What Is Welfare Economics?

Welfare economics is the study of how the allocation of resources and goods affects social welfare. This relates directly to the study of economic efficiency and income distribution, as well as how they affect the overall well-being of people in the economy. In practical application, welfare economists seek to provide tools to guide public policy to achieve beneficial social and economic outcomes for all of society. However, welfare economics is a subjective study that depends heavily on chosen assumptions regarding how welfare can be defined, measured, and compared for individuals and society as a whole.

Key Takeaways

  • Welfare economics is the study of how the structure of markets and the allocation of economic goods and resources determines the overall well-being of society. 
  • Welfare economics seeks to evaluate the costs and benefits of changes to the economy and guide public policy toward increasing the total good of society, using tools such as cost-benefit analysis and social welfare functions. 
  • Welfare economics depends heavily on assumptions regarding the measurability and comparability of human welfare across individuals, and the value of other ethical and philosophical ideas about well-being.

Understanding Welfare Economics

Welfare economics begins with the application of utility theory in microeconomics. Utility refers to the perceived value associated with a particular good or service. In mainstream microeconomic theory, individuals seek to maximize their utility through their actions and consumption choices, and the interactions of buyers and sellers through the laws of supply and demand in competitive markets yield consumer and producer surplus.

Microeconomic comparison of consumer and producer surplus in markets under different market structures and conditions constitutes a basic version of welfare economics. The simplest version of welfare economics can be thought of as asking, "which market structures and arrangements of economic resources across individuals and productive processes will maximize the sum total utility received by all individuals or will maximize the total of consumer and producer surplus across all markets?" Welfare economics seeks the economic state that will create the highest overall level of social satisfaction among its members.

Pareto Efficiency

This microeconomic analysis leads to the condition of Pareto efficiency as an ideal in welfare economics. When the economy is in a state of Pareto efficiency, social welfare is maximized in the sense that no resources can be reallocated to make one individual better off without making at least one individual worse off. One goal of economic policy could be to try to move the economy toward a Pareto efficient state.

To evaluate whether a proposed change to market conditions or public policy will move the economy toward Pareto efficiency, economists have developed various criteria, which estimate whether the welfare gains of a change to the economy outweigh the losses. These include the Hicks criterion, the Kaldor criterion, the Scitovsky criterion (also known as Kaldor-Hicks criterion), and the Buchanan unanimity principle. In general, this kind of cost-benefit analysis assumes that utility gains and losses can be expressed in money terms. It also either treats issues of equity (such as human rights, private property, justice, and fairness) as outside the question entirely or assumes that the status quo represents some kind of ideal on these type of issues. 

Social Welfare Maximization

However, Pareto efficiency does not provide a unique solution to how the economy should be arranged. Multiple Pareto efficient arrangements of the distributions of wealth, income, and production are possible. Moving the economy toward Pareto efficiency might be an overall improvement in social welfare, but it does not provide a specific target as to which arrangement of economic resources across individuals and markets will actually maximize social welfare. To do this, welfare economists have devised various types of social welfare functions. Maximizing the value of this function then become the goal of welfare economic analysis of markets and public policy.

Results from this type of social welfare analysis depend heavily on assumptions regarding whether and how utility can be added or compared between individuals, as well as philosophical and ethical assumptions about the value to place on different individuals' well-being. These allow the introduction of ideas about fairness, justice, and rights to be incorporated into the analysis of social welfare, but render the exercise of welfare economics an inherently subjective and possibly contentious field.