Welfare Economics and Sustainability

1. Welfare EconomicsandSustainability

2. Terms & Concepts • Resources, Market commodities and services, Externalities, Public Goods, Policies • Production, Consumption, Cost, Profit, Economic Surplus, Utility, Welfare • Indifference curve, possibility frontier

3. Production Economics • Profit maximization  Cost minimization • Efficiency implies • Using a given amount of resources, one cannot produce more of one good without producing less of at least some other good • All possible efficient production decisions form the production possibility frontier

4. Normal Production Function X2 Production Factor 2 Y = f(X1,X2) YA > YB > YC Y=YA Y=YC Y=YB X1 Production Factor 1

5. Leontief Production Function X2 Production Factor 2 Y=Min(X1/a,X2/b) Y = YB Y = YA X1 Production Factor 1

6. Cost function X2 Production Factor 2 C= r2*X1+r1*X1 X2= C/r2-(r1/r2)*X1 X1 Production Factor 1

7. Normal Production Function X2 Production Factor 2 Y = f(X1,X2) YA > YB > YC Y=YA Y=YC Y=YB X1 Production Factor 1

8. Leontief Production Function X2 Production Factor 2 Y=Min(X1/a,X2/b) Y = YB Y = YA X1 Production Factor 1

9. Production Possibility Frontier Y2 Production Good 2 Y = (Y1,Y2) = f(X1,X2) = f(X) YA = f(XA) YB = f(XB) YC = f(XC) Y1 Production Good 1

10. Production Possibility Frontier Y2 Production Good 2 Leontief Production Function YA = f(XA) YB = f(XB) YC = f(XC) Y1 Production Good 1

11. Revenue (R) Y2 Production Good 2 R = p1*Y1+p2*Y2 Y2 = R/p2-p1/p2*Y1 Y1 Production Good 1

12. Optimal Production Level Y2 Production Good 2 Y2* Y1* Production Good 1

13. Optimal Production Level Y2 Production Good 2 Leontief Production Function Y1 Production Good 1

14. Utility Economics • Utility (U) function of a person can be measured and depends on consumption (C) of goods and services • market and non-market goods • Social welfare (SW) function can be measured and depends on utility of all people in a society • may include expected utility of future people

15. Utility (U) Indifference Curves Consumption Good 2 U = U(C1,C2) U = UA U = UB U = UC Consumption Good 1

16. Budget (B) Constraint Consumption Good 2 p1*C1+p2*C2≤ B B/p2 C2≤ B/p2-(p1/p2)*C1 B/p1 Consumption Good 1

17. Optimal Consumption Levels Consumption Good 2 U = UA C2* U = UB U = UC C1* Consumption Good 1

18. Utility Possibility Frontier (UPF) • Shows the maximum utility of agents for a given amount of outputs • Combining all utility possibility frontiers yields the grand utility possibilities frontier (GUPF)

19. Pareto Efficiency / Optimality • No pareto improvement (PI) possible • No change in the allocation of goods and services can improve the utility of at least one person without decreasing the utility of at least another person • Vilfredo Federico Damaso Pareto (1848 1923) was an Italian engineer, sociologist, economist, and philosopher

20. Pareto Optimality • Strong: no alternative allocation of goods where at least one is better and no one is worse off • Weak: no alternative allocation of goods where all are better off • Actual: true PI without compensation • Potential: compensation possible • Kaldor-Hicks Criterion: judge policy efficiency using potential PI

21. Social Welfare Function • represents the joint utility of several (many, all) people • includes implicitly or explicitly equity (fairness) considerations • developed by Abram Bergson (1938,1948, 1954), Paul Samuelson (1947, 1950, 1956), Gerhard Tintner (1946) and Jan de Van Graaff (1957) • "Bergson-Samuelson" social welfare function SW = SW(U1, U2, ..)

22. Social Optimum • First Fundamental Welfare Theorem: every competitive equilibrium is Pareto-optimal. • Second Fundamental Welfare Theorem: every Pareto-optimal allocation can be achieved as a competitive equilibrium after a suitable redistribution of initial endowments.

23. Social Welfare (SW) Function, 1 Utility Person 2 SW Indifference Curves 45° SW = SWB SW = SWA Utility Person 1

24. Social Welfare (SW) Function, 2 Utility Person 2 SW = SWB SW = SWA Utility Person 1

25. Social Welfare (SW) Function, 3 Utility Person 2 SW = SWB SW = SWA Utility Person 1

26. Social Optimum Grand Utility Possibility Frontier Utility Person 2 SW = SWB SW = SWA Utility Person 1

27. Externality – Definition, 1 Definition in terms of effects : “an externality is present whenever some economic agent (say A’s) welfare (utility or profit) is affected by real (ie. non-monetary) variables whose values are chosen by others without particular attention to the effects on A’s welfare”

28. Externality – Definition, 2 Definition in terms of cause: “an externality is present whenever there is insufficient incentive for a potential market to be created for some good and the non-existence of the market leads to a non Pareto optimal equilibrium”.

29. Externality and Property Rights • Private property rights absent for external goods (transaction cost higher than private benefits from internalization) • Without property rights there is no market • Without market, allocation of good is not efficient (Market failure)

30. Examples • a construction company trucking through a private garden • a farmer polluting ground water through excess fertilization Similar events but different outcomes.

31. Externality Types • positive (beneficial) or negative (harmful) • consumption or production related • depletable (private) or non-depletable (public) • stock or flow related • point or not point source

32. Agricultural Externalities • are often negative (water, air, and soil pollution, biodiversity, habitat reduction, erosion) • can be positive (open landscape, emission sink) • relate to production • are mostly non-depletable • arise from non-point sources • local (odor), regional (water), or global (GHG)

33. Pesticide Externality, 1 Use of pesticides by farmer A wipes out pests that might affect farmer B. • positive? • production externality • primarily a flow externality (plus a possible stock effect by reducing the breeding pool) • local • depletable (private)

34. Pesticide Externality, 2 Use of pesticides by farmer A increases pesticide resistance, reducing effectiveness of pesticides available to other farmers. • negative • a production externality • a stock effect (resistance arises through cumulative use) • mutual (farmer A is affected too) • wider-than-local, potentially global • non-depletable?

35. Fertilizer Externalities • Decrease in species diversity, promotion of few fast growing grasses • Eutrophication/Hypoxia (Fish killing) • Increase leaching of potassium and calcium (mobilizing aluminum) • Human health effects (nitrite poisoning of babies)

36. Fertilization: Costs and Benefits 0

37. Marginal Effects Value 0 Marginal private benefit = Marginal social cost Marginal private benefit = marginal private cost

38. Fertilizer Externality Effects • Social and private marginal costs of fertilization differ - so prices reflect private costs, not social costs. • Individual profit maximizing behavior leads to Pareto inefficiency.

39. Leakage • unintended flows of economic activities across space, time, and/or sectors and their consequences for non-market goods and services • relates to commodity trade and can be couteracted through trade policies, i.e. so-called border tax adjustments

40. Scope of Sustainability Efforts • Time (Current period – Entire Future) • Space (Local – Global – Universal) • Commodities (Individual – All) • Resources (Individual – All) • Externalities (Individual – All)

41. Scope of Sustainability Efforts • Time (Current period – Entire Future) • Space (Local – Global – Universal) • Commodities (Individual – All) • Resources (Individual – All) • Externalities (Individual – All) Leakage High Low