FORMS OF MARKET AND PRICE DETERMINATION

WELFARE ECONOMICS

AGE 525

(MICROECONOMICS IN AGRICULTURE)

The Need for Welfare Economics • According to Adam Smith, the activities of individuals, in the

pursuit of their own self-interest, will lead, as if by an “invisible hand,” to an outcome which promotes the general welfare of all.

• However, the achievement of general equilibrium in the economy is not a sufficient condition for social welfare maximization. Different patterns of resource ownership connote different patterns of income distribution, different patterns of commodity distribution among consumers and, hence, different relative states of well-being of consumers.

• The need for welfare economics arises, therefore, from the need to define optimal distribution of resources and incomes that is compatible with a desirable general-equilibrium solution which maximizes the welfare of the society as a whole.

Welfare economics deals with the evaluation of alternative economic situations or economic states as they affect a society’s general wellbeing. If the welfare state of a country is W but, given its resource endowment (including its state of technology), the welfare state can be increased to, say, W*, the concern of welfare economics is • To show that the present welfare state W is inferior to a higher

attainable state W* (that is. W<W*), and • To show W can be increased to W*. Given the resource

endowment of an economy, many alternative general equilibrium states are possible.

The task of welfare economics is to evaluate the social welfare implications of the various possible general equilibrium states with a view to identifying the one that maximizes social welfare and how the maximum social welfare state can be achieved.

The Need for Welfare Economics

The measurement of social welfare, however, requires

• Some ethical standards for evaluating the relative social desirability of different welfare states,

• The relative “deservedness” or “worthiness” of different members of the society to receive different relative shares of the “total welfare” accruing to the society under different general equilibrium states, and,

• Some subjective criteria for assigning weights of relative “worthiness” to individuals, such that the weighted sum of the welfare accruing to individuals is consistent with the “total welfare” accruing to the society.

• The first requirement is about which welfare state is inferior or superior to which welfare state. The second is about which individuals deserve to receive relatively more or less of the preferred “total social welfare package” available to the society. And the third is about relative weights or proportions to be used in distributing the “total social welfare package” among individuals in the society, based on their relative “worthiness” or “deservedness” to receive different relative shares. All these decisions require some value judgements. We now discuss a few of the criteria for such social welfare judgements.

Measurement of social welfare

Criteria for Social Welfare Judgement

• Many criteria have been suggested for social welfare judgement.

• They propose different conditions for the achievement of social welfare improvement in a situation where a change in the economy benefits some but not all members of the society.

• We discuss five of these welfare criteria, namely;

(1) the growth of national income criterion (or the criterion of economic growth),

(2) Bentham’s criterion,

(3) Pareto-optimality criterion,

(4) Kaldor-Hicks criterion, and

(5) Bergson criterion.

• This is a social welfare criterion that dates back to the time of Adam Smith who proposed the growth in the wealth of a nation as a welfare criterion.

• Although Adam Smith did not specifically relate his concept of national wealth to the modern concept of national income, it is apparent that both concepts are almost synonymous as they regard national income growth and, hence, economic growth as the basis for social welfare improvement.

• Economic growth, an indicator of which is national income growth, implies improved social welfare in the sense that economic growth connotes the availability of more goods and services for consumption in a society and an increased capacity of members of the society to consume them.

• However, this economic growth criterion can be criticised on at least two grounds.

• First, the criterion implies the acceptance of an existing pattern of income distribution as being equitable and ethnical.

• Second, economic growth does not necessarily lead to an increased social welfare and may, in fact, lead to a reduced social welfare, depending on who benefits most from economic growth.

The Criterion of National Income Growth (or the Criterion of Economic Growth)

• Economic growth may benefit many or most members of the society but not all members. There would normally be gainers and losers from economic growth. The economic growth criterion does not provide a basis (or relative weights) for summing up the gains and losses in order to arrive at the net change in the welfare of the society as a whole.

• However, the economic growth criterion underscores the importance of economic efficiency in social welfare considerations, although economic efficiency itself is only a necessary but not a sufficient condition for social welfare improvement.

The Criterion of National Income Growth (or the Criterion of Economic Growth)

• Jeremy Bentham proposed that social welfare is improved when there is “the greatest good for the greatest number” of people in a society. Bentham’s criterion contains two key elements, namely that

• Increased social welfare requires the securing of the greatest (largest) possible amounts of goods for the society, but

• All members of the society need not benefit from the greatest amounts of goods for social welfare to increase, as long as the greatest number benefit.

• The first element implies economic efficiency in the society.

• The second element is based on the implicit assumption that the total welfare of a society is the sum of welfare of individual members and that as long as the total positive change in the welfare of some members more than offsets the total negative change in the welfare of other members, the society’s social welfare has increased.

Bentham’s Criterion

• This raises some ethical questions as to whether those who gain deserve to gain and those who lose deserve to lose. Is it not possible that those who gain has gained undeservedly and those who lose have lost undeservedly? In any case, what are the relative weights used in summing up individual gains and losses?

• Another problem is that the greatest good and the greatest number of people need not occur together and would, in fact, often not occur together.

• Bentham’s criterion does not provide a clue as to how to judge the relative social desirability of a welfare state in which the greater good goes to fewer number vis-à-vis another welfare state in which the smaller good goes to the greater number of people in the society.

• This is a distributional issue which is at the centre of social welfare judgement.

Bentham’s Criterion

• This is a criterion which derives from the concept of economic efficiency developed by Vilfredo Pareto and others. The Pareto-Optimality criterion states that a new social welfare state represents an improvement over a previous social welfare state if in the new state, at least one individual is better-off and no individual is worse-off than before. Or, in other words, a social welfare state is Pareto-optimal if it is impossible to make one individual better-off without making at least another individual worse-off.

• Pareto optimality, also known as Pareto efficiency, requires three marginal conditions for its achievement. The three conditions are:

• Efficiency of commodity distribution or exchange among consumers, which requires that the marginal rate of substitution of a commodity for another be equal for all consumers;

• Efficiency of factor allocation among firms, which requires that the marginal rate of technical substitution of one input for another be equal for all firms using the inputs, and,

• Efficiency of product-mix which requires simultaneous efficiencies in commodity production by firms and commodity distribution among consumers.

The Pareto-Optimality Criterion

• The Pareto-optimality criterion has been criticised on at least two grounds.

• The first criticism is that the criterion is not applicable to a situation where a social welfare change benefits some members of the society but hurts some others. That is, the

• Pareto-optimality criterion cannot be used to evaluate a welfare change which makes some individuals better-off but, at the same time, makes some individuals worse-off.

• Since, most often, this is the situation which occurs in real life; it can be argued that the Pareto-optimality criterion has limited applicability to real life social welfare evaluation.

• It is evident that the Pareto criterion tries to avoid the problem of interpersonal comparison of social utility, but such comparisons are often inevitable since, in real life, most public policies would bring about social welfare changes which would benefit some but harm others in the society.

• The Pareto criterion cannot address such situations and, to that extent, the criterion is of limited pratical applicability.

• The second criticism is, as pointed out before, that Pareto optimality does not necessarily translate into social welfare maximization because Pareto optimality is not a sufficient condition for social welfare maximization. Although it is impossible to achieve social welfare maximization without Pareto optimality, it is possible to achieve Pareto optimality without social welfare maximization. As would be recalled, all points on the production possibility frontier is Pareto-optimal, but in order to be able to choose the particular point on the frontier where social welfare is maximised, we also need to know the social welfare function of the society as a whole.

The Pareto-Optimality Criterion

• Both Nicholas Kaldor and John Hicks tried to fill the gap left by the Pareto criterion. Specifically, they proposed a criterion that can be used to evaluate a welfare situation. They suggested the following approach to establishing a welfare criterion.

• Assume that a change in the economy is 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 in order to prevent the change.

• If the amount of money of the ‘gainers’ is greater than the amount of ‘losers’, the change constitutes an improvement in social welfare, because the ‘gainers’ could compensate the ‘losers’ and still have some ‘net gain’. Thus, the Kaldor-Hicks ‘compensation criterion’ states that a change constitutes an improvement I social welfare if those who benefit from it could compensate those who are hurt, and still be left with some ‘net gain’.

• The Kaldor-Hicks criterion evaluates alternative situations on the basis of monetary evaluations of different persons. Thus it implicitly assumes that the marginal utility of money is the same for all the individuals in the society. Given that the income distribution is unequal in the real world, this assumption is absurd.

Kaldor-Hicks Criterion

• Assume, for example, that the economy consists of two individuals, A, who is a millionaire, and B who has an income of ₦4000. Suppose that the change (being considered by the government) will benefit A, who is willing to pay ₦2000 for this change to happen, while it will hurt B, who is prepared to pay ₦1000 to prevent the change.

• According to the Kaldor-Hicks criterion the change will increase the social welfare (since the ‘net gain’ to A, after he compensates B, is ₦1000). However, the gain of ₦2000 gives very little additional utility to millionaire A, while the ‘loss’ of ₦1000 will decrease a lot the well-being of B, who has a much greater marginal utility of money than A. thus the total welfare will be reduced if the change takes place.

• Only if the marginal utility of money is equal for all the individuals would the Kaldor-Hicks criterion be a ‘correct’ welfare measure.

• This criterion ignores the existing income distribution. In fact this criterion makes implicit interpersonal comparisons, since it assumes that the same amounts of money have the same utility for individuals with different incomes.

Kaldor-Hicks Criterion

• All the four social welfare criteria discussed above cannot adequately evaluate social welfare changes that benefit some individuals and hurt others because they do not have propositions on how to compare the relative desirability of different distributions of benefits or utilities among members of a society. This is what the Bergson criterion attempts to provide.

• The criterion suggests the use of an explicit social welfare function to evaluate welfare changes and provide a unique preference ordering of alternative welfare states in the society.

• It provides a preference ranking of alternative welfare states in which different individuals enjoy different levels of utility.

• However, there is no way to objectively determining a society’s social welfare function. In fact, the function is only a subjective, value-loaded set of rules which, we assume, enables a society to “add up” the social utilities accruing to different individuals under each of a number of alternative welfare states with a view to providing a preference ranking of these alternative welfare states in the society.

The Bergson Criterion

Social Welfare Model The social welfare model has all assumptions of Walrasian general equilibrium model. In the simple two-factor, two-product and two-consumer economy, the assumptions are that

• There are to consuming households A and B,

• There are two products or commodities q1 and q2 produced by two firms,

• There are fixed quantities of two inputs or production factors owned by the two consuming households,

• There is perfect competition in both input and output markets, and

• The goal of the consumer is to maximize utility (satisfaction) while the goal of the producer is to maximize profit.

However, we need one additional assumption for the social welfare model. The assumption is that there is a social welfare function which depends on the positions of members of the society on their own preference scales.

Social Welfare Model For the simple two-member society, the social welfare function can be expressed as:

• 𝑊 = 𝑓(𝑈𝐴, 𝑈𝐵), where

• W is the society’s level of welfare, A and B are the two members of the society and 𝑈𝐴 and 𝑈𝐵 are the utilities enjoyed by A and B respectively. The social welfare function provides a ranking of alternative welfare states in which different members (A and B) of the society enjoy different utility levels. In a society of only two members (A and B), the social welfare function can be represented by a set of social indifference curves each of which is the locus of indifferent combinations of the utilities of A and B that yield the same level of social welfare.

• As we did under general equilibrium analysis, we first discuss the conditions for the maximization of social welfare in the context of a two-factor, two-product and two-consumer economy and then generalize to a society with any n numbers, k producers and m commodities.