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Long run declining average costs in a natural monopoly. Certain types of taxes and tariffs. To determine whether an activity is moving the economy towards Pareto efficiency, two compensation tests have been developed.
Any change usually makes some people better off while making others worse off, so these tests ask what would happen if the winners were to compensate the losers. Using the Kaldor criterion, an activity will contribute to Pareto optimality if the maximum amount the gainers are prepared to pay is greater than the minimum amount that the losers are prepared to accept.
Under the Hicks criterion, an activity will contribute to Pareto optimality if the maximum amount the losers are prepared to offer to the gainers in order to prevent the change is less than the minimum amount the gainers are prepared to accept as a bribe to forgo the change.
The Hicks compensation test is from the losers' point of view, while the Kaldor compensation test is from the gainers' point of view. If both conditions are satisfied, both gainers and losers will agree that the proposed activity will move the economy toward Pareto optimality.
This is referred to as Kaldor—Hicks efficiency or the Scitovsky criterion. Equity[ edit ] There are many combinations of consumer utility, production mixes, and factor input combinations consistent with efficiency.
In fact, there are an infinity of consumption and production equilibria that yield Pareto optimal results. There are as many optima as there are points on the aggregate production—possibility frontier.
Hence, Pareto efficiency is a necessary, but not a sufficient condition for social welfare. Each Pareto optimum corresponds to a different income distribution in the economy. Some may involve great inequalities of income.
So how do we decide which Pareto optimum is most desirable?
This decision is made, either tacitly or overtly, when we specify the social welfare function. This function embodies value judgements about interpersonal utility. The social welfare function shows the relative importance of the individuals that comprise society. A utilitarian welfare function also called a Benthamite welfare function sums the utility of each individual in order to obtain society's overall welfare.
All people are treated the same, regardless of their initial level of utility. One extra unit of utility for a starving person is not seen to be of any greater value than an extra unit of utility for a millionaire.
At the other extreme is the Max-Min, or Rawlsian utility function Stiglitz,p [incomplete reference]. According to the Max-Min criterion, welfare is maximized when the utility of those society members that have the least is the greatest.
No economic activity will increase social welfare unless it improves the position of the society member that is the worst off.
Most economists specify social welfare functions that are intermediate between these two extremes. The social welfare function is typically translated into social indifference curves so that they can be used in the same graphic space as the other functions that they interact with.
A utilitarian social indifference curve is linear and downward sloping to the right. The Max-Min social indifference curve takes the shape of two straight lines joined so as they form a degree angle. A social indifference curve drawn from an intermediate social welfare function is a curve that slopes downward to the right.
The intermediate form of social indifference curve can be interpreted as showing that as inequality increases, a larger improvement in the utility of relatively rich individuals is needed to compensate for the loss in utility of relatively poor individuals.
A crude social welfare function can be constructed by measuring the subjective dollar value of goods and services distributed to participants in the economy see also consumer surplus.
Fundamental theorems of welfare economics The field of welfare economics is associated with two fundamental theorems.
The first states that given certain assumptions, competitive markets price equilibria with transfers, e. Walrasian equilibria  produce Pareto efficient outcomes.
Because of welfare economics' close ties to social choice theoryArrow's impossibility theorem is sometimes listed as a third fundamental theorem. Numerous utility functions can be derived, one for each point on the production possibility frontier PQ in the diagram above. A social utility frontier also called a grand utility frontier can be obtained from the outer envelope of all these utility functions.Welfare economics is a branch of economics that uses microeconomic techniques to evaluate well-being (welfare) at the aggregate (economy-wide) level.
A typical methodology begins with the derivation (or assumption) of a social welfare function, which can then be used to rank economically feasible allocations of resources in terms of the social welfare they entail.
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