CHAPTER THREE

General equilibrium and

1
welfare economics
 2 3.1 Walrasian General Equilibrium
Life of Walras (1834- 1910)
Marie Esprit Léon Walras (1834-1910) is a
French-born economist who founded the basis
of modern economic analysis by constructing a
general equilibrium theory for the first time in
the history of economics.
He started his studies for the profession of
engineering but latter on abandoned and
turned in to a journalist.
He joined as a professor of political economy at
the university of Lausanne in Switzerland from
1871-1892.
 3 His chief works

Elements of pure economics (1874)

Theory of exchange
Theory of production
Mathematical theory of social wealth
Studies in social economics
Studies in applied economics
 4 Doctrines of warlas
Together with William Jevons (1835-82) and Carl Menger (1840-1921),
Walras is also credited with founding marginalism in the 1870s.
Based on the idea of general equilibrium, Walras completed his theories
of exchange, production, and capital and money in his main work
Eléments d’économie politique pure (Elements of Pure Economics)
whose first edition was published in 1874.
Walras’ approach makes a stark contrast with the founder of the
Cambridge School, Alfred Marshall (1842-1924), in his partial
equilibrium approach, which analyzes the market assuming that other
conditions are equal. Today, microeconomics is based on the heritage of
both approaches.
 5

For Walras, general equilibrium means

(1)that demand and supply are equilibrated in all markets (market
equilibrium) and
(2) that all economic agents maximize their satisfaction under given
incomes (subjective equilibrium).
He described the state of general equilibrium using simultaneous
equations. Then, in order to obtain equations for maximization of
satisfaction, he used the marginal utility theory of value.
 6

His original scheme of political economy was actually composed of

three branches of economics: pure, social, and applied economics.
But the great influence of Walras on modern economic analysis is
limited to the field of his pure economics.
Walras attacked the advocates of laissez-faire all his life.
He attempt to mediate between liberalism and socialism and to
propose the reform of the property and tax system and the state’s role
in the market in his social and applied economics.
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Pure economics is a study of social wealth from the viewpoint of value

in exchange. It is a science based on the criterion of truth.
In the preface to the fourth edition of his Eléments, Walras defines
pure economics as the theory of determination of prices under a
hypothetical system of absolutely free competition.
Pure economics set out theoretical foundations for the argument for
social and applied economics.
Social economics is the study of social wealth from the viewpoint of
property based on the criterion of justice, and applied economics is
the study of social wealth from the viewpoint of industrial production
based on the criterion of efficiency.
 8 Principle of “rarete”
“rarete” of Warlas is referred as scarcity or marginal utility
He used the term “rarete” to mean the final degree of utility (for
Jevon) and marginal utility of modern writers.
Scarcity necessitates choices, while marginal utility guides those
choices by assessing the additional benefit of consuming more of a
good or service
Exchange value are proportional to rarete. Where exchange value is
determined by utility.
For Warlas value is the ratio between scarcities inherent in
commodities.
 9 Warlas on money
Money has been treated by him as a unit of account.
His theory is based on the assumption that the total money payment
made for the factors of production are equal to the total money
demand for the commodities.
He further assumed that the relative price for the factors, in the
present and in the future, remains the same.
Accordingly the rate of interest is the anticipated net yield of capital
divide by the current expense incurred on the production of the capital
goods.
 10 Approaches in welfare economics
1. Positive Vs. Normative economics
Positive economics approach
Analysis based on axioms (true statements) and observable behavior.
What “is”
Normative Economics
Value judgments in the analysis of resource allocation.
What “should be.”
Welfare economics tends to fall under normative economics in terms
of analysis.
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2. The New Welfare Economics Approach

 Pareto, Edgeworth, Hicks & Kaldor
 Differentiates between efficiency and distribution of factors.
 Pareto efficiency (optimality) (Evaluates changes based on whether they make
someone better off without harming others.)
 Kaldor-Hicks Compensation tests (it is a criterion for economic efficiency that
states that if a change makes some people better off and others worse off, then
that change will increase social welfare if those who gain from the change could
compensate the losers and still be better off
 Ordinal utility (ranking of commodity bundles using indifference curves)
 12

3. The Neoclassical Approach

Sidgwick, Marshall & Pigou
Fundamental Assumptions
Utility is cardinal (scale-measurable)
All individuals have comparable utility functions
Diminishing marginal utility
Social welfare function = sum of all individual welfare functions.

W  F (U Adam , U Eve )
 3.2 Details in the Approaches to
13 welfare economics
1. Early neoclassical approach to welfare economics
• Welfare economics which is the direct refutation of the classical
economics is originated from England.
• The classical pursued the objective of maximization of production and
wealth but for welfare economists the direct objective of all economic
thoughts and policies is welfare.
• Welfare was also an essential element of the utilitarian economics of
Bentham and his followers.
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Professor Alfred Marshall is regarded as the founder of the welfare

economics.
Other contributors includes:
Henry Clay(economics for the general reader-1916)
R.G Hawtrey (the economic problem -1962)
Hobson and A.C Pigou
 15

 The classical welfare economics is summarized in two Fundamental Theorems:

The First Fundamental Theorem of Welfare Economics: Assume that all individuals
and firms are selfish price takers. Then a competitive equilibrium is Pareto optimal.
The theorem confirms the idea of Adam Smith’s “invisible hand,” which suggests
that competitive markets ensure an efficient allocation of resources.
The Second Fundamental Theorem of Welfare Economics: suggests that almost any
Pareto optimal equilibrium can be supported via the competitive mechanism, for
some initial set of endowments (through redistribution of initial wealth).
However, attempts to correct the distribution may introduce distortions, and so
full optimality may not be attainable with redistribution.
 16
Vilfredo Pareto
2. New trends in welfare economics (1848 - 1923)
 The new type of welfare economics was developed by
Vilfredo Pareto and further extended by Edgeworth, Hicks,
Kaldor etc.
 The new welfare economics is free from value judgments and
quantitative utility measurement.
 Pareto shares the credit for an independent invention of
Indifference curves with the Englishman Francis Edgeworth
(1845–1926).
 The aim of the Idea of Indifference Curves was to avoid
measuring utility quantitatively.
 The Indifference curve approach avoids any quantitative
measurement of marginal utility
 3.3 Pareto efficiency in welfare and pre conditions of
17 Pareto efficient conditions
A resource allocation is said to be Pareto optimal if there is no
reallocation of resources that can make one person better-off with out
harming some other person.
According to Pareto, the following are conditions for the optimum,
1. Efficiency in Exchange: The required condition is that, the marginal
rate of substitution between any two products must be the same for
every individual who consumes both.
AMRSxv = BMRSxv = Px/Py
 18

2. Efficiency in Production: states that the marginal rate of

transformation between any factor and any product must be the same
for any pair of firms using the factor and producing the product. It
means that the marginal productivity of any factor in producing a
particular product must be the same for all firms.
AMRTSLK = BMRTSLK= PL/PK
 Objectives of the new welfare economics
19

1. To clarify and express the vague concept of riches in terms of quantity.

2. To clarify what it is that the economists have to say on matters of
public policy.
3. To develop those propositions which are scientifically free from ethical
considerations and which can serve as a basis for policy making.
 3.4 Caldor and Hicks criterion of efficiency
20
condition
In law and economics literature one of the most important criterions
of economic efficiency is Kaldor-Hicks criterion.
Based on the criterion that is famous for the two English economists
named Nicholas Kaldor and John R. Hicks,
Suppose:
Policy 2 (e.g., restricting pollution)
Policy 1 (e.g., not restricting pollution)
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Policy 2 is preferred to policy 1 if those who gain from policy 2 could

hypothetically compensate those who lose in going from policy 1 to 2
so that everyone would be made (weakly) better off by moving from
policy 1 to policy 2.
In the field of contract and transaction, economic efficiency is obtained
when performing a transaction results in improving status of one party,
even if the other party face with loss, conditioned that the first one
would be able to compensate the loss.
Of course compensating loss is a hypothetical assumption and is not
necessary to happen in reality. Therefore, Kaldor-Hicks efficiency
criterion is more real than Pareto criterion and is more acceptable in
economic analysis of law.
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Kaldor-Hicks efficiency criterion was created for overcoming difficulties

of Pareto criterion; since, Pareto criterion, in spite of being exact and
satisfactory for both parties, is not possible to apply for social problems
and making legal decisions because it is not possible to expect no
group or person would face with loss, as consequences of different
social decisions.
The problem is obtaining a mechanism for reaching maximum social
satisfaction.
Kaldor-Hicks efficiency criterion is created for solving this problem and
offers clear answer to this question.
 Critiques to the Caldor- Hicks efficiency criterion
23

1. Logical paradox (self - contradictory)

2. Measurement Problem (Calculation)- social utility may not be
maximized; but the wealth would be maximized.
3. Not Compensating Losses
4. Lack of Guarantee to Increase Utility of Society
5. Collectivism (giving priority to groups rather than individuals)
6. Lack of unanimity (lack of consent from all affected parties.)