The document provides an introduction to welfare economics. It defines welfare economics as the branch of economics concerned with evaluating proposed policies and projects to optimally allocate resources and maximize societal well-being. It discusses the differences between positive economics, which describes what is, and normative welfare economics, which determines what should be. While welfare economics aims to measure utility, utility cannot be directly observed or measured, posing challenges for the field.

1. Chapter 1
Introduction to Welfare Economics
Welfare Economics for MSc PPM Students

2. 2
Background of Welfare Economics
 Governments must make decisions regarding the
adoption of public policies and projects.
 Suppose you are asked to provide expert testimony
to a congressional committee regarding these
policies.
 Which, if any, policy would you support?
 What would be the economic basis for your
testimony?
 Is there an objective theoretical justification for
either policy?
 How would you go about calculating the expected
gains and losses from these proposed policies?
 One must bear in mind that public officials must and
will make these decisions whether or not they can
get objective advice.

3. 3
What is Welfare Economics?
Definitions of Welfare Economics
 Welfare economics is the branch of economics that
deals with how to evaluate proposed
policies/projects.
 It deals with how to use resources optimally to
achieve the maximum well-being for individuals in
society or more simply to help society make better
choices.
 “Welfare economics is the study of how the
allocation of resources affects economic well-being”
(Mankiw, 2004, p. 138).

4. 4
Positive vs Normative Economics
 Positive economics is that branch of economics
that is concerned with understanding and predicting
economic behavior.
 Positive economics is only concerned with what ‘is’.
- What determines the prices of houses, farmland, or
- What will happen to the output of a competitive firm
when a tax is imposed on each unit of its product?
 These are the types of questions that positive
economics tries to answer.

5. 5
Positive vs Normative Economics
 Welfare economics, on the other hand, is concerned
with what ‘ought’ to be.
 Welfare economics is normative economics.
 Welfare economics focuses on using resources
optimally to achieve the maximum well-being for the
individuals in society.
 But, unfortunately, agreement cannot always be
reached on what is optimal.

6. 6
Ethical Assumptions
 They are ethical assumptions or value judgments
with which economists may legitimately disagree.
 Two of these ethical assumptions are, however,
sufficiently widely accepted that they provide the
foundations for a large part of applied welfare
economics and policy evaluation. They are that
(1) the welfare status of society must be judged solely
by the members of society (also called fundamental
ethical postulate or the principle of individualism)
(Quirk and Saposnik 1968, p. 104 and
(2) the notion that society is better off if any member
of society is made better off without making anyone
else worse off (Pareto principle after the founder of
the principle, Vilfredo Pareto (1896)).

7. 7
Measurement issues
 A difficulty with welfare economics is that economic
‘welfare’ is not an observable variable like the
number of machines, houses, market prices or
profits.
 The economic welfare status of an individual is
formally represented by his or her utility level, a
term generally used synonymously with happiness or
satisfaction.
 Utility is measured by ‘utils’, which is an imaginary
and not a metric unit.

8. 8
Measurement issues
 But one cannot measure the increase in utility by
additional utils obtained from consumption.
 Consequently, positive economics assumes that
utility is only ordinally measurable, however,
normative economics seeks to measure welfare
cardinally.
 Hence,
i. Ordinality = the ability to (only) rank alternatives
according to the utility they provide
ii. Cardinality = indicate the magnitude of the change
in utility in moving from one alternative to another
(like a temperature scale)

9. 9
Measurement issues
 A cardinal system specifies exactly how much utility
each affected individual would gain or lose from a
proposed policy decision.
 Such information would surely be helpful to those
concerned with determining the maximum well-
being for society and would simplify the subject of
welfare economics substantially.
 Measurability of utility, however, is not sufficient to
determine optimal social choices.
 The point is that, even if utility were measurable,
there would still be the problem of how to weight
individuals: welfare weightings
 No objective way exists for solving this problem of
interpersonal comparisons.

10. 10
Compensating vs Equivalent Variations
 Since utility is not measurable, an alternative
measure must be chosen.
 The two most widely used willingess-to-pay welfare
measures proposed by John R. Hicks (1943, 1956)
are the compensating variation and the equivalent
variation.
 The motivation for the Hicksian measures is that an
observable alternative for measuring the intensities
of preferences of an individual for one situation
versus another is the amount of money the
individual is willing to pay or willing to accept to
move from one situation to another.
 This principle has become a foundation for modern
applied welfare economics.

11. 11
Compensating vs Equivalent Variations
 The two most important WTP measures are
compensating and equivalent variations.
 Compensating variation is the amount of money
which, when taken away from an individual after an
economic change, leaves the person just as well off
as before.
 For a welfare gain, it is the maximum amount that
the person would be willing to pay for the change.
 For a welfare loss, it is the negative of the minimum
amount that the person would require as
compensation for the change.

12. 12
Compensating vs Equivalent Variations
 Equivalent variation is the amount of money paid to
an individual which, if an economic change does not
happen, leaves the individual just as well off as if the
change had occurred.
 For a welfare gain, it is the minimum compensation
that the person would need to forgo the change.
 For a welfare loss, it is the negative of the maximum
amount that the individual would be willing to pay to
avoid the change.

13. 13
Efficiency and Equity
 Almost without exception, the great works in
economics have focused on some aspect of the
operation of the economy in terms of such criteria as
efficiency and equity.
 Economic efficiency has to do with producing and
facilitating as much consumption as possible with
available resources, whereas equity has to do with
how equitably goods are distributed among
individuals.
 Do competitive markets lead to the most preferable
state of society?
 What are the distributional effects of imperfect
competition and monopoly power?
 These are some of the fundamental questions of
efficiency and equity that can be addressed with
welfare economics.

14. 14
Primary Objectives of Decision Making Units
 In a certain economy, there are three decision
making units
1. Consumers: Maximize Utility
2. Producers:
a) The traditional economic theory
 maximize profits
b) The modern theories of the firm,
 Satisfying Behaviour
3. Government: Public welfare maximizer