In the words of Arthur Pigou (1877-1959), who was highly influential in the development of welfare economics, it is an important branch of the discipline that suggested that an economic system was better if even one person's satisfaction was increased while no one else's was decreased. Welfare economics is the study of economies where a nation or state intervenes or makes arrangements for some distribution of income. The study emerged from the political debate between laissez faire economics, where this is little, if any, government intervention in the economy, and those who favor that markets should be directed and managed in order to avoid monopolies and unfair competition.
In 1912, Pigou published his Wealth and Welfare (which was revised in 1920 as The Economics of Welfare) and suggested that welfare economics should be taken as a separate study and should develop independently from other branches of economics. Effective economic policies cannot follow directly from welfare economics. These should be carefully considered and applied according to the context and situation because welfare economics is not easily, if at all possibly, applied to real markets.
There are three theories of welfare. The first involves the Pareto optimal: the proposition that if one person makes money, another person somewhere must be spending money. In the case that at least one consumer is better off and no others worse off, this is Pareto improvement. The first theorem of welfare economics, therefore, states that the allocation by trade of initially distributed resources is Pareto optimal in a general equilibrium.
According to the second theorem, Pareto optimal is achievable through trade provided that the appropriate taxes and transfers are imposed on individuals and companies. This means that the perfect economy in which everybody gains wealth can be achieved by modification of the market mechanisms. These two theorems actually complement the theory of Adam Smith (1723-1790) that an all-win market is achievable without direction from a central figure to plan and control market operations.
The third theorem which influences welfare economics is Arrow's impossibility theorem, developed byAmerican economist Kenneth Arrow (b. 1921) in his book Social Choice and Individual Values (1951), and based on an origianl paper "A Difficulty in the Concept of Social Welfare," which led to Arrow being the co-recipient of the Nobel prize for Economics in 1972. Arrow's impossibility theorem states that there is no reliable way that the collective interest of the whole market or society may be determined from the differing and often contradictory interests of individuals. Therefore, a distribution and redistribution of resources and wealth that will satisfy the needs of all individuals and the whole market at the same time is not possible.
From around 1939, New Welfare Economics began to emerge, an adaptation of the Pareto method of looking at an economy, and to a certain extent predicted by the works of Pigou. The New Welfare Economics took as a starting point the Pareto optimal and focused on the non-optimal positions. Instead of aiming at a perfect equality, this principle makes use of different ranks of non-optimal positions. Thus, the movement for one non-optimal position to a higher or better non-optimal position can make everybody better off compared to the previous position.
Not all economists accept that universal social welfare is of any value because of the often vast differences between different elements in a market, such as the wealthy and the poor, while the relevance of Pareto optimal is also questioned because it tends to require a clear definition of economic factors, and this is rarely possible in reality.