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Presentation outline (12/31/2010)
Welfare economics
Pigouvian Theory – dual criteria, criticism
Pareto-optimality – conditions, criticism
Other criteria
Externalities – positive & negative
Diagrammatic explanation of externality –
pigovian tax
• Public goods, types of goods and free ride
Welfare economics
 Welfare economics is a branch of economics that uses
microeconomic techniques to determine the allocation
efficiency within an economy and the income distribution
associated with it. Therefore, it is a methodological
approach to assess resource allocations and establish
criteria for government intervention.
Pigouvian Theory
(Microeconomics, theory and applications by Ghai and Gupta)
A.C Pigou in his book ‘Economics of welfare’ distinguished
social welfare and economic welfare. According to him,
economic welfare is that part of social welfare that can be
brought directly or indirectly into relation with the measuring
rod of money. He defined economic welfare of the individuals
as the amount of satisfaction or utility he enjoys at a
particular time and social welfare as aggregate of welfare of
all the individuals in the society.
In order to explain his dual criterion for determining the
social welfare he assumed that it is possible to compare the
utility derived by consumers from goods and services. He also
assumed that consumers aims at maximizing utility.
Pigou’s dual criteria for determining the
social welfare:
• First criteria: Given the supply of factors of
production social welfare increases with the increase
in national income. National income is the sum of the
market value of final goods and services produced by
normal residents of the country in an accounting year.
Thus increasing national income results in more
satisfaction from more goods which increase in social
• Second criteria: Social welfare increases when
transfer of real income from the rich to poor increases
(but the transfer does not lead to decrease in national
Pigou defines social welfare as the aggregate
of utilities derived by the individuals in the
society. As the concept of utility is subjective,
it cannot be added and thus definition of social
welfare is unrealistic. As the value of money
keeps on changing, using money as a tool to
measure economic welfare may be inaccurate.
Pareto optimality criteria
The concept of Pareto- optimal or Paret – efficient is based on
the criterion given by Italian economist Vilfredo Pareto.
According to him, a situation is defined as Pareto-optimal (or
efficeint) if it is impossible to make anyone better-off without
making someone worse-off. The Pareto’s optimality criterion
states that any changes that makes one member of the society
better-off without making someone worse-off is an
improvement in social welfare. Conversely, if any changes
makes at least one member of the society worse-off without
making any member better-off, then it is decrease in social
welfare. In order to attain Pareto-efficeint situation, the
following three conditions need to be satisfied:
Three conditions
• Condition 1: Efficieny in production: it means
the efficient allocation of factors of production
among the firms
• Condition 2: Efficiency in exchange of
consumption it means the efficient distribution
of commodities among the consumers.
• Condition 3: Efficieny in product mix or
composition of output it means the efficient
allocation of factors among commodities.
The criteria considered only those changes that make anyone
better off without making someone worse-off. It does not take
into account those changes that make few people better-off by
making few people worse off.
1. As each point on the curve is Paret-efficent, there are infinite
number of points which are Pareto-optimal. These various
points are not comparable unless interpersonal comparison and
value judgements are made.
2. Pareto-optimality is necessary but not sufficient conditions for
the welfare maximization. In other words, a situation may be
Pareto-optimal without maximising social welfare. Thus this
criterion does not ensure the maximization of social welfare.
Other criteria's
• Kaldor – Hicks Compensation criterion
• Scitovsky’s double criteion
• Bergson’s Criterion
The buyer and seller of a packaged good do not
consider that the packaging material must be disposed in
some way. The costs of a garbage collection and
disposal scheme, if one exists, are not reflected in the
price of the packaged good and someone else- the local
or national tax payer pays that cost. If no organized
collection and disposed scheme exists, the garbage is
simply disposed in environment as litter in roadside
waste or in unregulated landfill tips as waste. In many
developing countries for example, considerable amount
of waste are fly-tipped (disposed off anywhere) legally or
illegally in rivers, or land , or in open bonfires.
Such unregulated or unsystematic disposal of waste
generate risks that entails a third party cost that is not
reflected in the price of the packaged good.
In economic terms, those costs are an external effect.
External benefit are possible but tend to be less common
than external costs. External effects or externalities are
market failures, that is, they are a distortion arising
because markets fail to function effectively. The
distinction between market failure and policy failure is
ambiguous. After all, governments can alter market
prices to reflect, albeit approximately, the external costs
of production and consumption. To that extent their
failure to do so is a policy failure, they fail to maximize
social welfare.
• Nonetheless, social cost pricing is not
necessarily a distant or unpractical prospect.
Government often have the means to effect
approximate adjustments for external costs: they
can, for example, raise gasoline taxes to
account for the air pollution, congestion, and
noise caused by the vehicles.
• Environment economics analyze pollution as an
externality. An externality is any impact on a third
party’s welfare that is brought about by the
action of an individual and is neither
compensated nor appropriated.
Types of externality
• Thus, in economics, an externality is a
cost or benefit, not transmitted through
prices, incurred by a party who did not
agree to the action causing the cost or
benefit. A benefit in this case is called a
positive externality or external benefit,
while a cost is called a negative
externality or external cost.
Negative externalities
• Anthropogenic climate change
• Water pollution
• Alcoholic driving
Positive externalities
• Beekeeping
• Individual planting
• Education and health
Supply and demand with negative
Supply and demand with positive externality
Public goods
Public good is a good that is nonrivalrous and non-excludable. Non-rivalry
means that consumption of the good by
one individual does not reduce availability
of the good for consumption by others;
and non-excludability that no one can be
effectively excluded from using the good.
Non-rivalness and non-excludability may
cause problems for the production of
public goods. Some economists argue that
the nature of public good lead to instances
of market failure, where uncoordinated
markets driven by parties working in their
own self interest are unable to provide
these goods in desired quantities.
Type of goods and their properties
Level of Exclusivity
Non rival
Private land based goods:
-Commodity production
-Mineral extraction
Common property goods:
-Lake, river system
Public forest
Public park
Club goods:
Golf courses
Heli-skiing, sky-diving
Purely public goods:
-Defense of land base
Free rider problem
Public goods provide a very important example
of market failure in which market-like behavior of
individual gain-seeking does not produce
efficient results. The production of public goods
results in positive externalities which are not
remunerated. If private organizations don't reap
all the benefits of a public good which they have
produced, their incentives to produce it
voluntarily might be insufficient. Consumers can
take advantage of public goods without
contributing sufficiently to their creation. This is
called the free rider problem.
Thanks for your attention