The existence of scarcity creates the basic economic problem faced by every society, rich or poor: how to make the best use of limited productive resources to satisfy human needs and wants. Recall that in economics we are ultimately trying to answer the following 3 fundamental questions regarding the allocation of resources.

1. What goods and services will be produced?

For example, an economy must decide whether they should produce medical ventilators or weapons, build and fix roads or buy textbooks for schools.

2. How will the goods and services be produced?

For example, should we use copper or plastic to make pipes? Should machines be used to make clothing or should workers make it by hand? Should the power plant be built close to the
ocean or inland? Which fertilizer is best for growing strawberries? There are millions of decisions that need to be made to figure out how to produce goods
and services.

3. Who will get the goods and services?
Once the goods and services are produced, who will get to consume them? Will people consume them on a first-come, first-served basis? Should goods be allocated or given out by height, weight, religion, age, gender race, looks, strength, health or wealth? How should the goods and services be distributed
among the people?

Welfare economics studies how the allocation of resources affects economic well-being. It is the study of the determinants of well-being, or welfare, in society. To avoid confusion, it is important to recall that the term “welfare” is also used to refer to cash payments to low-income single families. There are six major U.S. cash/welfare programs. They are the Temporary Assistance for Needy Families (TANF), Medicaid, Supplemental Nutrition Assistance Programs (SNAP or “food stamps“), Supplemental Security Income (SSI), Earned Income Tax Credit (EITC), and housing assistance. Thus, the term “welfare” to refer to the normative concept of well-being – as explained in this section, and “welfare program” to refer to cash/welfare payments.

To reiterate, welfare economics is a field of economics that looks at the problem of allocating resources. It uses techniques from microeconomics to assess general well-being. From this assessment, it tries to find an allocation of productive factors as to desirability and economic efficiency within an economy, often relative to competitive general equilibrium. It analyzes social welfare in terms of economic activities of the individuals that compose the theoretical society considered.  Social welfare refers to the overall welfare of society.

In this section we will discuss the determinants of social efficiency – or the size of the economic pie. Social efficiency is determined by the net benefits that consumers and producers receive as a result of their trades of goods and services. Social efficiency means taking into account all of the private and social costs and benefits of a decision / policy. Social welfare is optimized when marginal social benefit = marginal social cost.

The familiar demand and supply diagram holds within it the concept of economic efficiency. One typical way that economists define efficiency is when it is impossible to improve the situation of one party without imposing a cost on another. Conversely, if a situation is inefficient, it becomes possible to benefit at least one party without imposing costs on others.

Efficiency in the demand and supply model has the same basic meaning: The economy is getting as much benefit as possible from its scarce resources and all the possible gains from trade have been achieved. In other words, the optimal amount of each good and service is being produced and consumed.