NPTEL-Economics-Public Economics

Module 2
Lecture 6
Topics
2.20 Equilibrium and Social Welfare
2.20.1 The Role of Equity
2.20.2 Welfare Maximization

2.20 EQUILIBRIUM AND SOCIAL WELFARE

First Fundamental Theorem of Welfare Economics: competitive equilibrium, Q*,
maximizes social efficiency.
Any quantity other than Q* reduces social efficiency, or the size of the economic
pie.
Suppose, quantity is regulated at

Figure 6.1
Dead weight loss (MB> MC but still no
production)

1
Indian Institute Of Technology, Kanpur

NPTEL-Economics-Public Economics

Figure 6.2
A policy like price or quantity controls creates deadweight loss, the reduction in
social efficiency by restricting price quantity below the competitive equilibrium.

2.20.1 THE ROLE OF EQUITY

Social welfare is determined by both efficiency and equity.
The Second Fundamental Theorem of Welfare Economics states that society
can attain any efficient outcome by a suitable redistribution of resources and free
trade.
In reality, society often faces an equity-efficiency tradeoff
Resolving this tradeoff is harder than devising efficiency maximizing policies. It
raises the tricky issue of making interpersonal comparisons- who should have
more & who should have less.
Social Welfare Function: Maps individual utilities into an overall social utility
function.
This function incorporates the equity-efficiency tradeoff in to decision making
Loss of efficiency
All worse off
Redistribution might compensate for the loss of efficiency
The utilitarian social welfare function is:
The utilities of all individuals are given equal weight.
Utilitarian SWF is defined in terms of utility, not rupees.

2
Indian Institute Of Technology, Kanpur

NPTEL-Economics-Public Economics

- Society not indifferent between Re1 to rich and poor; rather indifferent
between 1 utility to rich & 1 utility to poor.

2.21.3 WELFARE MAXIMIZATION

Utilitarian SWF is maximized when

Thus, society should redistribute from rich to poor if the marginal utility of the
next dollar is higher to the poor person than to the rich person.

THE ROLE OF EQUITY (CONTD...)

The Rawlsian social welfare function is:

Societal welfare is maximized by maximizing the well-being of the worst-off

person in society.
Generally suggests more redistribution than the Utilitarian SWF.

3
Indian Institute Of Technology, Kanpur