Welfare Economics - Social Welfare Functions - Essay Example

Welfare Economics: Social Welfare Functions Name: Tutor: Course: Date: Introduction Construction of social welfare functions and measurement of relative efficiency have been formulated as analytical techniques to clarify normative changes in equity and efficiency (Johansson, 1991, p. 78). Friedman (2002, p. 62) concurs that Pareto optimal utilities have been criticized owing to varying value judgments and hence, making it difficult to be adopted in policy issues analysis. Economic analysts become sensitive equity and efficiency when approaching the impact of political feasibility and social goals (Roemer, 1998). The issues arising are fairness and balanced allocations that will maximize well-being of individuals and whether the social welfare functions are equitable or efficient with regard to the proposed or existing policies (Salvatore, 1989, p. 33. The aim of the essay is to examine social welfare functions as embodying the normative conception of efficiency and equity, as well as its criticism as an effective tool in welfare economic analysis. Social welfare functions: Integrating equity and efficiency Inefficient resource allocation and attempt by all individuals in an economy to maximize their utility have rendered the worst off members of society under social welfare (Manna, 1997). Chadwick and Schroeder (2002, p. 47) argue that social welfare functions seek to maximize efficiency and equality during transfer of resources to the poor members of society, finance public expenditures and income maintenance. Friedman (2002, p. 67) agrees that efficiency is resource allocation that balances the better off and the worse off person while equity is the distribution of well-being to the people within an economy relatively. Individuals judge their own well-being, and policy analysis affects utility level, and overall satisfaction (Manna, 1997, p. 458). At some level, normative consequences of transferring resources to individuals in an economy involve equity judgments and policy issues. The potential importance of equity is its impact on political feasibility and social goals (Ghatak, 2003, p. 457). Efficient resource transfer and equity allocation are best understood through an evaluation of social welfare functions that integrates equity and efficiency (Friedman, 2002, p. 68). A trade-off is made between equity and efficiency to understand efficient allocations that are more equitable. With the presence of economic constraints preventing attainment of efficient allocation BC, social judgment is required. This judgment is based on the level of social welfare and distribution of utility levels among members of the society (Friedman, 2002). In the graph below, allocation at point A is considered more equitable, but the current efficient allocation position is in point G for two individuals; Rand and Suzanne. The three social indifference curves through point A represent the various social welfare functions. Figure 1: Alternative social welfare functions Source: Friedman, 2002, p. 61 Mathematically, the above social welfare function is generated as; W=W(U1, U2,….., Um) where Ui refers to the utility levels of individuals in the economy to the ith individual (Friedman, 2002, p. 61). For the above case of Rand and Suzanne, the function will be; W = W (UR, US) Equality of distribution measures equity while measure of relative efficiency is used to measure the aggregate utilities (Friedman, 2002, p. 65). At point A, the set of Rand-Suzanne utility combinations aggregates to yield similar levels of social welfare. WB represents relative efficiency indifferent to degree of equality. The straight line of (slope= -1) represents social indifference curve. It implies that irrespective of changes in equality of distribution, aggregate level remains constant. However, increases in the aggregate sum of utility will improve social welfare by a similar amount irrespective of the recipient. Maximizing social welfare satisfaction (W = UR +US), will be represented by a shift from point A to E. WR represents an egalitarian function with a right angle split in the middle. It indicates that increasing social welfare is only possible through raising utility levels of all the individuals (point C) starting with that of the worst person, Suzanne. The Rawlsian function (WR) represents a point where inequality is tolerated until the worst person (Suzanne) has his welfare improved. WM implies that social welfare increases with greater equality for any levels of aggregate equality given. In a combined equity-efficiency judgment, there is a need to look at look at social welfare function in the utilities-possibility frontier (Friedman, 2002, p. 63). To choose an allocation among Rand and Suzanne, the social indifference curves are developed as shown in the figure 2 below. Figure 2: Utility possibilities frontier and social welfare Source: Friedman, 2002, p. 63 From the figure 2 above, a shift upwards and to the right increases the level of social welfare. For example, suppose the economy is at social welfare WA and efficient point A. Given that inefficient point B has greater social welfare than point A, then it implies that point B has social importance owing to greater equality. Point C represents the maximum social welfare and that point WD is not realistic since an economy has limited resources. Since equality does not happen at the 450 line, a utility possibility frontier is described. It shows that it’s easier to increase happiness of Rand than Suzanne based on preferences and available resources. At point E, the society attains maximum equality since it compensates for the loss in equality by gain in utility aggregate at point C. The maximum welfare associated with Rand and Suzanne is obtained through the highest social indifference curve (Friedman, 2002, p. 65). At this point, utility possibilities frontiers cut the 450 line to equalize their utilities. Figure 3: Maximum social welfare varying on degree of inequality and judged by alternative welfare functions Source: Friedman, 2002, p. 64 From the figure 3 above, utility of Rand equals that of Suzanne at Rawlsian maximum E, and at the middle-of-the-road maximum at C. Above the 450 line, any interior points show Suzanne as worse off ,but a shift to the right depicts a Rawlsian improvement (Friedman, 2002, p. 66). Below the 450 line, any interior points show Rand as worse off, and any shift upwards depicts a Rawlsian improvement. Point E will be the maximum attainable welfare for both individuals no matter their starting points. However, the social welfare functions in figure 1, 2 and 3 above do not reflect the concept of equal opportunity or room for improvement. Criticism of Social welfare functions as tools of real-world policy analysis The concepts of equity and efficiency should receive attention (Johansson, 1991). However, Roemer (1998, p. 104) notes that despite the social welfare functions providing a strong appeal to neatness of social values integration, there is no substitute for universal criteria of separate evaluation of equity and efficiency. Social consensus has not yielded concrete understanding of which concepts to apply and why (Sen, 1997, p. 252). Despite that, real-world policy users have been able to reach normative conclusions from an informed perspective by evaluating and predicting the normative elements such as a relative efficiency, equal opportunity, equality, and efficiency. Combining some of these elements in a social welfare function will be useful. There are limits to obtainable data hence; economic analysts are forced to develop tools that utilize minimum data and offers accurate results. According to Friedman (2002, p. 67) social welfare functions have been constructed to make clarifications on normative consequences on public policy changes involving equity judgments and efficient allocation of resources. Fairness of the process is an individual decision and having one set of prices of goods for all individuals can achieve efficiency in a complex economy (Friedman, 2002, p. 68). Individuals in an economy have preference-ordering and regularly make consumption choices (Friedman, 2002). They would wish to maximize ordinal utility which is neither interpersonally comparable nor measurable. Social welfare functions do not measure the relative individual satisfaction levels empirically. However, Arrow (1963) found out that some situations or observable characteristics favor the use of social welfare functions such as income levels. It is possible to treat all the individuals with similar characteristics alike despite their individual preferences based on common parameters like similar tax regimes and political environment. Social welfare functions are also criticized more on conceptual than empirical basis in that a vague understanding exists on what ‘proper’ social welfare function means (Sinha, 2007, p. 250). The lack of universal consensus or agreement emanates from the fact that every individual in the society has their own view of what is meant by ‘proper’ (Friedman, 2002, p. 64). Social welfare functions demonstrated by graphs in figure 1, 2 and 3 based on Benthamite and Rawlsian equations show various possibilities on how a society can undertake aggregate equality and utility trade-offs. However, Friedman (2002, p. 69) observes that other equity and efficiency concepts that deserve attention are not reflected in the social welfare formulations. For example, utility-possibilities frontier and social welfare functions are independent given than in figure 1, and location of utility-possibility frontier is not dependent on the level of social welfare over a specific allocation. This means that social indifference curves are usually generated without the knowledge of the frontier. Despite that, efficient allocations are demonstrated in figure 3. Any room for improvement is not provided by the level of social welfare especially if the individual stands at the interior of the utility-possibilities frontier (Friedman, 2002, p. 67). Efficient allocation or Pareto-Optimal allocations help in knowing the existence of a new or superior alternative (Sinha, 2007). As illustrated in the figures above, equal opportunity concept of equity is not reflected in the social welfare functions and thus a practical impossibility. Indeed, knowledge of utility outcomes is inadequate, and one is left to judge the fairness of the process and the starting point (Friedman, 2002, p. 63). For example, a change may make Rand better off than Suzanne if the former worked more hours than the latter or Suzanne denied a reward unfairly. In this case, the outcome levels and fairness vary and affect the social welfare functions based on an equal opportunity. Bergson-Samuelson introduced a social welfare function given as; W = W(U1, U2, U3,………,Un) Where W is the social welfare and Ui is the individual ordinal utility indices (Fleurbaey & Maniquet, 2011, p. 20). These indices are based on type and magnitude of work as well as the type of goods or service consumed. By introducing value judgments, social welfare functions differ and lack acceptable standards (ibid). Some authors like Little, Baumol and Streeten found that social welfare functions have limited significance in practice (Myrdal, 1998, p. 102). The authors argue that the function cannot apply in totalitarian or democratic states because of the existence of many vague social welfare functions. Streeton thinks the concept of social welfare function is highly formal and disconnected from facts of choice and social life (Chadwick & Schroeder, 2002, p. 457). Besides, the welfare functions do not explain how to obtain the value judgments needed in its formulation (Fleurbaey & Maniquet, 2011, p. 17). Welfare is influenced by economic variables like consumption of services and goods, environmental and political variables such as pollution-free environment, political freedom and human rights (Tewari, 2003, p. 230). For example, a social welfare function that apportions every individual in an economy some leisure and income may not improve community’s welfare if it undermines their cultural traditions or limits their individual freedom. Arrow Impossibility Theorem argues that acting on value judgments cannot help to construct social welfare functions if they are based on a democratic process of majority rule (Arrow et al. 2005, p. 11). Arrow notes that majority rule promotes intransitivity of social choices and contradictory results where individuals are asked to make two alternatives. Social welfare functions derived from ordinal preferences may not serve all the people in society, and that value judgments based on individuals will only serve to reflect the aspirations and aims of a dictator (Arrow, 1963, p. 33). Sen Armatya is another critic of modern welfare economics based on social welfare function and Pareto efficiency. According to Sen (1997, p. 251), it is difficult to interpret well-being provided by utilities or desire-fulfillment and happiness. For example, an individual with limited opportunities, life of misfortune and little hope are deprived than those from affluent and fortunate upbringing. The author suggests a change in public or organization policy to encompass capabilities to function that ultimately determines welfare of the people, their well-being, and freedom in the positive sense. Conclusion Social welfare functions have been developed to maximize efficiency and equality during transfer of resources to the poor members of society, finance public expenditures and income maintenance (Friedman, 2002, p. 63). Economic analysts have attempted to explore the concept of inefficient resource allocation in a bid to ensure that all individuals in an economy maximize their utility. Social welfare functions have been successful in defining the normative importance of the equity and efficiency to members of society (Roemer, 1998, p. 29). However, social welfare functions have been criticized by many economists and social analysts for lacking proper definition of social well-being and incorporating the various parameters of social welfare (Friedman, 2002, p. 68). The essay has provided a normative connection between equity and efficiency under social welfare functions and criticism of the latter on its limitations. References Arrow, K. J. (1963). Social Choice and Individual Values, 2nd Edition. New York: John Wiley and Sons. Arrow, K.J., Sen, A. & Suzumura, K. (2005). Handbook of Social Choice and Welfare. Gulf Professional Publishing. Chadwick, R.F. & Schroeder, D. (2002). Applied Ethics: Critical Concepts in Philosophy, Volume 5. Taylor & Francis. Journal of Applied Ethics. Vol 5 (4): 43-49. Fleurbaey, M. & Maniquet, F. (2011). A Theory of Fairness and Social Welfare. Cambridge University Press. Econometric Society Monographs. Vol. 48 (2): 16-23. Friedman, L.S. (2002). The Microeconomics of Public Policy Analysis. Princeton University Press. Ghatak, S. (2003). Introduction to Development Economics. Psychology Press. Johansson, P.O. (1991). An Introduction to Modern Welfare Economics. Cambridge University Press. Manna, M.L. (1997). Readings in Microeconomic Theory. Cengage Learning EMEA. Myrdal, G. (1998). The Political Element in the Development of Economic Theory. Psychology Press. Journal of Economics and Society. Vol. 7(2): 34-48. Roemer, J.E. (1998). Theories of Distributive Justice. Harvard University Press. Salvatore, D. (1989). African Development Prospects: A Policy Modeling Approach. Taylor & Francis. Sen, A. K. (1997). Choice, Welfare and Measurement. Harvard University Press. Sinha, U.P. (2007). Economics of Social Sector and Environment. Concept Publishing Company. Tewari, D.D. (2003). Principles of Microeconomics. New Age International. Read More