Chapter 4

PUBLIC SECTOR
ECONOMICS
Lecture 4:
The Social Welfare
Function and the
Quest for
Distributive Justice
PUBLIC SECTOR ECONOMICS
Richard W. Tresch
Lecture Slides by Mike Hilmer. Palgrave Macmillan, 2008.
The Social Welfare Function and

Distributive Justice
Suppose all technical and market assumptions for a wellfunctioning economy are met
Economy will reach a given
U
point on its Utility Possibility
Frontier (UPF) (say point A)
A
U
- A is efficient, but 2 is much
better off than than 1
- Is this the optimal outcome
for society?
- This is a question of
end-results equity
U
2

Richard W. Tresch
U1
Bergson-Samuelson
Individualistic Social Welfare Function
- Ranks social outcomes in terms of how individuals themselves
view personal well-being at each possible outcome
- Let W represent the total utility that a society of H individuals
receives from a given outcome
W = W(U1,,Uh,,UH)
- Each outcome provides individuals with different levels of utility
Some individuals will receive more; some will receive less
- Social welfare function ranks outcomes by the effect that
such changes have on overall welfare received by society
Defines a set of ethical rankings that define a set of social
indifference curves

Richard W. Tresch
Social Welfare Indifference Curves

- This ethical ranking defines a set of social welfare indifference curves
that are analogous to individual indifference curves (except trade-off is
between different individuals utility levels rather than different goods)
- Society is indifferent between A and B
because they provide the same level of
social utility (W0)
- Society prefers C to either A or B
because it provides more social utility
(W1 > W0)
- Slope indicates societys willingness to
trade one persons utility for anothers
(social marginal rate of substitution)

Richard W. Tresch
Wassily Leontief and the Pareto Principle

Wassily Leontief
- 1973 Nobel laureate Argued that social welfare should be
individualistic and should honor the Pareto Principle
Pareto Principle
- One of few things about which all economists
agree regarding the issue of distributive justice
- If any one persons utility increases (decreases), with
everyone elses utility held constant, then social welfare
should also increase (decrease)
- The social welfare function is not a market-based concept
Must be determined collectively through political process

Richard W. Tresch
The Bliss Point

- Similar to that for consumer
In this case, society wants to get to highest possible social
indifference curve subject to the constraint that it must be
on the UPF
- UPF shows combination of individual
well-being that society can produce
with efficient allocation of resources
- Point B is highest social welfare
(=W2) that can be attained given the
existing UPF
- B is distributionally the best of all
efficient combinations of U1 & U2
on the UPF
Richard W. Tresch
The Interpersonal Equity Condition

- Individual utility levels depend in large part on the amount of
income individuals have (i.e. need income to buy stuff)
- Can rewrite the social welfare function to depend on income:
W = W(U1(Y1),,Uh(Yh),,UH(YH))
- Suppose h gets more income without anyone elses changing
The change in social welfare is:
W = [(W/Uh )(Uh /Yh)] Yh

Richard W. Tresch
Marginal utilities of income

- The second term inside bracket is hs marginal utility of
income
The extra utility h gets from one more dollar of
income
- Marginal utilities of income are determined by
individuals based on preferences they have for stuff
they buy with extra income

Richard W. Tresch
Marginal Social Welfare Weights

-
The first term in bracket is the marginal social welfare weight

Represents the change in social welfare per unit change in
hs utility
(When multiplied by last two terms it gives the amount that
social welfare changes)
Marginal social welfare weights are determined collectively by
society through some political process
The optimal condition:

- To reach the social bliss point the social marginal utilities must
be equal for all individuals
Richard W. Tresch
Taxing and redistribution

- Suppose social marginal utilities are not equal for all
individuals (point A in figure 4.3)
Need to redistribute wealth so that person 1 gains utility
and person 2 loses utility
Accomplished by taxing 2 and redistributing to 1
This increases social welfare because at point A 1s
marginal utility of income exceeds 2s
This continues until doing so no longer increases social
welfare, which occurs only when
SMUhY is equal for all h=1,,h,,H
Richard W. Tresch
Policy implications
Lump-Sum Taxes and Transfers
- What kind of tax is appropriate for the redistribution
described above?
- The tax must be non-distorting (must not introduce
inefficiencies by altering relative prices)
- The only tax that is non-distorting is a lump-sum tax,
which is a tax for which the amount paid cannot be
altered by any economic decision made in response to
the tax
Cannot be an income or a unit tax

Richard W. Tresch
Summary:
The Mainstream Theory of Distributive
Justice
Two great questions of end-results equity
(1) What is the optimal distribution of individual well-being?
(2) If society is not at the optimal distribution, how should it
redistribute to reach the optimum?
Mainstream theory provides simple answers
If society can establish an ethical ranking that can be
represented by a Bergson-Samuelson social welfare function
(1) The optimal distribution of well-being occurs when social
marginal utilities of income are equal across individuals
(2) If initial distribution is not optimal, government should
lump-sum tax and transfer until bliss point is reached
Richard W. Tresch
(Summary: The Mainstream Theory of

Distributive Justice continued)
-
If Bergson-Samuelson social welfare function cannot be

determined, then society can never fully answer the two
questions
Initial distribution of resources is important because it will
govern which outcome is socially optimal
Determining the Allocation of Resources

Besides answering the distribution question, the social
welfare function also determines the final allocation of
resources among all possible efficient allocations
The social welfare function is one of the linchpins of
mainstream public sector economics theory
Richard W. Tresch
Problems in Applying the

Mainstream Theory of Distributive Justice
There are, however, a number of problems in
applying the mainstream theory of distributive
justice, and the remaining slides will explore
these

Richard W. Tresch
Lump sum taxes and transfers
In practice, taxes actually employed are not likely to be lumpsum

Optimal lump-sum tax must in some way be related to
income or consumption, but such taxes are normally not
lump-sum (non-distortionary) in practice
Example: Income tax
Not truly lump-sum because relevant wage to firm is wage

inclusive of tax, which creates distortion by increasing cost of
workers
Outcome is that an income tax forces society below its UPF

Richard W. Tresch
Unanswered questions
-
A major problem with the social welfare function

construct is that economics cannot answer several
important questions, namely:
- What is the social welfare function?
- What should the social welfare function be?
- Can there be a social welfare function

Richard W. Tresch
What Is the Social Welfare Function?

-
To satisfactorily utilize the social welfare function, an

economist would need to know the marginal social welfare
weights
The problem is that these values are determined by
society through the political process and the political
process is very difficult to judge
Hence, it is very difficult to know what a nations social
welfare function is

Richard W. Tresch
What Should the Social Welfare Function

Be?
-
This question has been pondered for years without a

convincing case made for one specific answer
Instead, economists rely on two possible explanations:
- Utilitarian Social Welfare
- Rawlsian Social Welfare

Richard W. Tresch
Utilitarian Social Welfare

-
Attributed to Jeremy Bentham (1748-1832), a political

economist in the late 18th and early 19th centuries
Argues that the goal of government should be to maximize
aggregate social welfare (the sum of individual welfares)
WB = Hh=1 Uh
The idea of maximizing this social welfare

function is referred to as utilitarianism

Richard W. Tresch
Utilitarian Social Welfare continued

- This welfare function gives
rise to 45 line indifference
curves
- Insures impersonality,
under which same weights
(in this case = 1) are given
to all people regardless of
their personal characteristics

Richard W. Tresch
Rawlsian Social Welfare

-
Named after John Rawls (1921-2002), a Harvard philosopher

in the mid- to late- 20th century
Argued that social welfare should be highly egalitarian
Proposed that society should make decisions through a veil of
ignorance
Idea is that in making decisions we are all handicapped by
knowing our position in life
Those who know they are rich would never favor
redistribution policies while those who know they
are poor would always do so

Richard W. Tresch
Rawlsian Social Welfare continued

-
Given that rich never favor redistribution and poor always do,
simply asking people to vote for a policy is unlikely to reach the
socially desirable outcome
To overcome this inherent bias in our thinking it is necessary for
each individual to act as if they did not know their true position
in the income distribution and how that might affect their future
outcomes (i.e. they would operate under a veil of ignorance)
Then rich might vote for redistribution if they thought there
was a chance they might end up poor while poor might vote
against it if they thought there was a chance they might end
up rich

Richard W. Tresch

-
Rawls argues that under such a construct each individuals

goal would be to guarantee the maximum protection against
the worst-case (minimum) possible outcome
This maximin policy leads to a social welfare function of
WR = min(U1,,Uh,,UH)
In words, this states that social welfare equals the utility

achieved by the member of society who is worst off
This social welfare function assumes that individuals are
extremely risk averse and vote to guard against the worst
possible outcome at the expense of all other possibilities

Richard W. Tresch

-
The Rawlsian social welfare

function generates L-shaped
social indifference curves
A movement from A to B makes
A better off without affecting B,
which means that social welfare
is not affected by such a move
This is the opposite extreme of
the Benthamite indifference
curve

Richard W. Tresch

-
Economists tend to be unconvinced by the Rawlsian

social welfare function for several reasons:
1. It is doubtful that individual are so extremely risk
averse
2. The Rawlsian principle violates the Pareto principle
(i.e. all groups should count not just the worst-off)

Richard W. Tresch
Can There Be A Social Welfare Function?

Arrows General Impossibility Theorem
Addresses the question whether a democratic society can be
expected to develop a consistent set of ethical rankings to solve
the problem of distributive justice
Kenneth Arrow (1921-)
American economist in the 20th century and 1972 nobel laureate
Demonstrated that in general the answer to the above question
is no
Considered by many to be the greatest intellectual contribution
to political economy in the 20th century

Richard W. Tresch
Arrows General Impossibility Theorem

Assumed that most individuals agreed with 5 general principles
(1) The social decision process must provide a complete ordering
of social outcomes
(2) Any individual preferences over social outcomes must be
allowed
(3) Social decision must honor the Pareto principle
(4) The independence of irrelevant alternatives
(5) Non-dictatorship
The key point of the impossibility theorem is that in general

these 5 principles cannot all hold simultaneously

Richard W. Tresch
Arrows General Impossibility

Theorem continued
-
Inconsistent preferences lead to

indifference curves that cross,
which cannot be the case
Note: Saying that social decisions in

general might not be consistent with
all 5 principles does not mean that they must be inconsistent
-
A necessary consequence of such inconsistency is that any policy can

win depending on order in which vote is taken
This means that controlling the voting agenda is crucial when
preferences are inconsistent (which usually occurs when policies are
controversial)

Richard W. Tresch

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PUBLIC SECTOR

The Social Welfare Function and

PUBLIC SECTOR ECONOMICS

PUBLIC SECTOR ECONOMICS

Social Welfare Indifference Curves

PUBLIC SECTOR ECONOMICS

Wassily Leontief and the Pareto Principle

PUBLIC SECTOR ECONOMICS

The Bliss Point

The Interpersonal Equity Condition

PUBLIC SECTOR ECONOMICS

Marginal utilities of income

PUBLIC SECTOR ECONOMICS

Marginal Social Welfare Weights

The first term in bracket is the marginal social welfare weight

The optimal condition:

Taxing and redistribution

PUBLIC SECTOR ECONOMICS

(Summary: The Mainstream Theory of

If Bergson-Samuelson social welfare function cannot be

Determining the Allocation of Resources

Problems in Applying the

PUBLIC SECTOR ECONOMICS

Lump sum taxes and transfers

In practice, taxes actually employed are not likely to be lumpsum

Example: Income tax

Not truly lump-sum because relevant wage to firm is wage

Outcome is that an income tax forces society below its UPF

PUBLIC SECTOR ECONOMICS

A major problem with the social welfare function

PUBLIC SECTOR ECONOMICS

What Is the Social Welfare Function?

To satisfactorily utilize the social welfare function, an

PUBLIC SECTOR ECONOMICS

What Should the Social Welfare Function

This question has been pondered for years without a

PUBLIC SECTOR ECONOMICS

Utilitarian Social Welfare

Attributed to Jeremy Bentham (1748-1832), a political

The idea of maximizing this social welfare

PUBLIC SECTOR ECONOMICS

Utilitarian Social Welfare continued

PUBLIC SECTOR ECONOMICS

Rawlsian Social Welfare

Named after John Rawls (1921-2002), a Harvard philosopher

PUBLIC SECTOR ECONOMICS

Rawlsian Social Welfare continued

PUBLIC SECTOR ECONOMICS

Rawlsian Social Welfare continued

Rawls argues that under such a construct each individuals

In words, this states that social welfare equals the utility

PUBLIC SECTOR ECONOMICS

Rawlsian Social Welfare continued

The Rawlsian social welfare

PUBLIC SECTOR ECONOMICS

Rawlsian Social Welfare continued

Economists tend to be unconvinced by the Rawlsian

PUBLIC SECTOR ECONOMICS

Can There Be A Social Welfare Function?

PUBLIC SECTOR ECONOMICS

Arrows General Impossibility Theorem

The key point of the impossibility theorem is that in general

PUBLIC SECTOR ECONOMICS

Arrows General Impossibility