Income distribution
Pareto efficiency is a necessary, but not a sufficient condition for social welfare.
Each Pareto optimum corresponds to a different income distribution in the economy. Some
may involve great inequalities of income.
The one needs to social welfare function.
The social welfare function is a way of mathematically stating the relative importance of
the individuals that comprise society.
A Utilitarian Welfare Function (also called a Benthamite welfare function) sums the
utility of each individual in order to obtain society's overall welfare. All people are treated
the same, regardless of their initial level of utility. One extra unit of utility for a starving
person is not seen to be of any greater value than an extra unit of utility for a millionaire. .
A utilitarian social indifference curve is linear and downward sloping to the right.
At the other extreme is the Max-Min, or Rawlsian John Rawls utility function. According
to the Max-Min criterion, welfare is maximized when the utility of those society 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. The Max-Min social
indifference curve takes the shape of two straight lines joined so as they form a 90 degree
angle.
The social welfare function is typically translated into social indifference curves so that
they can be used in the same graphic space as the other functions that they interact with A
social indifference curve drawn from an intermediate social welfare function is a curve that
slopes downward to the right. The intermediate form of social indifference curve can be
interpreted as showing that as inequality increases, a larger improvement in the utility of
relatively rich individuals is needed to compensate for the loss in utility of relatively poor
individuals.
1
Individual contributors to the welfare economics
Early neoclassical approach
Sidgwick (1838-1900)
He wrote “principle of political economy”.
He was among the first to mention the divergence between private and social products.
He challenged (put reservation) that an individual’s claim to wealth is not always the exact
equivalence of his net contribution to society (social product).
He argues that there may be externalities associated with economic activities: it may be positive or
negative.
He pointed out the possibility & significance of the divergence.
Therefore, he argued, government intervention is necessary if such divergence prevails.
Alfred Marshall (1842-1924)
Alfred Marshall has been regarded as the founder of welfare economics.
He provided the concepts of consumer’s surplus and producers’ surplus and maintained that a
policy to augments the two were desirable.
After Sidgwick, Marshall also raised the possibility & significance of divergence between private
& social product. And, therefore, he argued that there may be a need for government intervention
to correct these divergences.
2
His analysis was based on two assumptions:
1. Marginal utility of real money is constant, implying that demand is independent of
income (only substitution effect is recognized).
2. Utility is measurable (can be quantified) – cardinal utility.
ARTHUR CECIL PIGOU
Prof Pigou popularized the word welfare and gave a concrete meaning to it. In his book, Pigou dealt
with three things: (1) a definition of economic welfare (2) spelling out the condition under which
welfare is maximized and (3) pronouncement of policy recommendations for increasing welfare.
A. Definition of economic welfare
He defined individual welfare as the sum of satisfactions obtained from the use of goods and services.
Social welfare is the summation of all individual welfare in a society.
B. Condition for maximization of social welfare
According to Marshall, the national income represents the general welfare, but pigou believes
that welfare is not only dependent on the size of the nation’s income but also on the equality
of its distribution.
Economic welfare is generally proportional to the size of the national income, provided the
dividend accruing to the poor is not diminished, and increases in the size of the aggregate
national dividend.
He has suggested that economic welfare could be increased by the transfer of purchasing
power from the rich to the poor.
C. Difference between social and private benefit and cost
Social net product being the net product that accrues to society as a result of the decision.
In a competitive economy, decisions are made in such a way as to maximize private net
product but not necessarily social net product.
Appropriate taxes and subsidies could, however, make private and social net products
equal, thus leading each individual to behave in a way that maximizes social welfare.
The presence of external effects in production was seen by Pigou in the divergence between
social net product and private net product.
3
He defined social net product “as the aggregate contribution made to the national dividend”
and the private net product as the contribution which is capable of being sold and the
proceeds added to the earnings of the person responsible for investment.
The divergence between the two products shows itself in the form of external effects.
In some cases social net product is more than the private product while in others private
product is greater than the social product.
As an example of the former, Pigou pointed out to the greater social benefit from
technical training of workers by a private firm.
As an illustration of the latter he cited the fact that the smoke rising from the chimneys of
private factory spoils the atmosphere of the locality and increases the laundry bills of the
people of the neighborhood. But people are not compensated in any way by the factory
owner.
Pigou has made a distinction between private and social costs. The private marginal, cost of a
commodity is the cost of producing an additional unit. The social marginal cost is the expense or
damage to society as a consequence of producing that commodity.
By making a distinction between social and private valuations of economic activity, he paved the
way for the analysis of external effects or externalities in social welfare economics.
Prof. Pigou made the first attempt to lay down conditions of social optimum which he termed “the
ideal output” of the economic system as a whole. In his view, the social optimum (social ideal
output) prevails when marginal social products are equal in all industries and thus production of
real wealth is maximized.
Assuming that all the productive resources are being employed and that there is no cost of
movement between different occupations and places, it can be concluded that the national dividend
is the largest when the values of the marginal net products are equal in all industries. If this
arrangement prevails, the society is having its” ideal output”.
J. R. Hicks
Hicks’ first objective was to explain the problem of maximizing utility as a problem of
constrained choice for a rational consumer.
He analyzed this in his book “value and capital, 1939”.He used the indifference curve-
budget line and iso-quant -isocost lines analysis; where by the tangency points were taken as
the optimum points.
4
That is, equilibrium is achieved when the budget line (optimum combination of commodities,
say X and Y) is tangent to the Indifference Curve (the highest achievable indifference curve).
He examined the two traditional assumptions (constant marginal utility of money & cardinal
utility) and concluded that they are unrealistic.
He replaced cardinal with ordinal utility which means that consumers are able to show that
certain combination of goods is preferred to another combination.
This alternative was the use of indifference Curves analysis
The indifference curve analysis was used by Pareto and Edge worth before Hicks.
What Hicks did is not discovering but reviving this method of analysis because it was almost
forgotten.
Commodity Y
IC1 Indifference
Curves
IC2
Budget line
O
O X2 Commodity X
He was the first to demonstrate the possibility of separating the income effect & the substitution
effects. The Giffen paradox was shown later.
He had two propositions: the concept of diminishing marginal utility is not essential for the
construction of individual demand curve and the shift of the budget line to the right means the point
of tangency will be on a higher indifference curve.
New Welfare Economics
5
A new type of welfare economics quite different from that developed by Pigou and his followers has
been developed by Vilfredo Pareto.
Paretian optimality came to the forefront in which optimum division of income is the one from which
none can gain additional utility or satisfaction through a redistribution without someone losing some
utility in the process.
This stand was further refined to bring in a distinction between efficiency and equity dimensions of
redistribution.
It has further been extended by Edgeworth, Hicks, Kaldor, Barone, Scitovsky, etc.
The new welfare economics is normative in character and is free from value judgments and utility
measurement. We can illustrate it as follows:
Assume a given income is to be distributed /divided between two individuals only:
When, through redistribution, the total satisfaction obtained by both individuals put together increases
(U’1+U’2 > U1+U2), we say that the new distribution is more efficient.
Similarly, equity dimension would refer to the relative shares of the two individuals in the total
satisfaction.
New welfare Economics contributor
1. Vilfredo Pareto
Pareto Optimality
Maximum welfare, said Pareto, occurs when there are no longer any changes that will make
someone better off while making no one worse off.
This implies that society cannot rearrange the allocation of resources or the distribution of goods
and services in such a way that it aids someone without harming someone else.
The Pareto optimum thus implies 1). An optimal distribution of goods among consumers, 2) an
optimal technical allocation of resources, and 3). An optimal quantities of outputs.
We can demonstrate these conditions by supposing the existence of simple economy containing
two consumers (smith and Green), two products (hamburger and potato), and two resources
(labor and capital).
1. Optimal distribution of goods- the optimal distribution of goods, occurs where smith and
Green each have identical marginal rate substitution between the two goods. We express
this symbolically as,
MRShpS=MRShpG
6
2. Optimal technical allocation of resources- in our two goods, two resources example, and the
optimum allocation of resources to productive uses will occur where the marginal rate of
technical substitution between labor and capital in the production of hamburger and potatoes are
equal. This second condition for pareto optimality can be shown symbolically as,
MRTSLKH=MRTSLKP,
3. Optimal quantities of output- if production and distribution meet the conditions of Pareto
optimality, then optimum level of output will be achieved where the marginal rate of substitution
hamburger for potatoes equals the marginal rate of transformation (MRT) of potatoes for
hamburger. This is the rate at which it is technically possible to transform potatoes in to
hamburger. Symbolically,
MRShp=MRTph
Pareto’s welfare theory is significant contribution to economics.
However, the central Pareto criterion, “does a change makes someone better off while making
no one worse off?” is not well suited for evaluating public policies. In addition the Pareto
criterion has the following limitations
It fails to address the issue of distributive justice
Based on static view of efficiency
Conflict with social moral values
Against public policies
