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Welfare economics is the study of how a society can best use its scarce endowments—for example, its natural resources, technical know-how, stock of physical and human capital, and so forth—to maximize the well-being of its members. When the principles of welfare economics are used to evaluate a specific policy issue, it is known as welfare analysis. This entry describes the main features of welfare analysis, focusing on its intellectual foundations and practical challenges, as well as controversies surrounding its use.
Two policy examples will help clarify what welfare analysis is. First, psychologists have shown that the academic achievement of underprivileged children is significantly improved by enrollment in prekindergarten programs. These programs are, of course, expensive to run. Will society be better off if prekindergarten is freely and universally provided? Second, as of 2007, high gas prices have caused U.S. policymakers to consider opening the Arctic National Wildlife Refuge in Alaska for energy exploration. Would the benefits to society from the increase in domestic energy sources outweigh the environmental implications of this decision?
Neither of these questions has an obvious answer, although each can invoke varying opinions from different members of society. The task of welfare analysis is to assemble information to aid in determining whether the proposed policy action would on balance be beneficial to society. Economists use two fundamental concepts to aid in this process. The first is consumer sovereignty, which has its roots in the philosophy of individualism. Consumer sovereignty has two related consequences for welfare analysis: it implies that the individual is the best judge of what is good or bad for his or her well-being, and that a proposal can only be judged by examining the sum of its impacts on individuals. The latter gives rise to the second fundamental concept, the compensation criterion, as originally proposed by John Hicks (1939) and Nicholas Kaldor (1939). Almost any policy action will involve winners and losers. The compensation criterion suggests that a policy is desirable if those who gain from the action gain enough in aggregate that they would be able to compensate the losers for their losses. Thus welfare analysis is a matter of measuring changes in individuals’ well-being as they see it as a result of a policy change, and determining whether the sum of the individual gains is greater than the sum of the individual losses.
This view of welfare analysis might more accurately be described as the neoclassical interpretation in that it is intentionally silent on issues of fairness, justice, and other notions of equity. Said another way, neoclassical welfare analysis focuses narrowly on maximizing the size of the well-being pie rather than providing prescriptions on how it should be divided. Implicitly, distributional questions are left to other mechanisms. A wider view of welfare analysis requires specific judgments on what is fair and just and hence is more difficult to implement. Nonetheless there have been efforts by political economists past and present to cast welfare analysis in a wider light. Prominent among these is the work of Amartya Sen, who advocates the use of mild interpersonal comparisons—based, for example, on the ability of people to freely choose their lifestyle—in conjunction with neoclassical criteria. The work of Sen and others notwithstanding, the narrow view of welfare analysis as described above has tended o dominate the operational use of the technique.
The operational challenge of neoclassical welfare analysis is to assess changes in well being from an action. Because a person’s well being cannot be objectively measured, economists use money proxies in their stead. A prime example of this is willingness to pay, which measures how much money a person would pay out of their income to secure (or prevent) an action. This measure is valid and useful even if the payment is not actually made. The magnitude of the payment, if accurately assessed, provides a sense of the relative importance of the action under consideration. Techniques for measuring individuals’ willingness to pay have a long history in economics, beginning with Alfred Marshall (1930) and including seminal works by Robert Willig (1976), Michael Hanemann (1978), and Jerry Hausman (1981).
The principles of welfare analysis (if not always the techniques) are widely accepted by economists. Nonetheless, they can be controversial among noneconomists. Three of the main points of contention deserve mention in closing. First, some object on ethical grounds to the use of money measures to gauge the value of public policy issues related to, for example, human health and the environment. Second, based as it is on the notion of individualism, welfare analysis does not readily admit notions of collective responsibility. Finally, welfare analysis tends to be silent on the subject of income distribution. Nonetheless, welfare analysis is often the only means available to policymakers of organizing complex and conflicting points of view; as such, it will likely continue to play a role in policy decisions.
Bibliography:
- Hanemann, Michael. 1978. A Theoretical and Empirical Study of the Recreation Benefits of Improving Water Quality in the Boston Area. PhD diss. Harvard University, Cambridge, MA.
- Hausman, Jerry. 1981. Exact Consumer’s Surplus and Deadweight Loss. American Economic Review 71: 662–676.
- Hicks, John. 1939. The Foundations of Welfare Analysis. Economic Journal 49: 696–712.
- Kaldor, Nicholas. 1939. Welfare Propositions of Economics and Interpersonal Comparisons of Utility. Economic Journal 49: 549–552.
- Marshall, Alfred. 1930. Principles of Economics. London: Macmillan.
- Sen, Amartya. 1998. The Possibility of Social Choice. American Economic Review 89: 349–378.
- Willig, Robert. 1976. Consumer’s Surplus without Apology. American Economic Review 69: 589–597.
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