Chapter 15 Welfare economics

1. Chapter 15Welfare economics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9th Edition, McGraw-Hill, 2008 PowerPoint presentation by Alex Tackie and Damian Ward

2. Welfare economics The branch of economics dealing with normative issues. Its purpose is not to describe how the economy works but to assess how well it works.

3. Equity and efficiency Horizontal equity the identical treatment of identical people Vertical equity the different treatment of different people in order to reduce the consequences of their innate differences

4. Pareto efficiency An allocation is Pareto-efficient for a given set of consumer tastes, resources and technology, if it is impossible to move to another allocation which would make some people better off and nobody worse off.

5. Perfect competition and Pareto efficiency If every market in the economy is a perfectly competitive free market, the resulting equilibrium throughout the economy will be Pareto-efficient. As expressed in Adam Smith’s notion of the Invisible Hand.

6. Competitive equilibrium and Pareto-efficiency At any output such as Q1*, the last film must yield consumers P1* extra utility. The supply curve for the competitive film industry (SS) is the marginal cost of films. Away from P1*, Q1*, there is a divergence between the marginal cost and the marginal benefit derived by consumers so a move to that position makes society better off. SS D Price of films P1* D Q1* Quantity of films

7. Distortions A distortion exists whenever society’s marginal cost of producing a good does not equal society’s marginal benefit from consuming that good. some such distortions may be inevitable and it may be more efficient to spread such distortion over a wide range of markets, rather than concentrating it in one market this results from the theory of the second-best

8. Market failure … occurs when equilibrium in free unregulated markets will fail to achieve an efficient allocation. Imperfect competition Social priorities (e.g. equity) Externalities Other missing markets future goods, risk, information.

9. Externalities An externality arises whenever an individual’s production or consumption decision directly affects the production or consumption of others … other than through market prices e.g. a chemical firm discharges waste into a lake & ruins the fishing for anglers

10. A production externality Suppose DD represents the demand curve for a product (which we may interpret as marginal social benefit). D Price MPC is the marginal private cost incurred by the firm in producing the good (assumed constant for simplicity). P MPC D The market clears where MPC= DDat price P and quantity Q. Q Quantity

11. A production externality If the firm causes pollution, it imposes costs on society, presented by marginal social costs (MSC). MSC Price So the social optimum is where DD(MSB)=MSC at Q*. The overall welfare loss to society from the market failure is given by the excess of MSC over MPC between Q* and Q. MPC DD (MSB) Q* Q Quantity

12. A consumption externality MPC, MSC As a consequence of a consumption externality MSB>MPB, and the free market equilibrium provides the quantity Q. As compared with the social optimum at Q', whereMSB = MSC. MSB The brown area shows the welfare loss. Q Q' E.g. neighbours may benefit from a well-kept garden. Price DD(MPB) Quantity

13. Greenhouse gases

14. Climate Change

15. Kyoto Protocol Began 1997 By 2006 169 countries had signed, (not including the US) BY 2012 emissions will be 5% lower than in 1990 Various schemes in place including carbon trading

16. Is it worth it? Should China cut back today, to make the future better? Stern review suggests that cuts in carbon emissions will only cost 1% of GDP per annum.