Although all the points on the grand social utility frontier are Pareto efficient, only one point identifies where social welfare is maximized. At the other extreme is the Max-Min, or Rawlsian utility function Stiglitz,p [incomplete reference].
The first states that given certain assumptions, competitive markets Exam guide econs equilibria with transfers, e. Point E corresponds with point B in the previous diagram, and lies inside the social utility frontier indicating inefficiency because the MRS at point C is not equal to the MRT at point A.
There are as many optima as there are points on the aggregate production—possibility frontier. Fundamental Exam guide econs of welfare economics The field of welfare economics is associated with two fundamental theorems.
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. No economic activity will increase social welfare unless it improves the position of the society member that is the worst off.
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.
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. According to this line of argument, utility is not the only thing that matters and so a comprehensive Exam guide econs to welfare economics should include other factors.
Long run declining average costs in a natural monopoly. However, perhaps most significant of all are concerns about the limits of a utilitarian approach to welfare economics.
If both conditions are satisfied, both gainers and losers will agree that the proposed activity will move the economy toward Pareto optimality. To determine whether an activity is moving the economy towards Pareto efficiency, two compensation tests have been developed. So how do we decide which Pareto optimum is most desirable?
Certain types of taxes and tariffs. In fact, there are an infinity of consumption and production equilibria that yield Pareto optimal results. Some even question the value of ordinal utility functions.
Also, the economists of the Austrian School question the relevance of Pareto optimal allocation considering situations where the framework of means and ends is not perfectly known, since neoclassical theory always assumes that the ends-means framework is perfectly defined.
Some may involve great inequalities of income. This is referred to as Kaldor—Hicks efficiency or the Scitovsky criterion. 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.
A social indifference curve drawn from an intermediate social welfare function is a curve that slopes downward to the right. Such point is called "the point of bliss".
Walrasian equilibria  produce Pareto efficient outcomes. 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.
The social welfare function shows the relative importance of the individuals that comprise society. This function embodies value judgements about interpersonal utility. The reason given is that it is difficult to aggregate the utilities of various people that have differing marginal utility of money, such as the wealthy and the poor.
Criticisms[ edit ] Some, such as economists in the tradition of the Austrian Schooldoubt whether a cardinal utility function, or cardinal social welfare function, is of any value. Point D corresponds with point C from the earlier diagram. This can make it controversial. Each Pareto optimum corresponds to a different income distribution in the economy.Through the Cambridge International AS and A Level Economics syllabus, learners study how to explain and analyse economic issues and arguments, evaluate economic information, and organise, present and communicate ideas and judgements clearly.
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