Welfare economics is the economic study of the definition and the measure of the social welfare; it offers the theoretical framework used in public economics to help collective decision making, to design public policies, and to make social evaluations.
Questions usually tackled by welfare economics are the following: what is social welfare? Is there a reliable and satisfying way to measure it? If social welfare is based on individual preferences, can we derive a social preference from the preferences of individuals? Are competitive equilibrium outcomes optimal in the sense that they lead to the highest social welfare? Can any optimal outcome be achieved by a modified market mechanism? Can we really formulate recommendations for public policies on the basis of such welfare analyses?
In spite of the uncontroversial importance of all these issues, some have been overshadowed while others have drawn enormous attention.
The exclusion of normative information was justified in a bid to scientific rigour, until the oblivion of the prescriptive role of welfare economics. From then on, the death of welfare economics has been often foretold (Hicks 1939: 697; Chipman and Moore 1978: 548; Mishan 1981; Hausman and MacPherson 1996: 96). Setting out the history of welfare economics implies, first, to recall its evolution, secondly to discuss the reasons why it has almost missed its project. Thirdly, there are strong reasons to hope: welfare economics is back (Sen 1999; Fleurbaey and Mongin 2005), yet at the cost of accepting the normative nature of (welfare) economics.This entry defends that the driving forces of the evolution of welfare economics through the last century are the role of interpersonal comparisons of utility, the interpretation of utility, and the status of value judgements. Interpersonal comparisons of utility concern the trade-offs between different persons’ welfares; their existence requires these trade-offs to be meaningful. This entry recalls they have been more or less accepted. The interpretation of utility may be objective or subjective. Utility is subjective if it captures the individual’s personal judgement or degree of satisfaction.
It differs from other interpretations of utility capturing some mere description of a state of affairs, including revealed preferences or objective utility. This entry shows that when utility is subjective or based on revealed preferences, it can just be measured ordinally; in such a case the numerical value of utility captures mere comparisons but no computations are allowed. This is one reason to question whether interpersonal comparisons are meaningful. Value judgements refer to the incorporation of a particular set of values, regarding the rightness, goodness, usefulness or fairness in judgements, for instance, regarding the tradeoffs between different persons’ welfares. Consequently, the exclusion of values from the scope of welfare economics is another reason why interpersonal comparisons can hardly be made meaningful.The evolution of welfare economics marks up different periods and types of contributions. According to Philippe Mongin (2002, 2006), its history may be divided in at least four successive stages.
The pre-history of welfare economics is as old as political economics: classical and neo-classical economists were studying the efficiency and equity of productive systems, more specifically wondering how to value commodities or labour, and to assess the best allocation of goods and of tasks for the society (Myint 1965). Utilitarianism which, since Jeremy Bentham, aimed at providing tools to measure and improve individual and collective well-being, may be considered as one genuine root of welfare economics.
In the first stage, the creation of the first tool of welfare economics goes back to Alfred Marshall (or, even earlier, to the works of Jules Arsene Dupuit): the introduction of the notion of consumer surplus is meant to provide a method to measure relative change in consumers’ utility generated by some evolution of the environment, for example, by a variation of price induced by a fiscal policy. Assuming a link between welfare and demand, it uses the information on the shape of the demand functions to infer the utility variations.
Policy recommendations may be derived from the surplus analyses. However, welfare economics was more clearly born with Arthur Cecil Pigou’s book published in 1920, The Economics of Welfare, in which he has among others developed the famous distinction between private and social marginal cost or productivity, the role of the size and the distribution of the “national dividend” in measuring economic welfare, and his defence of the transfer principle. Pigou defends the distinction between private and social costs when there are what can now be called external effects. National dividend is somewhat the ancestor of our gross domestic product. Pigou claims that not only is welfare increased when the size of the dividend increases, but welfare also increases when its distribution among the rich and the poor is more equal. To capture the notion of equality, Pigou developed the principle of transfer according to which a distribution of income X is more equal than another distribution Y if the only difference between X and Y is that one individual transferred δ('' to a poorer person than her - who remains not as rich after transfers. In other words, X is more equal according to the Pigou criterion of transfers if the rich are less rich and the poor are not as poor. The definition of welfare was not really unified at this stage: it could be the “national dividend” or a mix between the amount of the dividend and the distribution of income, and even something else. The specificity of this early stage of welfare economics is its deliberate account for value judgements, and as a consequence, its use of interpersonal comparisons of utility.In the second stage, the new welfare economics established a clear separation between the optimality conditions based on the Paretian condition and their applications to the market. A social state X is better than Y according to the Pareto criterion if X is better than Y for every individual; X is Pareto optimal if it is not possible to improve the situation of any individual without injuring the situation of at least one individual.
There exist other Pareto conditions considering the possibility of transfers. At this stage, the definition of welfare was uniformly based on strictly ordinal and subjective individual utilities. The best-known applications are the fundamental theorems of welfare economics. The question of income distribution, including when applying the principle of compensation, was then mostly left aside.In the third stage, after the Arrovian negative result tolled the death knell in the 1950s, social choice theory, public economics and the theories of inequality and poverty have been kept separate for decades. The only noteworthy element of continuity and unity is that most contributions were then welfarist, that is, the only relevant information for social welfare or public decision was individual utilities.
In the fourth stage, some post-welfarist economic theories of justice or fairness have been developed recently. Some economists suggest redirecting their research, for example, to analyse rights, or to integrate information such as talents and handicaps, opportunities and capabilities among others.
This entry is organized as followed. The Paretian watershed exposed in the next section marks the evolution from the first to the second stage of welfare economics and the formulation of the two fundamental theorems of welfare economics. The problems raised with both approaches of the new welfare economics described in the following section provide some clues to understand the disintegration of the third stage. Recent and promising avenues for researches are developed in the last section.