Welfare Economics
PhD. Anto Bajo,
Faculty of Economics and Business,
University of Zagreb
Welfare Economics
•
In order to be able to adopt a view about desirable
government activities, a general framework is required
•
Most experts in the area of public finance use welfare
economics as this general framework
•
Welfare economics – the branch of economic theory that
deals with social desirability of alternative economic
states
•
Welfare theory is used to distinguish the circumstances under
which the market fails from those in which the market is
successful to provide desirable results.
Edgeworth box
(distribution of two goods between two persons)
Eva
y
Figure leaf, yearly
r
0’
v
u
Adam
0
w
s
x
Apple, yearly
1
Indifference curve in an Edgeworth
box
Eva
r
0’
E1
E2
Fig. leaves
E3
A3
A2
A1
Adam
s
0
Apples
Improvement in Adam's position with no
deterioration in Eve's
Eva
r
0’
Fig leaves
Eg
g
h
Pareto efficient
allocation
p
Ap
Ah
Ag
Adam
s
0
Apples
Foundations of welfare economics
(IV)
•
Pareto efficient allocation – if there is no other allocation in
which some other individual is better off and no individual is
worse off
Pareto efficiency – standard for evaluation of the desirability of
allocation of resources
Pareto improvement – the reallocation of resources that
makes one person better off without making anyone else worse
off
There are number of Pareto effective points, and the line
between all Pareto effective points is called the contract curve
2
The contract curve – the line joining all Pareto
efficient points
Eva
r
0’
Eg
g
Fig leaves
Contract
curve
p4
Ep2
p2
p3
p
p1
Ap2
Ag
Adam
s
0
Apples
Foundations of welfare economics
(VI)
In the Pareto efficient point, the curves of indifference practically
touch – they are tangents, their slopes are the same
The marginal rate of substitution is the absolute value of the
indifference curve. This is the rate at which the individual is
willing to exchange one good for an additional amount of a
another good.
Pareto efficiency requires that the following condition be met:
MRSafAdam= MRSafEve
Foundations of welfare economics (VII)
Production possibility curve –
shows the maximum amount of a
good that can be produced with
any set quantity of other goods
C
l Slope l =
Fig leaves p.a.
W
Marginal rate of
transformation
Y
C
O
x
z
Apples p.a.
The marginal rate of transformation – the rate at which an economy can
transform the production of a good into the production of another good.
This is an absolute value of the slope of the production possibilities curve =
distance wy/distance xz = MCa / MCf.l.
3
Foundations of welfare economics (VIII)
When the supplies of apples and fig leaves are variable,
the conditions for Pareto efficiency obtain:
MRTaf. = MRSafAdam= MRSafEve ,
or
MCa / MC f = MRSafAdam= MRSafEve .
In such conditions Pareto improvement can be achieved.
Basic theorem of welfare economics
The basic theorem of welfare economics says that:
As long as producers and consumers work as perfect
competitors, i.e., while they accept the prices that are set,
then, with certain conditions, Pareto efficient allocation of
resources and means appears.
Adam maximises his utility when MRSafAdam = Pa / Pf .
Eve maximises her utility when MRSafEva = Pa / Pf .
The competitive firm maximises its utility when
MCa / MC f = MRTaf = Pa / Pf .
From this it derives that MRTaf = MRSafAdam= MRSafEva .
The role of Fairness (I)
All the points on the utility
possibilities curve are Pareto
effective but they indicate different
distributions of income between the
two individuals
U
Adam utility
Utility possibilities curve – shows
the maximum utility of an individual
with a given level of utility of
another individual. It is derived from
the contract curve.
Utility possibilities curve
U
O
Eve utility
The Pareto efficiency criterion of itself is not enough for the evaluation of an
alternative allocation of resources and means.
4
The role of fairness (II)
The choice of the best point on the utility possibilities curve derives
from the function of social welfare.
Increase social
welfare
Social indifference
curve
Eve’s utility
Increase social
welfare
i
Adam utility
Adam utility
The function of social welfare represents the views of society about
the relative deservedness of individual members of the society. Social
welfare depends on the utility's of each member of society, or: W = F
(UAdam, UEve).
iii
ii
Eve’s utility
Role of equity (III)
A competitive system leads to some allocation on the relative
utilities curve, but this does not have to be the point that
maximises social welfare.
Government intervention, even if the economy creates Pareto
efficient allocation of resources and means, may be necessary to
achieve efficient distribution of utility.
Government activity is also justified by the possibility that
certain conditions essential for the working of the basic theorem
of welfare economics do not have to be satisfied in a real market.
If they do not exist, the allocation of resources cannot be efficient.
Market failures
The whole economy may be inefficient for two basic reasons
– because of market power or nonexistence of markets.
Market power – if some individuals or firms can affect
prices, then allocation will on the whole be inefficient. A firm
that has huge market power can raise the prices above the
marginal cost and offer fewer products than the competition
would.
The non-existence of a market – e.g., insurance against
poverty.
Causes of non-existence of a market – asymmetrical
information, externalities, public goods.
5
Allocative inefficiency of the market
Cases of market allocative inefficiency, i.e., a situation when there
are no conditions for the achievement of an efficient market
solution:
(1) Falling average costs, monopoly, other cases, when perfect
competition is distorted
(1)
Asymmetrical information, or high risk
(2)
Public goods
(3)
The existence of externalities
Allocation policy – measures undertaken to change the manner and
scale of investment of economic resources, particularly for the sake of
stopping inadequate efficiency.
... monopolist behaviour
Monopolists that maximise profit do not attempt to achieve
the condition MC=p but MC=MR – Pareto efficiency conditions
are not met, and monopolists supply a quantity lower than the
optimal.
Government may affect an increase in supply
• By paying unit subsidies in the amount of the difference
between p and MC
• By bringing in initial assistance to new suppliers, to
increase competition
• By measures to stimulated competition – which increase
the chances for success of allocation policy – aimed at
creation of preconditions
Distortion of competition
In some cases the measures of government revenue and
expenditure policy can bring about distortions in market
competition and encourage monopolist behaviour.
Competition can be distorted by taxes, tax laws,
subsidies (especially to maintain existing capacities), tax
privileges or breaks (for given areas, for R and D), various
regulations and edicts, and so on (the big firms cope best
with them) and by government protectionism.
In general, because of government regulation, an economy
becomes more inflexible and less apt to take risks, and
dependent on judgements from the administration.
Costs of regulation – direct costs of administration and
implementation of regulations, uncertainty and vacillation
in decision making, costs related to rent-seeking.
6
Assimetrical information and high
risk
Incomplete or asymmetrically deployed information is a cause
of market inefficiencies that come into being when there are no
insurance markets or when the effect is inadequate.
Asymmetrical information exists when an individual who
wishes to secure himself from the damage created by the onset
of a certain event has better information than the insurer
Risks that the market cannot insure – and social risks (inflation,
wars, profound crises), risks of investment in R&D, big technical
projects
The achievements of welfare economics
• Welfare economics has certain
weaknesses- it is founded on an
individualist social philosophy
and is focused on results and
not processes.
• Yet, it provides a good
framework of the evaluation of
various kinds of government
actions.
• To do with government
activity, the framework of
welfare economics enforces
three questions:
• Will
the
actions
of
government have desirable
consequences
to
distribution?
• Will
they
efficiency?
encourage
• Can they be carried out with
reasonable costs?
• The very act of asking these
questions is a good basis for
the decision making process.
In short about welfare economics
•
WE studies the social desirability of alternative economic
states of affairs
•
The indicator of the efficient working of an economy is
Pareto efficiency
•
Pareto efficiency is achieved when one person has it better
without another person becoming worse off
•
A precondition for Pareto efficiency is that for every person
MRS=MRT
•
Under certain conditions, competitive markets lead to
Pareto efficiency
7