Introduction to General Equilibrium and Welfare Economics
• Are market allocations of resources socio-economically
• Welfare Economics: “The branch of economic theory
concerned with the social desirability of alternative
The theory is used to distinguish circumstances under which
markets can be expected to perform well
It also helps define some circumstances under which we
might want government intervention.
• There are two mainstream approaches to welfare economics: • Neoclassical approach and
• New welfare economics approach.
• The Neoclassical approach was developed by economists such as Edgeworth, Sidgwick, Marshall, and Pigou and based on the
• Utility is cardinal, that is, scale-measurable by observation or judgment. • Preferences are exogenously given and stable.
• 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.
Social Welfare Functions
• Social Welfare functions
• a real-valued function that ranks conceivable economic states from lowest to highest.
• In using welfare measures of persons in the society as inputs, the social welfare function is individualistic in form.
• One use of a social welfare function is to represent prospective patterns of collective choice as to alternative economic states.
• The social welfare function is analogous to the indifferencecurve/budget constraint equilibrium for an individual, except that
• the social welfare function is a mapping of individual preferences or judgments of everyone in the society as to collective choices, which apply to all, whatever individual preferences are for (variable) constraints on factors of production.
Social Welfare Functions
• There are two major distinct but related types of social welfare functions
• Bergson–Samuelson social welfare function considers welfare for a given set of individual preferences or welfare rankings.
• Arrow social welfare function considers welfare across different possible sets of individual preferences or welfare rankings and seemingly reasonable axioms that constrain the function
• The New Welfare Economics (NEW) approach is based on the work of Pareto, Hicks, and Kaldor.
• NWE gave up two assumptions in the Neoclassical approach to evaluating alternative economic states, i.e. that :
• Utility can be measured cardinally and is a measure for social welfare • Utility is interpersonally comparable and could be summed up. • It explicitly recognizes the differences between the efficiency aspect of the discipline and the distribution aspect and treats them differently.
• Questions of efficiency are assessed with criteria such as • Pareto efficiency
• Kaldor-Hicks compensation tests,
• Questions of income distribution are covered in social welfare function specification.
• Further, efficiency dispenses with cardinal measures of utility, replacing it with ordinal utility, which merely ranks commodity bundles (with an indifference-curve map, for example).
Defining the Problem
• Assuming we have a perfectly competitive market
Property rights to resources are clearly defined and enforced; Legal rights of ownership
Firms and consumers are revenue and utility maximisers
There is free entry of firms into the market;
Consumers and producers have perfect information;
Labour and capital are mobile;
The outcome in a particular market only affects the buyers and sellers in that market
e.g. no side-effects (called externalities) which affect others who are not...
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