Prerequisites

Prerequisites

Almost
Almostessential
essential
Welfare:
Basics
Welfare: Basics
Welfare:
Welfare:Efficiency
Efficiency

WELFARE: THE SOCIALWELFARE FUNCTION

MICROECONOMICS
Principles and Analysis
Frank Cowell

March 2012

Frank Cowell: Welfare - Social Welfare function

Social Welfare Function

Limitations of the welfare analysis so far:
Constitution approach
Arrow theorem is the approach overambitious?

General welfare criteria

efficiency nice but indecisive
extensions contradictory?

SWF is our third attempt

Something like a simple utility function?

Requirements
Requirements
March 2012

Frank Cowell: Welfare - Social Welfare function

Overview...
Welfare: SWF

The Approach

What is special about

a social-welfare
function?

SWF: basics

SWF: national
income
SWF: income
distribution
March 2012

Frank Cowell: Welfare - Social Welfare function

The SWF approach

Restriction of relevant aspects of social state to each person

(household)
Knowledge of preferences of each person (household)
Comparability of individual utilities
utility levels
utility scales

An aggregation function W for utilities

contrast with constitution approach
there we were trying to aggregate orderings
AAsketch
sketchofofthe
the
approach
approach

March 2012

Frank Cowell: Welfare - Social Welfare function

Using a SWF
b
Take the utility-possibility set
Social welfare contours
A social-welfare optimum?

a
b
W(
W(a,,b,...
,... ))

W defined on utility levels

Not on orderings

Imposes several restrictions

..and raises several questions

March 2012

Frank Cowell: Welfare - Social Welfare function

Issues in SWF analysis

What is the ethical basis of the SWF?
What should be its characteristics?
What is its relation to utility?
What is its relation to income?

March 2012

Frank Cowell: Welfare - Social Welfare function

Overview...
Welfare: SWF

The Approach

Where does the

social-welfare
function come from?

SWF: basics

SWF: national
income
SWF: income
distribution
March 2012

Frank Cowell: Welfare - Social Welfare function

An individualistic SWF
The standard form expressed thus

W(1, 2, 3, ...)

an ordinal function
defined on space of individual utility levels
not on profiles of orderings

But where does W come from...?

We'll check out two approaches:
The equal-ignorance assumption
The PLUM principle

March 2012

Frank Cowell: Welfare - Social Welfare function

1: The equal ignorance approach

Suppose the SWF is based on individual preferences.
Preferences are expressed behind a veil of ignorance
It works like a choice amongst lotteries
don't confuse and !

Each individual has partial knowledge:

knows the distribution of allocations in the population
knows the utility implications of the allocations
knows the alternatives in the Great Lottery of Life
does not know which lottery ticket he/she will receive

March 2012

Frank Cowell: Welfare - Social Welfare function

Equal ignorance: formalisation

Individualistic welfare:

payoffs
payoffs ifif assigned
assigned
identity
identity 1,2,3,...
1,2,3,... in
in
the
the Lottery
Lottery of
of Life
Life

W(1, 2, 3, ...)

vN-M form of utility function:

u(x)

Equivalently:

Replace by set of identities

{1,2,...nh}:

h hh
A suitable assumption about
probabilities?
nh

W=
March 2012

1
nh=1
h
h

use theory of choice under

uncertainty to find shape of W
probability assigned to
u : cardinal utility function,
independent of
utility payoff in state
welfare is expected utility
from a "lottery on identity
An additive form of the
welfare function

Frank Cowell: Welfare - Social Welfare function

10

Questions about equal ignorance

Construct a lottery on identity
The equal ignorance assumption...
Where people know their identity with
certainty

Intermediate case

The equal ignorance

assumption: h = 1/nh
But is this appropriate?
|

| |

1 2 3

identity

nh

Or should we assume that

people know their identities
with certainty?
Or is the "truth" somewhere
between...?

March 2012

Frank Cowell: Welfare - Social Welfare function

11

2: The PLUM principle

Now for the second rather cynical approach
Acronym stands for People Like Us Matter
Whoever is in power may impute:
...either their own views,
... or what they think societys views are,
... or what they think societys views ought to be,
...probably based on the views of those in power
Theres a whole branch of modern microeconomics that is a

reinvention of classical Political Economy

Concerned with the interaction of political decision-making and

economic outcomes.
But beyond the scope of this course

March 2012

Frank Cowell: Welfare - Social Welfare function

12

Overview...
Welfare: SWF

The Approach

Conditions for a welfare

maximum

SWF: basics

SWF: national
income
SWF: income
distribution
March 2012

Frank Cowell: Welfare - Social Welfare function

13

The SWF maximum problem

Take the individualistic welfare model

Standard
assumption

Assume everyone is selfish:

my utility depends
only on my bundle

Substitute in the above:

Gives SWF in terms

of the allocation

W(1, 2, 3, ...)

h = Uh(xh) , h=1,2,...nh

W(U1(x1), U2(x2), U3(x3), ...)

aaquick
quicksketch
sketch

March 2012

Frank Cowell: Welfare - Social Welfare function

14

From an allocation to social welfare

(x
(x11aa,, xx22aa))
(x
(x11bb,, xx22bb))

From the attainable set...

...take an allocation
Evaluate utility for each agent

Plug into W to get social welfare

aa=U
=Uaa(x
(x11aa,, xx22aa))
bb=U
=Ubb(x
(x11bb,, xx22bb))
But what happens to
welfare if we vary the
allocation in A?
W(
W(aa,, bb))

March 2012

Frank Cowell: Welfare - Social Welfare function

15

Varying the allocation

Differentiate w.r.t. xih :
dh = Uih(xh) dxih

The effect on h if
commodity i is changed

marginal
marginalutility
utilityderived
derived
by
h
from
good
i
by h from good i

Sum over i:
n
dh = Uih(xh) dxih
i=1

Differentiate W with respect to uh:

nh

dW = Wh dh marginal
marginalimpact
impacton
onsocial
social
h
Substitute for
d
in the above:
n
n
dW = Wh Uih(xh) dxih
h

March 2012

Changes in utility change

social welfare .

welfare
welfareofofhs
hsutility
utility

h=1

Weights
Weightsfrom
from h=1
the
theSWF
SWF

The effect on h if all

commodities are changed

i=1

So changes in allocation
change welfare.

Weights
Weightsfrom
from
utility
function
utility function

Frank Cowell: Welfare - Social Welfare function

16

Use this to characterise a welfare optimum

Write down SWF, defined on individual utilities.
Introduce feasibility constraints on overall consumptions.
Set up the Lagrangean.
Solve in the usual way

Now
Nowfor
forthe
the
maths
maths

March 2012

Frank Cowell: Welfare - Social Welfare function

17

The SWF maximum problem

First component of the problem:
W(U1(x1), U2(x2), U3(x3), ...)
Utility
Utility depends
depends on
on
own
own consumption
consumption

Individualistic
Individualistic welfare
welfare

Second component of the problem:

n
(x) 0, xi = xih
h

h=1

The objective function

All
All goods
goods are
are
private
private
nh
h
h=1

Feasibility constraint

The Social-welfare Lagrangean:

W(U1(x1), U2(x2),...) - ( x )

Constraint subsumes
technological feasibility and
materials balance

FOCs for an interior maximum:

Wh (...) Uih(xh) i(x) = 0

From differentiating
Lagrangean with respect to xih

And if xih = 0 at the optimum:

Wh (...) Uih(xh) i(x) 0

Usual modification for a

corner solution

March 2012

Frank Cowell: Welfare - Social Welfare function

18

Solution to SWF maximum problem

Any
Anypair
pairofofgoods,
goods,i,ji,j
Any
Anypair
pairofofhouseholds
householdsh,h,

From FOCs:

Uih(xh)
Ui(x)
=
Ujh(xh)
Uj(x)

MRS equated across all h.

Also from the FOCs:

social marginal utility of

toothpaste equated across all h.

Weve met this condition

before - Pareto efficiency

Wh Uih(xh) = W Ui(x)

Relate marginal utility to prices:

U (x ) = Vy pi
h
i

This is valid if all consumers

optimise

Marginal
Marginalutility
utilityofofmoney
money

Substituting into the above:

Wh Vyh = W Vy
March 2012

Social
Socialmarginal
marginal
utility
of
utility ofincome
income

At optimum the welfare value of

$1 is equated across all h. Call
this common value M

Frank Cowell: Welfare - Social Welfare function

19

To focus on main result...

Look what happens in neighbourhood of optimum
Assume that everyone is acting as a maximiser
firms
households
Check what happens to the optimum if we alter incomes or

prices a little
Similar to looking at comparative statics for a single agent

March 2012

Frank Cowell: Welfare - Social Welfare function

20

Changes in income, social welfare

Social welfare can be expressed as:

W(U1(x1), U2(x2),...)
= W(V1(p,y1), V2(p,y2),...)

Changes in utility and change

social welfare

Differentiate the SWF w.r.t. {yh}:

nh

dW = Wh du

h=1

nh

= WhVyh dyh
h=1

nh

dW = Mdy

SWF in terms of direct utility.

Using indirect utility function

h=1

...related to income
change
change in
in national
national income
income

Differentiate the SWF w.r.t. pi :

nh

nh

dW = WhVihdpi = WhVyh xihdpi

h=1

nh

dW = M xihdpi
March 2012

h=1

h=1
Change
Change in
in total
total
expenditure
expenditure

Changes in utility and change

social welfare

from
from Roys
Roys
identity
identity

...related to prices
.

Frank Cowell: Welfare - Social Welfare function

21

An attractive result?
Summarising the results of the previous slide we

have:

THEOREM: in the neighbourhood of a welfare

optimum welfare changes are measured by changes

in national income / national expenditure

But what if we are not in an ideal world?

March 2012

Frank Cowell: Welfare - Social Welfare function

22

Overview...
Welfare: SWF

The Approach

A lesson from risk

and uncertainty

SWF: basics

SWF: national
income
SWF: income
distribution
March 2012

Frank Cowell: Welfare - Social Welfare function

23

Derive a SWF in terms of incomes

What happens if the distribution of income is not ideal?
M is no longer equal for all h
Useful to express social welfare in terms of incomes
Do this by using indirect utility function V
Express utility in terms of prices p and income y
Assume prices p are given
Equivalise (i.e. rescale) each income y
allow for differences in peoples needs
allow for differences in household size
Then you can write welfare as

W(ya, yb, yc, )

March 2012

Frank Cowell: Welfare - Social Welfare function

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Income-distribution space: nh=2

The income space: 2 persons

Bill's
income
li

o
e
n

eq
t
c
fe
r
pe

lit
a
u

An income distribution

Note the similarity with a

diagram used in the analysis
of uncertainty

y
45
O

March 2012

Alf's
income
Frank Cowell: Welfare - Social Welfare function

25

Extension to nh=3
Charlie's
income

Here we have 3 persons

An income distribution.

ct
e
f
er
p
of y
e
lin ualit
eq

Bil

e
com
n
i
l's

y
O
Alf's inco
me
March 2012

Frank Cowell: Welfare - Social Welfare function

26

Welfare contours
An arbitrary income distribution
Contours of W
Swap identities
Distributions with the same mean
Equally-distributed-equivalent income

yb

equivalent
equivalent in
in
welfare
welfare terms
terms

Anonymity implies symmetry of W

Ey

Ey is mean income
Richer-to-poorer income
transfers increase welfare.

higher
higher
welfare
welfare

y
ya

is income that, if received

uniformly by all, would yield same
level of social welfare as y.
Ey is income that society would
give up to eliminate inequality

Ey
March 2012

Frank Cowell: Welfare - Social Welfare function

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A result on inequality aversion

Principle of Transfers : a mean-preserving redistribution from

richer to poorer should increase social welfare

THEOREM: Quasi-concavity of W implies that social welfare

respects the Transfer Principle

March 2012

Frank Cowell: Welfare - Social Welfare function

28

Special form of the SWF

It can make sense to write W in the additive form

W=

nh

yh
nh h=1

where the function is the social evaluation function

(the 1/nh term is unnecessary arbitrary normalisation)
Counterpart of u-function in choice under uncertainty

Can be expressed equivalently as an expectation:

W = E yh

where the expectation is over all identities

probability of identity h is the same, 1/nh , for all h

Constant relative-inequality aversion:

1
1
y =
y
1
where is the index of inequality aversion
works just like ,the index of relative risk aversion

March 2012

Frank Cowell: Welfare - Social Welfare function

29

Concavity and inequality aversion

W

The social evaluation function

Let values change: is a concave
transformation.

(y)

lower
lower inequality
inequality
aversion
aversion

(y)
higher
higher inequality
inequality
aversion
aversion

= ()

More concave () implies higher

inequality aversion
...and lower equally-distributedequivalent income
and more sharply curved contours

y
income
March 2012

Frank Cowell: Welfare - Social Welfare function

30

Social views: inequality aversion

yb

Indifference to inequality

yb

Mild inequality aversion

Strong inequality aversion

Priority to poorest

Benthamite case (= 0):

ya

ya

nh

W= yh
h=1 ():
General case

nh

W = [yh]1-/ [1-i]
h=1

Rawlsian case ():

W = min yh

March 2012

h
Frank Cowell: Welfare - Social Welfare function

31

Inequality, welfare, risk and uncertainty

There is a similarity of form between
personal judgments under uncertainty
social judgments about income distributions.
Likewise a logical link between risk and inequality
This could be seen as just a curiosity
Or as an essential component of welfare economics
Uses the equal ignorance argument
In the latter case the functions u and should be taken as

identical
Optimal social state depends crucially on shape of W
In other words the shape of
Or the value of

March 2012

Frank Cowell: Welfare - Social Welfare function

Three
Threeexamples
examples

32

Social values and welfare optimum

yb

The income-possibility set Y

Welfare contours ( = 0)
Welfare contours ( = )
Welfare contours ( = )

Y derived from set A

Nonconvexity, asymmetry come
from heterogeneity of households

y* maximises total income

irrespective of distribution

y***

y** trades off some income for

greater equality

**

y*
ya
March 2012

y*** gives priority to equality; then

maximises income subject to that

Frank Cowell: Welfare - Social Welfare function

33

Summary
The standard SWF is an ordering on utility levels

Analogous to an individual's ordering over lotteries

Inequality- and risk-aversion are similar concepts

In ideal conditions SWF is proxied by national income

But for realistic cases two things are crucial:

1.
2.

March 2012

Information on social values

Determining the income frontier

Item 1 might be considered as beyond the scope of simple

microeconomics
Item 2 requires modelling of what is possible in the
underlying structure of the economy...
...which is what microeconomics is all about

Frank Cowell: Welfare - Social Welfare function

34