Welfare Economics - Two Approaches

Two Approaches

There are two mainstream approaches to welfare economics: the early Neoclassical approach and the New welfare economics approach.

The early Neoclassical approach was developed by Edgeworth, Sidgwick, Marshall, and Pigou. It assumes the following:

• Utility is cardinal, that is, scale-measurable by observation or judgment.
• Preferences are exogenously given and stable.
• Additional consumption provides smaller and smaller increases in utility (diminishing marginal utility).
• All individuals have interpersonally comparable utility functions (an assumption that Edgeworth avoided in his Mathematical 'Psychics).

With these assumptions, it is possible to construct a social welfare function simply by summing all the individual utility functions.

The New Welfare Economics approach is based on the work of Pareto, Hicks, and Kaldor. It explicitly recognizes the differences between the efficiency aspect of the discipline and the distribution aspect and treats them differently. Questions of efficiency are assessed with criteria such as Pareto efficiency and the Kaldor-Hicks compensation tests, while questions of income distribution are covered in social welfare function specification. Further, efficiency dispenses with cardinal measures of utility, replacing it with ordinal utility, which merely ranks commodity bundles (with an indifference-curve map, for example).