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Tools of normative analysis. Lecture 2. Welfare economics. Need of tools to evaluate desirability of alternative policies (“states of the world”) WE helpful to understand when markets work or fail Microeoconomic approach Fundamental tool for government advisors. Pure exchange.
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Tools of normative analysis Lecture 2 Public Finance - Introductory
Welfare economics • Need of tools to evaluate desirability of alternative policies (“states of the world”) • WE helpful to understand when markets work or fail • Microeoconomic approach • Fundamental tool for government advisors Public Finance - Introductory
Pure exchange • Edgeworth box • 2 goods (A and C), 2 individuals (groups), here Adam and Eve • Total goods quantities given, set equal to 1 • What Adam does not have is owned by Eve • 2 origins • Point v, endowment → distribution before exchange Public Finance - Introductory
y v u w x Edgeworth Box2 person / 2 good economy Eve 0’ r Fig leaves per year 0 s Adam Apples per year Public Finance - Introductory
Individual preference and Pareto-optimality • Individual preferences described by indifference curves (IC) • Begin with endowment point at intersection of IC • Lens is domain of exchange (Pareto set) • Pareto set denotes distributions that individuals may freely choose because • One is better off and none is worse off • Both are better off • Points within Pareto set are Pareto optimal Public Finance - Introductory
E1 E2 E3 A3 A2 A1 Indifference curves in Edgeworth Box Eve r 0’ Fig leaves per year 0 s Adam Apples per year Public Finance - Introductory
Pareto efficiency - 1 • A Pareto efficient/optimal distribution: impossible to improve the situation of one individual without making another worse off (e.g. point p) • In Pareto efficient distributions individual ICs are tangent • Pareto improvement (Pareto superior move) → move from a situation where ICs are not tangent to one where they are tangent Public Finance - Introductory
Eg Ap Ah Ag Beginning at Point g, how to make Adam better off without Eve becoming worse off Eve r 0’ g h A Pareto Efficient Allocation Fig leaves per year p 0 s Adam Apples per year Public Finance - Introductory
Ep1 Eg Ag Beginning at Point g, how to make Eve better off without Adam becoming worse off Eve r 0’ g p Fig leaves per year p1 A Pareto Efficient Allocation s 0 Adam Apples per year Public Finance - Introductory
Ep2 Eg Ag Ap2 Beginning at Point g how to make both Adam and Eve better off Eve r 0’ g • Pareto efficient • Pareto improvement p Fig leaves per year p2 p1 0 s Adam Apples per year Public Finance - Introductory
Pareto efficiency - 2 • Point p not only optimal point • Conditional on original endowment • Contract curve is locus of all Pareto optimal points • Locus of tangency points • Slope of ICs identifies MRS • Pareto efficiency implies Public Finance - Introductory
Eg Ep2 Ap2 Ag Starting from a different initial point: Point k Eve 0’ r g k p4 p3 p Fig leaves per year p2 p1 0 s Adam Apples per year Public Finance - Introductory
Eg Ep2 Ap2 Ag The Contract Curve Eve r 0’ g The contract curve –locus of all Pareto efficient points p4 p3 Fig leaves per year p p2 p1 0 s Adam Apples per year Public Finance - Introductory
Economics with production • Relax hypothesis of fixed quantities • Hypothesis: inputs (labour and capital) can be re-allocated between production of goods • If inputs are efficiently employed, producing more of good A shifts inputs from the production of good C • Production of C will decrease • ‘Production possibility frontier’ (often cited by Hitler: Do you want more butter or more guns?) denotes the maximal quantity of good A that can be produced at any given quantity of good C Public Finance - Introductory
Production Possibilities Curve C │Slope│ = marginal rate oftransformation Fig leaves per year w y C 0 x z Apples per year Public Finance - Introductory
Marginal rate of transformation • To produce more C, from quantity 0x to 0z, one needs to produce less A, from 0w to 0y • Segment wy is marginal cost (MC) of producing xz more (opportunity cost) • MRT is ratio of wy to xz, so that • To produce wy → more inputs must be reallocated from production of A to production of C → producton of A reduced by xz Public Finance - Introductory
Efficiency with variable production • Condition of Pareto efficiencybecomes (1) • Suppose MRSAdam=1/3 and MRT=2/3. • Adam wants 1 of bread in exchange of 3 croissants, butif he produces 3 croissants can obtain 2 of bread • Adam can be better off withoutanyonebeingworse off → alwayspossiblewhenMRS≠MRT • When MRS=MRT utility levelcannot be changed • Rearranging (1) Public Finance - Introductory
First Theorem of Welfare Economics - 1 • First Theorem of Welfare Economics: if producers and consumers are perfectly competitive (price takers) under certain conditions (to be explained later) they will always reach a PE distribution of resources (→ laissez faire) • FTWE shows that competitive markets authomatically allocate resources in the most efficient way, without need of government intervention (Adam Smith’s “invisible hand”) Public Finance - Introductory
First Theorem of Welfare Economics - 2 • Competition implies that all individuals face same prices • Under utility maximization, price ratio must be equal to individuals’ MRSs • On the production side, firm produces till P=MC. Setting prices equal to marginal costs • Price ratio is hence equal to MRT • This equation is equivalent to efficiency condition → perfect competition determines efficient allocation of resources Public Finance - Introductory
Role of equity - 1 • If markets produce efficient use of resources, government has no economic role • Efficiency not the only criterion to evaluate the employ of resources • In the diagram p3 is efficient and q is not, but q is characterized by a more equal distribution of resources Public Finance - Introductory
The role of equity - 2 • On the contract curve UAdam and UEve are in trade off→ the higher the utility of Adam, the lower that of Eve • Utility possibilities frontier • Locus of maximal utility levels on the contact curve • Which is the ‘best point’? • Social welfare function: equivalent for society of an individual IC • iii is optimum of optima Public Finance - Introductory
Does society have to choose between p3 & q? Efficiency versus Equity Eve r 0’ p3 Fig leaves per year q p5 s 0 Adam Apples per year Public Finance - Introductory
Utility Possibilities CurveMaximum amount of one person’s utility given each level of another person’s utility Adam’s utility U p3 p5 q U Eve’sutility Public Finance - Introductory
Social Indifference CurveSociety’s willingness to trade off one person’s utility for another’s W = F(UAdam,UEve) Adam’s utility Increasingsocialwelfare Eve’sutility Public Finance - Introductory
Maximizing Social Welfare If society values a more equitable distribution of goods - embodied in Social Indifference Curves, fairness and efficiency are possible (iii) i Adam’s utility iii ii Eve’sutility Public Finance - Introductory
Role of equity - 3 • SWF is “seducing” side of WE – no scientific underpinnings! • Heavily influenced by value judgements • Slope of SWF is MRS between individual utilities • How to assess that one individual is more important of another (Egalité, etc…)? • Problem of ethics (but an unsolved/unsolvable one) • Efficiency has empirical dimensions and can be evalated with tools of economic analysis Public Finance - Introductory
Violations of FTWE - 1 • Market power or non-existing markets • P>MC: market economy produces inefficient results → violation of FTWE • Asymmetric information • Market does not emerge (Akerlof’s ‘market for lemons’) → government may intervene • Externalities • Activity of one individual affects the utility of others without going through price system (market) → government may intervene • Public good • Good whose consumption is non rival → individual has no incentive to reveal her MU → MU≠P Public Finance - Introductory
Violations of FTWE - 2 • The fact that markets fail to produce efficient allocations does not mean that governments can do better • It’s a possibility, which depends on many issues • There are also government failures • One of the subject matters of Public Choice • FTWE helps thinking rigorously about merits of government intervention • Are distributive consequences desirable? • Are there efficiency improvements? • Are costs reasonable? • When the answer to any of these questions is no → better to opt for market alternative • Government intervention might be demanded for reasons of general interest (e.g. equity) but become in fact a special advantage (lobbies, bureaucracy) Public Finance - Introductory