Welfare Economics; branch of economics dealing with normative issues. Welfare Economics; branch of economics dealing with normative issues

Welfare Economics; branch of economics dealing with normative issues.

• Welfare Economics; branch of economics dealing with normative issues.

• How well does the economy work?

• What do we mean by ‘well’?

• Equity or Efficiency??

Horizontal equity; identical treatment of identical people

• Horizontal equity; identical treatment of identical people

• Vertical equity; different treatment of different people to reduce the consequences of these innate differences

• Most people agree that horizontal equity is desirable (i.e. no discrimination).

• But very different views re. vertical equity; i.e. how many resources should be redistributed from rich to poor? Positive discrimination?

Pareto Efficiency

• Pareto Efficiency

• Vilfredo Pareto; Manuel D’economie Politique (1909)

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

The Pareto criterion is independent of value judgements and thus can only be used to judge moves to north-east or south-west

• The Pareto criterion is independent of value judgements and thus can only be used to judge moves to north-east or south-west

• Nevertheless, it is the most we can say about efficiency without becoming entangled in value judgements

Production Possibility Frontier (PPF)

• Production Possibility Frontier (PPF)

• Points beyond frontier non-feasible

• Points on frontier are Pareto-efficient

• Points within frontier are Pareto-inefficient

The ‘Invisible Hand’ (Adam Smith)

• The ‘Invisible Hand’ (Adam Smith)

• If every market in the economy is a perfectly competitive free market, the resulting equilibrium though out the economy will be Pareto-efficient

• Cornerstone of welfare economics

• Individual firms and consumers, acting in own self-interest, generate a Pareto efficient general (i.e. economy wide) equilibrium as if guided to it by a benign invisible hand

Illustration: Assume many consumers and producers but only two goods (x and y)

• Illustration: Assume many consumers and producers but only two goods (x and y)

• Both markets are free, unregulated and perfectly competitive

• Assume that in equilibrium:

• Price of good x : px = £5

• Price of good y : py = £10

Note:

• Note:

• Labour is the variable factor of production and workers are indifferent as regards the non-monetary aspects of employment in industry x and industry y

• Thus, migration of workers will ensure wages are equalised across all industries

Stage 1

• Stage 1

• Recall that p = marginal utility (MU)

• Thus, last unit of x produced must yield consumers £5 extra (i.e. marginal) utility; last unit of y produced must yield consumers £10 extra (i.e. marginal) utility

• Implication; consumers willing to exchange 2 units of x (£10 worth of utility) for 1 unit of y (£10 worth of utility) since such an exchange will not change their total utility (i.e. MRS)

Stage 2

• Stage 2

• Each firm produces to the point that p = MC

• Thus, marginal cost of the last unit of x produced must be £5

• And marginal cost of the last unit of y produced must be £10

Stage 3

• Stage 3

• Migration of workers between industries will ensure that:

• wx = wy = w

• Stage 4

• In equilibrium, it must be the case that:

Stage 5

• Stage 5

• wx = wy = w; MCx = £5; MCy= £10

• Thus:

Stage 6

• Stage 6

• Hence, decreasing the output of good y by 1 unit and transferring the labour thus freed to the production of good x would increase the output of good x by 2 units

• Feasible resource allocation; society is able to exchange 2 units of good x for one unit of good y

Stage 7

• Stage 7

• Consumers willing to exchange two units of good x for one unit of good y; producers able to exchange two units of good x for one unit of good y

• There is thus no feasible reallocation of resources that can make society better off;

• Initial competitive equilibrium in both markets is Pareto efficient

Moreover, since workers are paid their marginal product vis:

• Moreover, since workers are paid their marginal product vis:

• Then:

• MCy = value of good x sacrificed by using last unit of labour to make good y rather than good x

• And if industry x is in competitive equilibrium (i.e. px = MUx), then MCy is also the MU that consumers would have derived from the consumption of good x sacrificed

First Theorem of Welfare Economics

• First Theorem of Welfare Economics

• Competitive equilibrium in all markets generates a Pareto efficient allocation

• But, there is an infinite number of Pareto efficient allocations; what determines the actual Pareto efficient outcome?

Second Theorem of Welfare Economics

• Second Theorem of Welfare Economics

• Any Pareto efficient allocation can be achieved from a competitive equilibrium with appropriate adjustments to initial endowment

Circumstances in which equilibrium in freely competitive unregulated markets fails to achieve an efficient allocation

• Circumstances in which equilibrium in freely competitive unregulated markets fails to achieve an efficient allocation

• i.e. distortions prevent invisible hand from allocating resources efficiently

Five main distortions

• Five main distortions

• 1. Imperfect Competition

• 2. Taxation

• 3. Externalities

• 4. Public goods

• 5. Information

Imperfect Competition

• Imperfect Competition

• MB = p > MR = MC

• Under production; consumer’s willing to pay more for output at the margin than it costs firms to produce

• Pareto inefficient

Taxation

• Taxation

• Purchase Tax / Sales Tax

• Marginal Benefit (Utility) ≠ Marginal Cost

• Under production

Public Goods

• Public Goods

• (i) Non-Diminishing

• (ii) Non-Excludable

• E.g. Defence; light-houses; street lights

• Free-riding

Externalities

• Externalities

• An externality arises whenever an individual’s production or consumption decisions affects the production or consumption of other individuals, other than through market prices

• Externalities can be positive or negative depending upon whether the original production or consumption decision increases or decreases external production or consumption

Information

• Information

• Asymmetric information; one side to the contract / exchange knows more than the other

• Akerlof, G. (1970). ‘Adverse Selection and the Market for Lemons.’ Quarterly Journal of Economics, 84(3), pp. 488-500.

Reservation price data

• Reservation price data

Two Scenarios:

• Two Scenarios:

• (i) Symmetric Information

• Quality is observable and known with certainty
• Buyers prepared to pay 10 for lemon and 20 for peach
• Sellers willing to accept 8 for lemon and 16 for peach
• Assume buyers’ reservation prices rule in equilibrium
• Separating Equilibrium
• Lemons (peaches) trade at 10 (20)

(ii) Asymmetric Information

• (ii) Asymmetric Information

• Quality unobservable
• Assume buyers ‘knows’ that a proportion q of the goods on offer are peaches
• Reservation Price …

• pd = q*pPeach + (1 - q)*pLemon

• = q*20 + (1 - q)*10

• = 10q + 10

Assume q = 0.5

• Assume q = 0.5

• pd = 10q + 10

• = 10(0.5) + 10 = 15

• But since the supply price of lemons (peaches) is 8 (16), then only lemons offered for sale

• Buyers revise q downward towards zero; pd = 10

Market for lemons

• Market for lemons

• Adverse Selection leading to market failure; lemons drive out the peaches

• There is a potential Pareto improvement; both prospective buyers and sellers of peaches would like to trade

• Signalling: Green Flag; AA; University of Bath?