Introduction to Welfare Analysis

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When studying markets, economists not only want to understand how prices and quantities are determined, but they also want to be able to calculate how much value markets create for society.

Economists call this topic of study welfare analysis, but, despite its name, the subject doesn’t have anything directly to do with transferring money to poor people.

How Economic Value Is Created By a Market

Economic value created by a market accrues to a number of different parties.

It goes to:

  • consumers when they can purchase goods and services for less than they value the use of the items
  • producers when they can sell goods and services for more than each item cost to produce
  • the government when markets provide an opportunity to collect taxes

Economic value is also either created or destroyed for society when markets cause spillover effects for parties not directly involved in a market as a producer or a consumer (known as externalities).

How Economic Value Is Quantified

In order to quantify this economic value, economists simply add up the value created for all of the participants in (or onlookers to) a market. By doing so, economists can calculate the economic impacts of taxes, subsidies, price controls, trade policies, and other forms of regulation (or deregulation). That said, there are a few things that must be kept in mind when looking at this type of analysis.

First, because economists simply add up the values, in dollars, created for each market participant, they implicitly assume that a dollar of value for Bill Gates or Warren Buffet is equivalent to a dollar of value for the person who pumps Bill Gates’ gas or serves Warren Buffet his morning coffee.

Similarly, welfare analysis often aggregates the value to consumers in a market and the value to producers in a market. By doing this, economists also assume that a dollar of value for the gas station attendant or barista counts the same as a dollar of value for a shareholder of a large corporation.

(This isn't as unreasonable as it may initially seem, however, if you consider the possibility that the barista is also a shareholder of the large corporation.)

Second, welfare analysis only counts the number of dollars taken in in taxes rather than the value of what that tax revenue is ultimately spent on. Ideally, tax revenue would be used for projects that are worth more to society than they cost in taxes, but realistically this is not always the case. Even if it were, it would be very difficult to link up taxes on particular markets with what the tax revenue from that market ends up buying for society. Therefore, economists purposely separate out the analyses of how many tax dollars are generated and how much value spending those tax dollars creates.

These two issues are important to keep in mind when looking at economic welfare analysis, but they don’t make the analysis irrelevant. Instead, it’s helpful to understand how much value in the aggregate is created by a market (or created or destroyed by regulation) in order to properly assess the tradeoff between overall value and equity or fairness. Economists often find that efficiency, or maximizing the overall size of the economic pie, is at odds with some notions of equity, or dividing that pie in a manner that is considered fair, so it's crucial to be able to quantify at least one side of that tradeoff.

In general, textbook economics draws positive conclusions about the overall value created by a market and leaves it to philosophers and policy makers to make normative statements about what is fair. Nonetheless, it's important to understand how much the economic pie shrinks when a "fair" outcome is imposed in order to decide whether the tradeoff is worth it.