Kaldor Hicks
compensation criterion is correct only when the marginal utility of money is equal for all
Dr Ratheesh C, Assistant Professor, Department of Economics, FMNC, Kollam Page 2
Welfare Economics
Welfare economics
Welfare economics is that branch of economic theory which evaluates alternative pattern of
resource allocations from the point of view of maximising economic welfare of the society as
a whole. In other words, the function of welfare economics is to evaluate alternative
economic situations and determine whether one economic situation yields greater economic
welfare than others.
Objectives of welfare economics
1. The most fundamental objective of welfare economics is the measurement of social
welfare.
2. Welfare economics aims the evaluation of social desirability of alternative economic
situations
3. Welfare economics attempt to evaluate alternative policy options before the
authorities.
4. Welfare economics analyses the optimum allocation of resources and thereby leads to
the maximisation of social welfare.
Different Criteria used to Measure Social Welfare
To measure social welfare, various criteria have been suggested by economists at different
times. They are:
1. Growth of GNP as a criterion for social welfare
Adam smith developed this criterion to measure social welfare. He implicitly accepted
that the growth of wealth of a society, that is the growth gross national product as a
welfare criterion. He believed that economic growth increases social welfare because
growth increases employment and the goods available for consumption to the community.
Growth criterion implies the acceptance of ethical distribution of income and importance
of economic efficiency in social welfare. Thus according to this criterion the maximum
social welfare depends of production and distribution efficiency. However, critics of this
criterion pointed out that efficiency is a necessary condition but is not a sufficient
condition of the maximisation of social welfare.
2. Bentham’s criterion
Jeremy Bentham an English economist in his social welfare criterion argued that welfare
is improved when the greatest goods (is secured) for the greatest number. He assumed the
total welfare of a society is the sum of the utilities of the individuals of the society. To
illustrate the pitfalls in Bentham’s criterion assumes that a society consists of three
individuals A, B and C, so that
W= UA+ UB + UC
According to Bentham ∆ 𝑊 > 0 if (∆𝑈𝐴 + ∆𝑈𝐵 + ∆ 𝑈𝐶) > 0. However, if a change
which resulted change in the individual utilities is such way that individual A and
individual B’s utilities are increase while C’s utility decreases, but if (∆ 𝑈𝐴 + ∆𝑈𝐵) >
∆𝑈𝐶. In other words two individuals are better off while the third is worse off after a
Dr Ratheesh C, Assistant Professor, Department of Economics, FMNC, Kollam Page 1
, change, but the sum of utilities of A and B is greater than the decrease in the utility of
individual C, the change will lead to increase social welfare. This implies Bentham’s
criterion involves interpersonal comparison. Another difficulty of Benthams criterion is
that it cannot be applied to compare situations where the greatest good and the greatest
number exist simultaneously.
3. Cardinalist criterion
The cardinalist criterion was proposed the use of diminishing marginal utility as a
criterion of welfare. The cardinalist criterion can be illustrated with the help of the
following example. Assume the society consists of three individuals A, B and C.
Individual A has an income of Rs 1000, while B and C have an income of Rs.500 each.
The example indicates that consumer A can purchase double quantities of goods with his
income as compared to individuals B and C. However, given the diminishing marginal
utility, A’s total utility is less than the total utility of either B or C because A’s marginal
utility of money is lower than that of B or C. Thus to increase welfare the income should
be redistributed equally among all members in a society.
The important limitations of this criterion are, firstly it assumes that all individuals have
identical utility functions of money, so that with an equal income distribution all would
have the same marginal utility of money. It is an unrealistic assumption. Secondly, the
welfare effects of an equal distribution of income cannot be examined in isolation from
the effects of resource allocation.
4. The Pareto optimality criterion
This criterion was developed by Wifredo Pareto (1848-1923). This criterion refers
economic efficiency can be objectively measured. According to this criterion any change
that makes at least one individual better off and no one worse off is an improvement in
social welfare. Conversely a change that makes no one better off and at least one worse
off is a decrease in social welfare. Thus a situation is Pareto efficient, if it is impossible to
make anyone better off without making some one worse off is said to be Pareto efficient
or Pareto optimal.
The important limitations of this criteria are (1) The Pareto criterion cannot evaluate a
change that makes some individuals better off and others worse off.(2) A Pareto efficient
situation does not guarantee the maximisation of the social welfare.
5. The Kaldor Hicks compensation criterion
Nicholas Kaldor and John Hicks suggested the compensation criteria to establish social
welfare. Assume that a change in the economy being considered which will benefit some
(gainers) and hurt others (losers). One can ask the gainers how much money they would
be prepared to pay in order to have the change and the losers how much money they
would be prepared to pay to prevent the change. If the amount of money of the gainer’s
would be prepared to pay for the change is greater than the amount of money of the losers
prepared to pay in order to prevent the cahange, the change constitutes an improvement in
social welfare because the gainers could compensate the losers and still some net gain.
The limitations of Kaldor Hicks compensation criterion are (1) Kaldor Hicks
compensation criterion is correct only when the marginal utility of money is equal for all
Dr Ratheesh C, Assistant Professor, Department of Economics, FMNC, Kollam Page 2
