The Pareto Welfare Criterion - Essay Example

"The Pareto welfare criterion requires that welfare improvements for some are not achieved at the expense of damages to others. As it is impossible to imagine any change that does not reduce somebody's welfare the criterion is useless for policy purposes" Vilfredo Pareto an Italian economist was the creator or founder of the now commonly known Pareto Principle. These days this principle is also known as the "80/20 Rule". Pareto discovered the principle in 1906 and he came to know that 80 percent of the territory is owned by 20 percent of the people. This finding helped him to create a theory which he realized was also effective in other parts of life. As a decision-making tool, the Pareto chart provides facts and insights necessary for setting priorities. Pareto set up a welfare criterion known as the Pareto optimum which turned out to be an introductory perception in the theory of welfare. This Pareto optimum introduced by Vilfredo is a situation of dealing in which no individual can be improved through welfare while making the other individual worse off. If a change in the economy is in the positive and no individual is worsened off on the cost of one individuals betterment then it is known as Pareto improvement. It can also be said that the situation is Pareto superior. Pareto efficiency is a state resulting in an improvement in welfare of one or more individuals without adversely affecting the welfare of others. Pareto's theory was based upon the equal distribution of resources so that the well being of one person would not affect the well being of the other. This is not being achieved in the now world but in the recent years governments are taking steps to influence proper resource allocation. These steps include the introduction of public goods and services which are an exception and face no rival ness. The governments are increasingly getting involved in the field of semi public goods which are neither owned by the private or public sector companies. The governments provide subsidies which help in lowering the goods prices; lower the cost prices, impose tax penalties to limit the consumption or production of a good and mandate the goods or services like education on the public. This helps the government to properly allocate all the resources available. Tax penalties or legal punishments are enforced on the manufacturers by the government in order to limit the production or consumption of a good for e.g. pollution. They would impose excise taxes on products so that the production of harmful goods is dispirited for e.g. alcohol. The government also has an important role to play in the public Economic Enterprises. They could invest more in their public sector and improve the goods in the market provided by them to the public at a much lowered price then available in the market. They could even privatize the companies so that natural monopolies are avoided in the market which exhibit increasing returns to scale. Such types of monopolies are taken over by the government on the basis of efficiency. The government would charge a price for the products less than the average cost and this shortage would be balanced by the tax revenues. And lastly the government could put on economic regulations so that the market works on a safety standard for e.g. providing licenses or patents, setting general anti-trust regulations and etc. This would help the government to change the pattern of resource allocation and thus attain the level of Pareto efficient allocation. Pareto efficiency has proved tremendously helpful for economists; The First Welfare Theorem affirms that when manufacturers and customers both are price takers, the equilibrium allocation is always Pareto efficient. For this reason, a competitive financial system fundamentally will distribute resources proficiently as customers can make the most of their utilities. The Second Welfare Theorem states that any market that is Pareto efficient will include a set of given costs that forms a competitive equilibrium in the economy. Many economists may and do use this concept for game theory. However on the other side there are many limitations to the Pareto efficiency. Even now there is a need of clearness as to where the customers finish up in the end since it only takes into account the inclinations of specified consumers and it does not pay specific attention to consumers that are not included. For a Pareto efficiency to exist an equal distribution of wealth is not required. For example even in an economy, in which the wealthy own most of the resources, is known to be as Pareto efficient. Hence it is always not pleasing. Another factor which limits Pareto efficiency is the imposition of taxes which can be either direct or indirect and may lead to inefficient allocation of resources. Other limitations can be market irregularities such as markets in which monopolies are to be found exercise their own authority and do whatever they like. The provision of public and merit goods is also an important factor. However the first and Second theorems lead the market to a Pareto efficient allocation. Pareto efficiency also overlooks any externalities which may arise. The criterion of Pareto is not considered to be useful in practical use this is because a criterion of unity is not always favorable in voting conditions. A perfect alternative for the Pareto criterion can be the prospective Pareto criterion which is also identified as Kaldor-Hicks criterion. This criterion of Kaldor-Hicks was introdued in the 1930s by many famous British economists. Before this scheme was introduced it was normally believed that every being had an equivalent capability for pleasure and that achievement and losses of diverse beings could be distinguished. But in 1939 Kaldor came up with an answer to the previous questions asked by many about the policy directions. Kaldor approved the helplessness of economists to set up a methodical source for creating interpersonal service relationships but he also recommended that this complexity could be made inappropriate. He disagreed that schemes that resulted in a boost to the cumulative real returns are always advantageous because the prospective subsists to make everyone better off: "[T]he economist's case for the policy is quite unaffected by the question of the comparability of individual satisfaction, since in all such cases it is possible to make everybody better off than before, or at any rate to make some people better off without making anybody worse off". Kaldor proposed that a project is only acceptable if the money measure of gains surpasses the money measure of losses. Hick another well known economist of that time acknowledged the approach of Kaldor and this approach later became known as the KH criterion. This scheme of Kaldor-Hick tries to circumvent interpersonal utility comparisons by splitting equity from efficiency. Kaldor also suggested that decision makers deal with reactions concerning equity outside the scope or range of Cost Benefit Analysis. The modification in cumulative gains was to be the calculation of efficiency, hence the scheme put forward by Kaldor-Hick clearly separates efficiency and distributional effects. Kaldor approved the method taken up by Pigou, which Kaldor illustrated as dividing welfare effects into two parts in which the first part would be concerned to the production while the second one to distribution. The approach of KH produces results that are equal to those produced by the supposition that the marginal utility of revenue is equal around all individual i.e. each and every pound received by any individual is treated the same not considering the person who received it. Hick also agreed to this separation and stated that if measures to ensure efficiency are to be introduced then it is necessary that they should be at liberty from distributive complications. The division of efficiency and equity is a solution to the entire welfare problems these days. It would help in curbing the issue of allocation of resources and ensure an efficient system. Bibliography McLure, M. (1998). Pareto on collective economic welfare. Perth: Curtin University of Technology, School of Economics and Finance. Bergson, A., & Pareto, V. (1982). Pareto on social welfare: note. Cambridge, Mass: Harvard Institute of Economic Research. Read More