Welfare Economics and Pareto Efficiency in Income Distribution

1. Kapitel 3 (Einkommensum-)Verteilung (VL Theorie der WIPO WS 16/17 Prof. Dr. Thomas Wein)

2. Kapitel 3 "Einkommens-(umverteilung)"

3. Kapitel 3 "Einkommens-(umverteilung)"

4. Kapitel 3 "Einkommens-(umverteilung)"

5. Welfare Economics Concerned with the social desirability of alternative economic states. VL WIPO, Prof. Dr. Thomas Wein

6. Consumption Economy • Edgeworth Box - an analytical device used to model welfare economic theory • Depicts distribution of goods in a 2-good/2-person economy • Pareto Efficiency – an allocation of resources such that no person can be made better off without making another person worse off • Pareto Improvement – a reallocation of resources that makes at least one person better off without making anyone else worse off VL WIPO, Prof. Dr. Thomas Wein

7. y v u w x Edgeworth Box2 person / 2 good economy Eve 0’ r Fig leaves per year At “v”, how many apples and figs do Adam and Eve consume? 0 s Adam Apples per year VL WIPO, Prof. Dr. Thomas Wein

8. E1 E2 E3 A3 A2 A1 Indifference curves in Edgeworth Box Eve r 0’ Fig leaves per year 0 s Adam Apples per year VL WIPO, Prof. Dr. Thomas Wein

9. 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 VL WIPO, Prof. Dr. Thomas Wein

10. 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 VL WIPO, Prof. Dr. Thomas Wein

11. 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 VL WIPO, Prof. Dr. Thomas Wein

12. 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 VL WIPO, Prof. Dr. Thomas Wein

13. 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 VL WIPO, Prof. Dr. Thomas Wein

14. Pareto Efficiency in Consumption Adam Eve MRSaf = MRSaf Where MRS: -is the rate at which an individual is willing to trade one good for another -is the absolute value of the slope of an indifference curve VL WIPO, Prof. Dr. Thomas Wein

15. Production Economy • Analysis when supplies of 2 goods (applies and figs) are variable rather than fixed • Production Possibilities Curve • Graph to model production economy • Maximum quantity of one output that can be produced given the amount of the other output VL WIPO, Prof. Dr. Thomas Wein

16. Production Possibilities Curve C │Slope│ = marginal rate oftransformation Fig leaves per year w y C 0 x z Apples per year VL WIPO, Prof. Dr. Thomas Wein

17. Marginal Rate of Transformation MRTaf= Marginal rate of transformation of apples for fig leaves MRTaf = rate at which the economy can transform one good into another MRTaf= Absolute value of slope of Production Possibilities Frontier MRTaf = MCa/MCf VL WIPO, Prof. Dr. Thomas Wein

18. Pareto Efficiency Conditions with Variable Production Adam Eve Adam Eve MRTaf = MRSaf = MRSaf MCa/MCf = MRSaf = MRSaf VL WIPO, Prof. Dr. Thomas Wein

19. 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 VL WIPO, Prof. Dr. Thomas Wein

20. 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 VL WIPO, Prof. Dr. Thomas Wein

21. 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 VL WIPO, Prof. Dr. Thomas Wein

22. 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 VL WIPO, Prof. Dr. Thomas Wein

23. Nutzenmöglichkeitenkurve US UJ Kapitel 3 "Einkommens-(umverteilung)"

24. Simple Utilitarianism 0 • Utilitarian Social Welfare Function:W = F(U1, U2, ,,,, Un) • “Promote Greatest Good for Greatest Number” • Additive Social Welfare FunctionW = U1 + U2 + … + Un • Assume • Individuals have identical utility functions that depend only on their incomes • Utility functions exhibit diminishing marginal utility of income • Total amount of income is fixed Kapitel 3 "Einkommens-(umverteilung)"

25. Implications for Income Inequality 0 This is the net gain to society Paul gains this much utility Paul’s marginal utility Peter’s marginal utility e f Peter loses this much utility d c Take ab from Peter and give to Paul Social welfare maximized MUPeter MUPaul Paul’s income Peter’s income 0 0’ b a I* Paul’s income Peter’s income Kapitel 3 "Einkommens-(umverteilung)"

26. Evaluating the Assumptions Assumption 1 Assumption 2 Assumption 3 Kapitel 3 "Einkommens-(umverteilung)"

27. The Maximin Criterion Social Welfare FunctionW = Minimum (U1, U2, …, Un) Maximin criterion - No inequality acceptable unless it works to the advantage of the least well off Original position – “behind the veil of ignorance” Critique of Rawls Kapitel 3 "Einkommens-(umverteilung)"

28. Pareto Efficient Income Redistribution Will redistribution always make someone worse off? Utility FunctionUi = F(X1, X2, …, Xn, U1, U2, …, Ui-1, Ui+1, …, Um) Redistribution if gain in utility from charity exceeds loss from reduced consumption Government reduces cost of redistribution Income distribution as a Public Good Social safety net Social stability Kapitel 3 "Einkommens-(umverteilung)"

29. Non-individualistic Views • Fundamental principles specifying income distribution derived independent of tastes • Incomes distributed equally as matter of principle • Plato’s 4:1 ratio of highest to lowest income • Commodity Egalitarianism Kapitel 3 "Einkommens-(umverteilung)"

30. Other Considerations • Processes versus Outcomes • Fairness of distribution of income judged by fairness of process that generated it • Robert Nozick • Society cannot redistribute income because society has no income to redistribute • Mobility • Corruption Kapitel 3 "Einkommens-(umverteilung)"

31. Expenditure Incidence Relative price effects Public goods Valuing in-kind transfers Kapitel 3 "Einkommens-(umverteilung)"

32. In-Kind Transfers H 420 Other goods per month E3 340 A F U 300 E1 260 B D 20 60 150 210 Pounds of cheese per month Kapitel 3 "Einkommens-(umverteilung)"

33. In-Kind Transfers H 420 Other goods per month A F 300 E5 168 E4 136 B D 82 126 150 210 Kapitel 3 "Einkommens-(umverteilung)" Pounds of cheese per month

34. Reasons for In-Kind Transfers Commodity egalitarianism Reduce welfare fraud Political factors Kapitel 3 "Einkommens-(umverteilung)"

35. Literaturhinweise • Rosen, H.S./Gayer, T. (2008), Public Finance, Boston et al. (McGraw-Hill), 8th. edition, chapter 12. • Nicholson, Walter/Snyder, Christopher/Luke, Peter/Wood, Michael (2008), Intermediate Microeconomics, London (Cengage Learning, S. 349-361. Kapitel 4 “NPÖ"