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Welfare Economics: Individuals
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Welfare economics is concerned with the welfare of individuals, as opposed to groups, communities, or societies because it assumes that the individual is the basic unit of measurement. It ... assumes that individuals are the best judges of their own welfare, that people will prefer greater welfare to less welfare, and that welfare can be adequately measured either in dollars (or some other unit of currency) or as a relative preference.
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This is a fully revised and updated version of Hans van der Doel’s Democracy and Welfare Economics. It presents the economic theory of political decision-making (otherwise knownn as new political economy, or public choice), providing students with an accessible and clear introduction to this important subject. The authors identify four different methods of decision-making by which the political process transforms the demands of individual citizens into government policy and public goods and services: negotiation, majority decision, representations and bureaucratic implementation. These are analysed, in turn, as independent decision-making models whose effectiveness is examined with reference to economic theory. A final chapter draws conclusions from this analysis, arguing that the size of the public sector is a result of forces that work in different directions at different stages of the political process.
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Harsanyi may be viewed as the last representative of the old welfare economics, to which he made a major contribution in the form of two arguments. The first one is often called the "impartial observer argument". An impartial observer should decide for society as if she had an equal chance of becoming anyone in the considered population. This is a risky situation in which the standard decision criterion is expected utility. The computation of expected utility, in this equal probability case, yields an arithmetic mean of the utilities that the observer would have if she became anyone in the population. Harsanyi (1953) considers this to be an argument in favor of utilitarianism. The obvious weakness of the argument... is that not all versions of utilitarianism would measure individual utility in a way that may be entered in the computation of the expected utility of the impartial observer.
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Welfare economics addresses the issue of interpersonal utility comparisons by using observations about consumption as a vector of choices rather than a utilitarian summation of the utility they derive from a particular consumption bundle. When making comparisons between more than one individual, a particular allocation of resources is pareto-optimal if you could not make one individual better off without making another person worse off.
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Specialists of welfare economics once claimed that Arrow's result had no bearing on economic allocation (e.g. Samuelson 1967), and there is some ambiguity in Arrow (1951) about whether, in an economic context, the best application of the theorem is about individual self-centered tastes over personal consumptions, in which case it is indeed relevant to welfare economics, or about individual ethical values about general allocations. It is now generally considered that the formal framework of social choice can sensibly be applied to the Bergson-Samuelson problem of ranking allocations on the basis of individual tastes. Applications of Arrow's theorem to various economic contexts have been made (see the surveys by Le Breton 1997, Le Breton and Weymark 2002).
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Important results in the applied welfare literature are used to extend a conventional Harberger cost-benefit analysis. A conventional welfare equation is obtained for marginal policy changes in a general equilibrium economy with tax distortions. It is extended to accommodate internationally traded goods, time, income taxes, and non-tax distortions, including externalities, non-competitive behaviour, public goods, and price-quantity controls. The welfare analysis is developed in stages, and where possible is explained using diagrams, to make it more amenable to the different institutional arrangements encountered in applied work. Computable welfare expressions are solved using demand-supply elasticities. In a conventional cost-benefit analysis, lump sum transfers are used to separate the welfare effects of individual policy variables.
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