Welfare in Economics

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    In economics, we refer to the well-being of a society as its welfare. Did you know that the quality of welfare can change a lot about the economic possibilities we all experience? Don't believe me? Read on to see how welfare in economics affects us all!

    Welfare Economics Definition

    What is the definition of welfare in economics? There are a few terms that contain the word "welfare", and it can be confusing.

    Welfare refers to the well-being of an individual or group of people. We often look at different components of welfare such as consumer surplus and producer surplus in the buying and selling of goods and services.

    When it comes to social welfare programs, the government gives a payment to people who are in need. People who are in need are generally living below the poverty line, and require some assistance to help them pay for basic necessities. Most developed countries have some sort of welfare system; however, what varies is how generous that welfare system will be to people. Some welfare systems will offer more to their citizens than others.

    Welfare economics is a branch of economics that looks at how welfare can be enhanced.

    Welfare is defined as the general well-being and happiness of people.

    Welfare analysis in economics looks at components of welfare such as consumer surplus and producer surplus in economic transactions of goods and services.

    Therefore, economists will generally look at common welfare programs and see who are the recipients and whether their well-being is being improved. When a government has many welfare programs for its citizens, it is typically referred to as a welfare state. There are three general goals of a welfare state:

    1. Alleviating income inequality

    2. Alleviating economic insecurity

    3. Increasing access to healthcare

    How are these goals achieved? Typically, the government will provide aid to low-income individuals and families to relieve the hardships that they face. People who receive aid in the form of transfer payments or benefits will generally be under the poverty line. Specifically, the United States has many programs designed to help low-income individuals and families who are in poverty.

    Some examples of welfare programs in the United States are the following: Supplemental Nutritional Assistance Program (commonly known as food stamps), Medicare (healthcare coverage for the elderly), and Supplemental Security Income.

    Many of these programs are quite different from one another. Some require individuals to meet a certain income requirement, some are given as money transfers, and some are social insurance programs. As you can see, there are a lot of moving parts that must be accounted for when analyzing social welfare programs!

    Economics of Social Welfare

    Welfare and its surrogates receive a lot of political scrutinies as it's very easy to find some aspects of its aid unfair to others. Some people might say "why are they getting free money? I want free money too!" What effects does it have on the free market and the large economy if we do or don't help? Why do they even need help, to begin with? To find answers for these questions, we need to understand the economics of social welfare.

    The free market, fueled by intense competition has provided society with innumerable wealth and amenities. Intense competition forces businesses to provide the best at the lowest prices. Competition requires someone to lose for another to win. What happens to the businesses that lose and don't make it? Or the workers who were laid off so a company could become more efficient?

    So if a competition-based system requires losses, what is to be done about those unlucky citizens who experience it?Moral arguments can be made about the reason for forming societies to collectively alleviate suffering. That explanation may be good enough for some, but there are actually valid economic reasons for doing so as well.

    The Economic case for welfare

    To understand the economic reasoning behind welfare programs, let's understand what happens without them. Without any assistance or safety nets, what happens to laid-off workers and failed businesses?

    Individuals in these circumstances must do whatever it takes to survive, and without an income, that will include selling assets. Selling assets such as a car can generate a short burst of income to cover food costs, however, these assets provide utility to the owner. The number of available jobs is directly tied to your ability to access those jobs. In North America, this means that you have to drive to the job in most cases. Suppose that people have to sell their cars to make ends meet, the ability of workers to commute will then depend on public transit and friendly city design. This new limitation to the movement of labor will hurt the free market.

    If individuals experience homelessness, they suffer immeasurable mental health problems that degrade their abilities to hold a job and work effectively. Additionally, without a house to rest safely, individuals will not be physically rested enough to work effectively.

    Lastly, and most importantly, we must consider the costs the economy pays as a result of allowing poverty to run out of control. Lack of opportunity and deprivation of basic resources are some of the biggest causes of crime. Crime and its prevention are a massive cost to an economy, one that directly inhibits our efficiency. Not to mention that when convicted of crimes, we send people to jail where society now has to pay for all their living expenses.

    Everything can be best understood by viewing its trade-offs.

    Consider two scenarios: no welfare support and robust welfare support.Scenario A: No welfare support

    No funds are allocated to social programs. This decreases the tax revenue the government is required to take in. A reduction in taxes will increase economic growth, increasing the growth of businesses and investments. More jobs will become available, and business opportunities will increase with a reduction in overhead costs.

    However, citizens who fall on hard times will have no safety nets, and homelessness and crime will increase. Law enforcement, judiciaries, and prisons will expand to accommodate the increase in crime. This expansion of the penal system will increase the tax burden, reducing the positive effects created by the tax decrease. Every additional job required in the penal system is one fewer worker in the productive sectors.Scenario B: Robust welfare support

    First and foremost, a robust welfare system will increase the tax burden. This tax burden increase will discourage business activities, reduce the number of jobs, and slow economic growth.

    A robust safety net that is effectively implemented can protect individuals from losing their productive capacity. Real affordable housing initiatives can eliminate homelessness and lower overall costs. Reducing citizens' suffering experience will remove an incentive that leads people to commit crimes. Reductions in crime and prison populations will lower the overall cost of the penal system. Inmate rehabilitation programs will change the inmates from being fed and housed by tax dollars. To have them work jobs that allow them to pay taxes into the system.

    Impact of Welfare

    Let's go over the impact of welfare programs in the United States. There are many ways one can measure the impact that welfare has had on the United States.

    Looking at Table 1 below, the funds allocated to social expenditures are listed as a percentage of GDP. That is a way to quantify how much a country spends against how big the country's economy is and what it can afford to spend.

    The Table indicates that compared to other developed nations, the United States spends the least on social expenditures. Consequently, the poverty reduction effect of the welfare programs in the US is much lower than the welfare programs in other developed nations.

    CountrySocial Expenditures on non-elderly(as a percentage of GDP)Total percent of poverty reduced
    United States2.3%26.4%

    Table 1 - Social expenditures and poverty reduction1

    If perfect information was available for all economic activities we could isolate the costs incurred and costs avoided as a result of alleviating poverty. The best use of this data would be to compare the costs of the social expenditures, to the recovered efficiency created by poverty reduction. Or in the United States case, the lost efficiency as a result of poverty incurred in exchange for not allocating more funds to social expenditures.

    One of the most popular welfare programs the United States has is Social Security. It provides a guaranteed income to all citizens over the age of 65.

    In 2020, Social Security lifted over 20,000,000 people out of poverty.2 Social Security is seen as the most effective policy for reducing poverty.2 This gives us a good initial look at how welfare can positively impact citizens. However, we must note that this is just one program. What does the data look like when we view the impact of welfare in aggregate?

    Now, let's look at the overall impact of welfare programs in the United States:

    Welfare in Economics Poverty in the United States StudySmarterFig. 1 - Poverty Rate in the United States. Source: Statista3

    The chart above shows the poverty rate in the United States from 2010 to 2020. Fluctuations in the poverty rate are caused by significant events, such as the 2008 financial crisis and the 2020 COVID-19 pandemic. Look at our example above on social security, we know that 20 million individuals are kept out of poverty. That is approximately 6% more of the population that would be in poverty without it. That would make the poverty rate in 2010 nearly 21%!

    Example of Welfare in Economics

    Let's go over examples of welfare in economics. Specifically, we will look at four programs and analyze the nuances of each one: Supplemental Security Income, food stamps, housing assistance, and Medicare.

    Example of Welfare Programs: Supplemental Security Income

    Supplemental Security Income provides aid to those that are unable to work and cannot earn an income. This program is means-tested and provides a transfer payment for individuals. A means-tested program requires people to qualify for the program under certain requirements, such as income.

    Means-tested requires people to qualify for a program under certain requirements, such as income.

    Example of Welfare Programs: Food Stamps

    The Supplemental Nutritional Assistance Program is commonly known as food stamps. It provides nutritional assistance to low-income individuals and families to guarantee access to basic food necessities. This program is means-tested and is an in-kind transfer. An in-kind transfer is not a direct money transfer; instead, it is a transfer of a good or a service that people can use. For the food stamps program, people are provided a debit card that can only be used to purchase certain food items. This differs from a money transfer since people cannot use the debit card for anything they want — they must purchase what the government allows them to purchase.

    In-kind transfers are a transfer of a good or service that people can use to assist themselves.

    Example of Welfare Programs: Housing Assistance

    The United States has different housing assistance programs to help its citizens. First, there is subsidized housing, which provides rental payment assistance for low-income individuals and families. Second, there is public housing, which is a state-owned house that the government provides at a low rent payment to low-income individuals and families. Lastly, there is the Housing Choice Voucher program, which is a type of housing subsidy that the government pays to the landlord, and in some instances, even allows low-income families to purchase a home.

    Example of Welfare Programs: Medicare

    Medicare is a program that provides subsidized health care to individuals that reach 65 years of age. Medicare is not means-tested and provides in-kind benefits. Therefore, Medicare does not require people to qualify for it (apart from the age requirement), and the benefit is dispersed as a service instead of a direct money transfer.

    Pareto Theory of Welfare Economics

    What is the Pareto theory of welfare in economics? Pareto's theory in welfare economics posits that proper implementation of welfare enhancement must make one person better off without making someone else worse off.4 Applying this theory "accurately" in an economy is a difficult task for the government. Let's take a deeper look at why that might be.

    For example, how would the United States implement welfare programs without higher taxes or redistribution of wealth?

    Depending on how you view "making someone worse off," implementing a welfare program will inevitably make someone "lose" and someone else "wins." Higher taxes are generally used to fund national programs; therefore, depending on the tax code, some groups of people will incur higher taxes so that others can benefit from welfare programs. By this definition of "making someone worse off," the Pareto theory will never be truly achieved. Where the line should be drawn on increasing taxes to benefit those in need is an ongoing debate in economics, and as you can see, it can be difficult to come to a solution.

    A Pareto optimal outcome is one where no individual can be made better off without making another individual worse off.

    What are the assumptions of welfare economics? First, let's define what we mean by welfare economics. Welfare economics is the study of economics that looks at how to enhance well-being. With this view of welfare, there are two main assumptions that economists pay attention to. The first assumption is that a perfectly competitive market will yield a Pareto optimal outcome; the second assumption is that a Pareto efficient outcome can be supported by competitive market equilibrium.5

    The first assumption states that a perfectly competitive market will yield a Pareto optimal outcome. A Pareto optimal outcome is one where an individual cannot improve their well-being without making another individual worse off.

    In other words, it is a market in complete equilibrium. This assumption is only achievable if consumers and producers have perfect information and there is no market power. In sum, the economy is in equilibrium, has perfect information, and is perfectly competitive.5

    The second assumption states that a Pareto-efficient outcome can be supported by a competitive market equilibrium. Here, this assumption generally says that a market can achieve equilibrium through some form of intervention. However, the second assumption does recognize that attempting to 're-calibrate' to market equilibrium may cause unintended consequences in the market. In sum, intervention can be utilized to guide the market toward equilibrium, but it may cause some distortions.5

    Welfare in Economics - Key takeaways

    • Welfare in economics is defined as the general well-being and happiness of people.
    • Welfare analysis in economics looks at components of welfare such as consumer surplus and producer surplus in economic transactions of goods and services.
    • Welfare economics is the study of economics that looks at how to enhance aggregate welfare.
    • The following are examples of social welfare programs in the US: Supplemental Security Income, food stamps, Social Security, and Medicare.
    • Pareto's theory in welfare economics posits that proper welfare enhancement must make one person better off without making someone else worse off.


    1. Table 1, Poor People in Rich Nations: The United States in Comparative Perspective, Timothy Smeeding, Journal of Economic Perspectives, Winter 2006, http://www2.hawaii.edu/~noy/300texts/poverty-comparative.pdf
    2. Center on Budget and Policy Priorities, https://www.cbpp.org/research/social-security/social-security-lifts-more-people-above-the-poverty-line-than-any-other
    3. Statista, U.S. Poverty Rate, https://www.statista.com/statistics/200463/us-poverty-rate-since-1990/#:~:text=Poverty%20rate%20in%20the%20United%20States%201990%2D2021&text=In%202021%2C%20the%20around%2011.6,line%20in%20the%20United%20States.&text=As%20shown%20in%20the%20statistic,within%20the%20last%2015%20years
    4. Oxford Reference, https://www.oxfordreference.com/view/10.1093/oi/authority.20110803100306260#:~:text=A%20principle%20of%20welfare%20economics,any%20other%20person%20worse%20off
    5. Peter Hammond, The Efficiency Theorems and Market Failure, https://web.stanford.edu/~hammond/effMktFail.pdf
    Frequently Asked Questions about Welfare in Economics

    What do you mean by welfare in economics?

    Welfare refers to the general well-being or happiness of people. 


    Consumer surplus and producer surplus in the transactions of goods and services are components of welfare.

    What is an example of welfare in economics?

    Consumer surplus and producer surplus are components of welfare in the transactions of goods and services.

    What is the importance of economic welfare?

    Welfare analysis in economics can help us understand how to increase the total well-being of society.

    What is the function of welfare?

    The function of welfare programs is that they assist low-income individuals who are in need of help.

    How do we measure welfare?

    Welfare may be measured by looking at the change in consumer surplus or producer surplus.

    Test your knowledge with multiple choice flashcards

    Social Security is one of the least successful welfare programs in the United States.

    If prices decrease, consumer surplus will ________

    If prices increase, consumer surplus will ________


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