Introduction

Economic policy causes changes in the level and structure of economic activity. Policy intervention (such as to impose foreign exchange rationing, or to provide investment grants) is undertaken because it is judged by the relevant political authorities to produce an outcome which is superior to the alternative without the intervention. Conceivably that superiority may be judged by non-economic criteria (such as electoral success), but an inevitable question is whether it is superior in economic terms. Welfare economics is the body of economic theory which has addressed this question by trying to establish criteria for economic superiority and also operational procedures to permit one outcome to be compared to another.

The starting point for this theoretical analysis is the concept of’ Pareto optimality” named after the Italian-born economist Vilfredo Pareto. Pareto stated what with hindsight seems an obvious and wholly acceptable criterion namely that one state of the economy would be classed as superior to another if moving to it makes at least one individual better off without making anybody else worse off. However this is in fact a weak criterion, since it does not allow comparison of the normally observed situation in which improving the lot of one or more people usually involves loss to at least one other person. (How economists address this issue of how to balance some peoples’ losses against others’ gains is dealt with in Section 10.4).