1. Welfare economics analyzes how economic policies affect overall social welfare. Classical welfare economics assumed welfare was additive and could be quantitatively measured and compared between individuals. 2. New welfare economics is normative rather than positive and recognizes welfare cannot be cardinally measured, only ordinally. It compares the relative social welfare of different economic states. Scholars like Hicks, Pigou, Kaldor and Scitovsky contributed to developing new welfare economics. 3. The Hicks-Kaldor compensation principle states that if one group gains from a policy change while another loses, but the gainers could potentially compensate the losers and still be better off, then the change increases social welfare. Scitovsky

1. WELFARE ECONOMICS
Prof. Prabha Panth,
Osmania University,
Hyderabad

2. Welfare Economics
• Classical economists assume “the greatest good
for the greatest number.”
• Total welfare of the economy =  individual
welfare (welfare is additive).
• Interpersonal comparison of welfare possible.
• An individual’s welfare is independent of others
welfare.
• Welfare is measured in terms of Utility (Cardinal
Analysis).
• Only Economic welfare – consumption.
• Based on egalitarian distribution of income.
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3. New Welfare Economics
• Normative economics, not positive.
• Equity and Social Well being and Value Judgment.
• No cardinal measure of welfare possible.
• Only ordinal measurements.
• Compares the social welfare of one type of
allocation with another.
• Hicks, Pigour, Kaldor, Scitovsky, Bergson
contributed to New Welfare Economics
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4. • Pareto Optimality:
• At Pareto Optimum both parties are satisfied.
• There is social welfare.
• But this is not the only unique equilibrium point.
• If one person improves his welfare, another’s will
decrease.
• What happens then to social welfare?
• New welfare economics suggests that
compensation can be paid by those who are
better off (welfare ), to those who are worse off
(welfare ) to keep Social welfare constant.
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5. Compensation Principle
• If a change in allocations or economic policy
makes A better off, without making B worse off,
then Social Welfare (SW) will increase if A can
compensate B for his loss, and still be better off.
• For e.g. if fishing is prohibited in a lake, but
swimming and boating are allowed, then
fishermen are worse off, but tourists are better
off. Has social welfare increased or decreased?
• If the latter pay compensation to the fishermen
for the loss of their income due to the new law,
then Social welfare can remain constant.
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6. Hicks - Kaldor Compensation Principle
• Kaldor’s Criterion: Allocation X is socially
preferable to allocation Y, if those who gain from
X could compensate the losers, and still be better
off.
• Hick’s Criterion: Allocation X is socially preferable
to allocation Y, if those who lose from X, cannot
bribe the gainers into not making the change
from Y to X.
• (In the former example, the fishermen cannot pay
off the tourists to not use the lake).
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7. Prabha Panth 7
1. Hicks – Kaldor Compensation Principle
The Utility Possibility Curve : Contact Curve of Consumption,
drawn in outer space. If both consumers are at Z, A’s U is A0
and B’s is B0. Not an optimal point.
If A moves to point R, his U  to Ar, but B’s U falls to Br.
If A can compensate B worth B0Br, so that B is back to Z with
his original U: B0, i.e. point S, then A’s U still  to As.
At S, A is still better off, while B’s U has not , he is not worse
off. So movement from Z to S is improvement in social welfare.
E.g. At point R, if A’s welfare
increases by Rs.1000, and B’s
utility falls by Rs.200, then A
can pay Rs.200 to B as
compensation, and still be
better off with extra Rs.800
than at point Z.
So from Z  S is improvement
in SW.
B’sUtility
A’s Utility
S
0
V
T
B0
R
Z
A0 Ar
Br
AsAv
Bt
Bv

8. Scitovsky’s Paradox
• Scitovsky pointed out an important limitation of Kaldor-
Hicks criterion.
• This could lead to contradictory results.
• It is possible that if R is an improvement for A, then another
point, V could be an improvement for B.
• Based on the same criterion.
• So there is inconsistency in the Kaldor – Hicks proposition.
• For getting consistent results if V is preferred to R on the
basis of a welfare criterion,
then position R must not be preferred to position V on the
same criterion.
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9. • In the same way, B may try to improve his
welfare, and move to point V from Z.
• His U increases to Bv, but A’s falls to Av, and he
may not allow B to move to V.
• If B pays a compensation of AvA0 to A, then A
can move back to Z.
• B moves to T, but still has higher U = Bt,
compared to at Z.
• So B is better off, while A is not worse off.
• So which of the two, A’s movement or B’s
movement leads to Social welfare?
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10. Scitovsky’s Double Criterion
• To ensure that there is no inconsistency in SW
improvements, he suggests a Double
Criterion.
– If the gainers of a change can persuade losers to
accept the change,
– But losers are not able to persuade the gainers to
remain in the original situation,
It leads to improvement in Social Welfare.
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11. • But:
– Assumes that welfare can be measured in money
terms. But many types of welfare cannot be
measured in money terms.
– Assumes equal distribution of income. But if B is a
poor man, and A is rich, then latter can dominate
over B.
– Assumes MUm for both are equal. If B is poorer,
then his MUM will be > than of A.
– Theoretical only. Actually no real compensation is
paid.
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