WALFARE ECONOMICS Welfare economics is a branch of economics that uses microeconomic techniques to evaluate well being welfare at the aggregate economy wide level I e Welfare economics uses the perspective and techniques of microeconomics but it can be aggregated to make macroeconomic conclusions Welfare economics focuses on the optimal allocation of resources and goods and how the allocation of these resources affects social welfare This relates directly to the study of income distribution and how it affects the common good Welfare economics is a subjective study that may assign units of welfare or utility to create models that measure the improvements to individuals based on their personal scales What is Pareto Efficiency Pareto efficiency or Pareto optimality is an economic state where resources cannot be reallocated to make one individual better off without making at least one individual worse off Pareto efficiency implies that resources are allocated in the most efficient manner but does not imply equality or fairness A Pareto improvement is said to occur when at least one individual becomes better off without anyone becoming worse off Pareto efficiency will occur on a production possibility frontier When an economy is operating on a simple production possibility frontier e g at point A B or C it is not possible to increase output of goods without reducing output of services However at Point D 16 goods and 17 services It is possible to increase either without leading to a decline in the output of the other Thus to be at point D would be classed as Pareto inefficient and this is generally considered to be bad for the economy Pareto efficiency is related to the concept of productive efficiency Productive efficiency is concerned with the optimal production of goods which occurs at the lowest point on the short run average cost curve and occurs on a PPF Pareto efficiency is also concerned with allocative efficiency To be Pareto efficient the distribution of resources needs to be at a point where it is impossible to make someone better off without making someone worse off Note it is not possible to produce at a point beyond the PPF Examples of Pareto efficiency If we were building a new airport let us assume there are winners and losers The private and external benefits are estimated at 20bn The cost of building airport is 13bn Residents living nearby see a loss in personal welfare of 1bn due to pollution and congestion The net benefit to society is 20bn 14bn A clear gain of 6bn However using principles of Pareto efficiency this is not a Pareto improvement because those living nearby lose out What should we do The scheme has a net welfare gain but some lose out One option is to make the airport company compensate local residents for the inconvenience of losing out In this way the airport goes ahead and the company make a profit but local residents are compensated for losing out However in practice there are often practical difficulties and high frictional costs in compensating losers from a particular project