CHAPTER THREE

3. General Equilibrium and Welfare Economics

3.1. General Equilibrium

3.1.1. Walrasian General equilibrium

Leon Walras (1834-1910)

Leon Walras born in Everex, France in 1834

Walras developed and advocated general equilibrium analysis, which considers the
interrelationship among many variables in the economy.

Walras general equilibrium theory presents a framework consisting of the basic price and
output interrelationships and factors of production.

Its purpose is to demonstrate mathematically that all prices and quantities produced can
adjust to mutually at consistent levels.

Its approach was static, because it assumes that certain basic determinants remain
unchanged, such as consumer preferences, production function, forms of competition and
factors supply schedules.

Walras showed that prices in a market economy can be determined mathematically, taking
cognizance of the interrelatedness of all prices.

He assumes the function for the quantity demanded of a good depends on the price. That is
price is independent and quantity demanded is dependent variable.

Let us begin with set of equations which covers the consumer goods. The amount of a
consumer goods produced and consumed would be the same. There is one equation for each
of the goods a, b, c … as follows.

Ga=Fa (Pm, Pn, Po …, Pa, Pb, Pc…) ………………………………………… (1)

Gb=Fa (Pm, Pn, Po …, Pa, Pb, Pc…) ………………………………………… (2)

Gc=Fa (Pm, Pn, Po …, Pa, Pb, Pc…) …………………………………………. (3)

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Thus in this set equation (1) sows the amount Ga of good a is being consumed and produced in
the economy is a function of prices of or cost of inputs m, n, o… and prices of consumer goods
a, b, c… and so on for other equations. The logic here is that the amount of consumption good
depends on the costs of its production and also up on the prices of the substitutes and
complementary goods.

The second set of equation covers the allocation of economy’s productive resources between
various consumer goods. Each productive resource is represented by one equation showing
the way it is allocated for the production of various consumer goods. These equations are of
the type,

m=amGa+bmGb+cmGc+… ………………………………………………….. (4)

n=anGa+bnGb+cnGc+ …………………………………………….…….. ..(5)

o=aoGa+bnGb+coGc+… …………………………………………….……… (6)

Here, for example, out of the total m of the productive factor, m, am is needed to produce
one unit of good a and therefore an amount amGa of this input is used in the production of
good a. similarly, an amount bmGb of the productive factor m is used in the production of
good b and so on. It also follows that for producing one unit of good a we need am amount of
factor m, an amount of factor n, ao amount of factor o and so on.

The third set of equations gives the composition of costs of various consumer goods in terms
of quantities and prices of the services of the production factors used in manufacturing them.

P’a=amP’m+anP’n+aoP’o+… ……………………………………………………. (7)

P’b=bmP’m+bnP’n+boP’o+… …………………………..…………………………. (8)

P’c=cmP’m+cnP’n+coP’o+… …………………………………………………. (9)

Here Pa shows the total cost of production per unit of the commodity a. of this total cost amP’m
is accounted for by the input m, anP’n is accounted by the input n, and so on; similarly for other
goods.

The fourth set of equations is added to complete the picture. Here each equation shows that
the cost of production per unit of a consumer good is equal to its selling price. In other
words,

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P’a=Pa……………………………………………………………………………. (10)

P’b=Pb…………………………………………………………………………… (11)

P’c=Pc …………………………………………………………………………… (12)

These sets of equations can be solved to arrive at the general equilibrium.

We can solve the equations sets for the prices of the consumer goods namely, Pa, Pb, Pc, …;
the prices of productive resources, namely P’m, P’n, P’o,… ; and the quantities of consumer
goods to be produced and consumed, namely, Ga, Gb, Gc,… and so on.

3.2. WELFARE ECONOMICS

 Welfare means a state of well-being.
 It notes that an individual’s claim to wealth is not the exact contribution to
society.
 It is a branch of economic science concerned with discovering principles
for maximizing social wellbeing (welfare optimality) , identifying factors
that may impede the achievement of wellbeing , suggesting ways that
the impediments might be removed and so on.
 Individuals are the basic units for aggregating to social welfare as there is no
"social welfare" apart from the "welfare" associated with its individual units
thus it can be specified as the summation of the welfare of all the individuals in
the society.

3.2.1. Approaches to Welfare Economics

There are two mainstream approaches to welfare economics: the early neoclassical approach
and the new welfare economics approach.

The early neoclassical approach was developed by Edgeworth, Sidgwick, Marshall, and
Pigou. It assumes that:

 Utility is cardinal, that is, scale-measurable

 Preference is exogenously given and stable.

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  Additional consumption provides smaller and smaller increases in
utility (diminishing marginal utility).
 All individuals have interpersonally comparable utility functions

 With these assumptions, it is possible to construct a social welfare function

simply by summing all the individual utility functions.
 The new welfare economics approach is based on the work of Pareto, Hicks, and Kaldor.
 They explicitly recognize and analyse the concepts of efficiency and the income
distribution.

Efficiency

 Situations are considered to have distributive efficiency when goods are distributed to the
people who can gain the most utility from them.

 Many economists use Pareto efficiency as their efficiency goal. According to this
measure of social welfare, a situation is optimal only if no individuals can be made better
off without making someone else worse off. This ideal state of affairs can only come
about if
 The marginal rates of substitution in consumption are identical for all consumers. This
occurs when no consumer can be made better off without making others worse off.
 The marginal rate of transformation in production is identical for all products. This
occurs when it is impossible to increase the production of any good without reducing the
production of other goods.
 The marginal resource cost is equal to the marginal revenue product for all production
processes. This takes place when marginal physical product of a factor must be the same
for all firms producing a good.
 The marginal rates of substitution in consumption are equal to the marginal rates of
transformation in production. These are where production processes must match
consumer wants.

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There are a number of conditions that, most economists agree, may
lead to inefficiency. They include:

 Imperfect market structures, such as a monopoly, monopsony, oligopoly, oligopsony, and

monopolistic competition.
 Factor allocation inefficiencies in production theory basics.
 Market failures and externalities; there is also social cost.
 Imperfect Price discrimination and price skimming.
 Asymmetric information
 Long run declining average costs in a natural monopoly.
 Certain types of taxes and tariffs.

To determine whether an activity is moving the economy towards Pareto efficiency, two
compensation tests have been developed.

Using the 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.

Under the 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.

The Hicks compensation test is from the losers' point of view, while the Kaldor
compensation test is from the gainers' point of view. If both conditions are satisfied, both
gainers and losers will agree that the proposed activity will move the economy toward
Pareto optimality.

This is referred to as Kaldor-Hicks efficiency or the Scitovsky criterion.

Income distribution

Pareto efficiency is a necessary, but not a sufficient condition for social welfare.

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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.

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A simplified seven-equation model

The basic welfare economics problem is to find the theoretical maximum of a social welfare
function, subject to various constraints such as the state of technology in production, available
natural resources, national infrastructure, and behavioural constraints such as consumer utility
maximization and producer profit maximization. In the simplest possible economy this can be
done by simultaneously solving seven equations. This simple economy would have only two
consumers (consumer 1 and consumer 2), only two products (product X and product Y), and
only two factors of production going into these products (labour (L) and capital (K)). The model
can be stated as: maximize social welfare:

W=f(U1 U2) subject to the following set of constraints:

K = Kx + Ky (The amount of capital used in the production of goods X and Y)

L = Lx + Ly (The amount of labour used in the production of goods X and Y)

X = X(Kx Lx) (The production function for product X)

Y = Y(Ky Ly) (The production function for product Y)

U1 = U1(X1 Y1) (The preferences of consumer 1)

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 U2 = U2(X2 Y2) (The preferences of consumer 2)

The solution to this problem yields a Pareto optimum. In a more realistic example of millions of
consumers, millions of products, and several factors of production, the math gets more
complicated. However, a model like the one above can be viewed as an argument that solving a
social problem (like achieving a Pareto-optimal distribution of wealth) is at least theoretically
possible.

Individual contributors to the welfare economic

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. Positive externalities
are activities that yield benefit to others for which the individual is not paid. On the other hand, negative
externalities are activities that impose costs on others for which the individual is not charged. He pointed
out the possibility & significance of the divergence. Therefore, he argued, government intervention is
necessary if such divergence prevails.

Alfred Marshall (1842-1924)

The 20th Century welfare economics is realistic and pragmatic. 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. This possibility, according to him, is associated with the cases of long run increasing &
decreasing cost industries. And, therefore, he argued that there may be a need for government
intervention to correct these divergences. So, he differed from the classical welfare theory.

His analysis was based on two assumptions:

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 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.

He believed, at equilibrium, MUx/Px = MUy/PY ..... this implies the traditional equi-marginal
equilibrium theory. Nevertheless, his contribution was on partial welfare analysis.

ARTHUR CECIL PIGOU

Son of an army officer, A.C. Pigou was born in 1877 and educated at Harrow and King's
College, Cambridge. He compiled a brilliant record that included numerous prizes. Pigou was a
prominent member of the Cambridge school and faithful pupil of Marshall. After Marshall, he became
the leading neo classical economist. He was Marshall’s student and teacher of J.M. Keynes. He was
the founder of Welfare Economics. His leading ideas on welfare economics are found in his “Economics
of Welfare” (1920). 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. Similarly he defined economic
welfare as that part of social welfare “that can be brought directly or indirectly into relation with the
measuring rod of money.”

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. Prof Pigou had a dual criterion for detecting the increase in social
welfare. First, he measured the economic welfare of the society in money value and thus, given
the supply of resources, an increase in national dividend meant an increase in social welfare.
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

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purchasing power from the rich to the poor.

B. 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. 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
of production associated with marginal increments of output. 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. He was of the opinion that the state should equalize the private
net product with social net product. If in industry where private net product is more, it should be
taxed and if another industry shows a lesser private net product ought to be subsidized.
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 prevails when marginal social
products are equal in all industries and thus production of real wealth is maximized. Assuming that all the

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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”.
For this, his rule is that the allocation of resources & their utilization in different employments should be
such as to lead to equality between social marginal benefit & social marginal cost. (SMB = SMC).
Overall, then, except that his analysis is detailed, Pigou’s theory was similar to that of Marshall’s.
While advocating that in the interest of economic welfare the state should protect the interest of the poor,
he has suggested that economic welfare could be increased by the transfer of income/purchasing power
from the rich to the poor. Because the transfer of income from a relatively rich man to relatively poor man
of a similar temperament enables more intense wants to be satisfied at the expense of less intense wants.
This will increase the aggregate sum of satisfactions. \

He may be credited with establishing a scientific welfare economics. He was the first to put the whole
thing about welfare in to a system. He shifted on to the consideration of national welfare with reference to
social marginal cost and social marginal benefit. He had also suggested that the problem of
unemployment could be solved through the manipulation of wages; but, later on, he appeared to be much
nearer to Keynes when he suggests the manipulation of investment for combating unemployment. For
him, the chief aim of economic science will be unrealistic.

J. R. Hicks
After all, the phenomenon of Marshall and Pigou’s theory of welfare economics, traditional theory of
welfare) leave the way for the new era of Hicks’ modern micro economic theory of welfare economics.
Hicks’ first objective was to explain the problem of maximizing utility as a problem of constrained choice
for a rational consumer. His further objective was to show how the analysis of the consumers’ problem
could be applied to unify economic theory by analyzing the problem of the producers’ behavior in terms
of the same principles. 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. 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 approach

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 freed consumes theory ( and welfare economics theory ) from making value judgment. This alternative
was the use of indifference Curves analysis to show consumers behavior as a problem of constrained
choice (by finite income or budget and prices of commodities) to optimize preference, i.e. the technique
provides an alternative (to traditional) way of determining the optimum allocation of a consumer’s
incomes between two commodities, given the constraints of income & prices.

The indifference curve analysis was used by Pareto and Edgeworth before Hicks. What Hicks did is not
discovering but reviving this method of analysis because it was almost forgotten. This indifference curve
approach more qualitatively affected the Marshallian and Pigouvian welfare theory.

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. These approaches more
qualitatively affect the Marshallian and Pigouvian concepts. It is a fundamental approach in that it
dropped the need for measurable marginal utility.

New Welfare Economics

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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.
 The two dimensions are so interrelated that it is not possible to operate along one with out affecting
the other also. However, the two dimensions may or may not come in to conflict with each other.
 Some economists recommend redistribution with reference to efficiency, but equity is something to
be decided on political or other grounds. But, can we ignore the equity aspect of redistribution? You
may discuss it with your class mates.
Pareto’s stand was modified to say that income distribution becomes more efficient if, through
redistribution, gainers gain more than is the loss of the losers; in that case the gainers can compensate the
losers and still be better off. This had been known as the Kaldor principle. That is, Kaldor argued in favor
of ignoring the equity dimension by pointing out that the economist should leave the equity decision to
the state/legislature. He said that if the gainers can potentially compensate the losers and still gain after
redistribution, the redistribution is welfare enhancing.

New welfare Economics contributor

1. Vilfredo Pareto
Welfare economics dates back to the classical economic ideas of smith and Bentham. Several
subsequent economists dealt with welfare consideration, including who examined the welfare
effects of taxes and subsidies in decreasing cost industries. Historians of economic thought,
however, view Vilfredo Pareto as the originator of “new welfare economics”, which is rooted in
Walras’s general equilibrium.

Pareto Optimality

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Of particular relevance to the topic at hand, Pareto refined Walras’s general equilibrium and set
forth the conditions for what we call now Pareto optimality, or maximum welfare.

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 where MRShpS and MRShpG are smith’s and Green’s MRS of
hamburger for potatoes.

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, where MRTSLKH and MRTSLKP are the marginal rate of
technical substitution labor for capital in the production of hamburger and potatoes
respectively.

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

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Pareto’s welfare theory is significant contribution to economics. He did much to help
economists better understand the conditions for, and the welfare significance of, of economic
efficiency. 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

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