Welfare economics

An introduction

Economics is both
a descriptive science that explains the functioning of the economy and
a normative science, which tries to make prescriptions
a.
the prescriptions are based on value judgements which are made explicit
b.
the most important value judgements are
i.
consumer sovereignty, i.e. individuals preferences are to be count
ii.
Pareto criterion, i.e. if at least one is better off but no one worse off, the
economy is better off
iii.
direct judgements on distribution of well-being
this normative science is called welfare economics
Societys objective is to maximize the well-being of its citizens. For that we must be able to
represent the well-being in a practical way and we need a way of comparing different individuals.
We will start with the first issue, namely on the impact on human well-being from changes in
quantity and quality of resources. We will therefore in the next section focus on individual wellbeing. In order to do that we need a way to represent mathematically the well-being of
individuals.

Individual preferences

It is assumed that the individuals have preferences over all bundles of goods and services that they
come across. The preferences will be represented by the symbol
xy
which interpretation is that the bundle x is at least as good as the bundle y in the views of the
individual. If x y but not y x, then x is strictly preferred to y, and we write
x y.
and if he is indifferent between the two
bundles (x y and y x) we write
y - x.
The set {x; x - y} is called an
indifference set. In two dimensions, an
indifference set is an indifference curve.

We need some assumptions on the properties of the preferences.

Transitivity
If

then

Reflexivity

xy and zx,
zy
x-x

Completeness or connectedness
For all x and y, either

xy or yx

Continuity

The preference order is continuous if the set

A ={y; yx}
is closed.
This means that if a sequence of y 0 A, i = 1, 2, ... converges to z, then z 0 A, lim y = z | z 0
A.
i

Utility functions

For practical reasons we would like a simpler representation of the preferences. Utility functions
offer such opportunity.

The existence of a utility function

If there exists a function u mapping commodity bundles to real numbers such that
x y Y u(x) $ u(y)
and
y - x Y u(x) = u(y),
then the function u is the utility function of the individual. The utility function is a representation
of preferences! Note that it is wrong to say that an individual prefers x to y because x gives higher
utility. The correct way to express the statement is that if the individual prefers x to y, then the
utility of x is higher than the utility of y.
If u(x) > u(y), we will also interpret that as meaning that the individual is better off with x than
with y, otherwise he would not prefer x to y! This is the assumption of consumer sovereignty:
Only the individual can judge what is good for him. Thus we can use the utility function to
measure the well-being of an individual as he himself judges it.
Usually we impose on the utility function various structures. Doing environmental valuation
requires for example special structures.
If the preference order is continuous, then there exists a utility function.
The following example illustrates a preference order that cannot be represented by a utility

function!

The lexicographic order

The lexicographic order is not continuous and it is impossible to represent this order with a utility
function
Assume two commodities, x1 and x2. The preference order is lexicographic if
(x1, x2) (x1', x2') when x1 > x1' or when x1 = x1' and x2 $ x2'
For this preference order no indifference curves exist.
The set of bundles better than or indifferent to (x1', x2') are the points to the right of the blue
whole line and points on the black broken line. The only point indifferent to (x1', x2') is itself!

Monotonic transformations of utility

There is no unique representation of a preference order in terms of a utility function!

If
x y implies that u(y) $ u(x),
then any monotonic increasing function of the utility function is also a utility function. For
example, if u = xy, then ln u = ln x + ln y or u2 = x2y2 are also utility functions representing the
same preferences. They are equally valid representations. Any monotonic increasing
transformation of a utility function is a valid utility function representing the same preferences. If
f(.) is a monotonic increasing function, f(u(x)) is a utility function.
The trick is to find an f such that the transformed utility is as simple as possible! We will later
introduce the expenditure function or cost of utility function as such a transformation.

Ordinal utility

Because any monotonic increasing transformation of a utility function also is a utility function,
utility is ordinal.

Utility functions and well-being

!
!
!
!

Utility is a representation of preferences.

The individual knows best his own well-being - consumer sovereignty.
We therefore also interpret utility as the well-being of the individual.
Utility is a non-unique non-linear index of well-being.

Properties of utility functions

!
!
!

Utility is increasing in goods and decreasing in bads

Utility is continuous (except in some cases such as lexicographic preference orders)
Utility is quasi-concave, that is the set {x;u(x)$"} is convex for all ". (More on convexity
later.)

Preferences among risky choices

Let L be a lottery with outcomes c and with associated probabilities B ,

i = 1, 2, ...n. Let L be another lottery with the same probabilities B but with outcomes c . Then
there exist a utility function u such that if L is preferred to L, then
E B u(c ) > E B u(c )
E B u(c ) is the von Neuman and Morgenstern expected utility.
Note that expected utility is only invariant to linear transformation and is therefore cardinal.
i

Existence of the expected utility function

Assume that preferences satisfy

! conditions on preference order for certain outcomes, i.e.
" completeness
"
transitivity
"
reflexivity
"
continuity
! and two new conditions
"
probabilistic equivalence
"
probabilistic independence
Then there exists an expected utility index.
Probabilistic equivalence

Individuals are indifferent between two lotteries offering the same outcomes with the same
probabilities.
This means that the individual does not care about the process by which outcomes and
probabilities are generated but only about the final outcomes and the final probabilities.
Probabilistic independence

The individuals preferences between two lotteries that offer the same outcomes in some states of
the world must be independent of these outcomes.
Many individuals

How do we measure social well-being when there are many individuals?

The Pareto criterion

A change that makes at least one individual better off but no one worse off satisfies the Pareto
criterion.
By the Pareto criterion is meant
A partial order on the set of allocations of resources such that one allocation A is socially
preferred to another allocation B if at least one individual is better off with A and no one is
worse off with A.
Let the utility of individual h in allocation A be uhA and the utility in B uhB. Then A is better than B
according to the Pareto criterion if
uhA $ uhB with strict inequality for at least one individual.
This is a partial order, because not all allocations can be compared.

Pareto optimality

A change that makes at least one individual better off but no one worse off satisfies the Pareto
criterion.
By Pareto optimality is meant
An allocation such that it is not possible to improve the situation of one or more
individuals without harming other individuals.
A Pareto optimal allocation is thus a maximal allocation with regard to the Pareto criterion.
Note that a given Pareto optimal allocation may not be socially desirable at all because the
distribution of well-being, that is the utilities may be very unevenly distributed.

Utility possibility frontiers

The red curve gives the maximum utility to individual 2, given 1's utility. The curve is known as
the utility possibility frontier.

Competitive equilibrium

Competitive markets consist of

1.
producers, that cannot affect prices, that maximize profits and of

2.
3.

consumers that cannot affect prices, and maximize utility within their budgets, and
of
equilibrium prices such that consumers total demand for each good and service is
not greater than the total supply of the same goods and services from the
producers.

The first theorem of welfare economics

if

all goods and services can be bought and sold on markets, and
if the economy is in a competitive equilibrium,
then the competitive equilibrium is a Pareto optimum.
This theorem does not say much because the resulting Pareto Optimal allocation may not be
desirable. The second theorem addresses this problem.

Second theorem of welfare economics

If

production possibilities are convex and continuous,

each individual has a continuous utility function which is quasi-concave,
all goods and services can be bought and sold on a market,
Then, each possible Pareto optimum can be achieved as a competitive equilibrium after initial
endowments have been correctly redistributed.
Note the three conditions:
1
Convexity
2
Continuity
3
Private property rights

Convexity

A set is convex if two arbitrary points can be connected with a straight line that belongs
completely to the set.

A set i strictly convex if the boundary does no contain any straight line segments.

Convex production sets

Convexity in production means loosely that we have diminishing returns. More strictly we can
represent convexity as follows:
In this figure a production function is drawn. The production set is the set of all combinations of
inputs and outputs that are on or below the production function. Take two arbitrary points in that
set, for example A and B and connect them with a line. If that line is completely in the set, the set
is convex.
With two inputs, the production set is the set of combinations of labour, capital and output that is
on or below the surface in the figure above. Once again, take two arbitrary points in this set and
draw a line

Preferences are convex if the indifference curves look as they usually do in textbooks, that is as is
depicted in the diagram below.

Quasi concave functions

The shaded area, above and to the right of the indifference curve is convex.
The function is strictly quasi concave if the set is strictly convex.
U(x) is quasi concave if {x; u(x)$ "}
is convex for all ".
Preferences are convex if the area above an indifference curve is convex (that is if a line drawn
between two arbitrary points in that area is wholly inside the area).

We can get an intuitive understanding of the economic meaning of convexity and a feeling for the
two theorems if we look at Robinson Crusoe who can produce two goods, x and y. Robinson is
alone but we will try to think of him as two persons: a producer and a consumer. As a producer,
Robinson must choose a bundle of the two goods that is feasible, i.e., that belong to the
production set in the figure.

This set is defined by the transformation curve T-T and the area below it.
Note that it has been drawn as convex area. Robinson, the consumer has preferences that are
represented by the indifference curves I-I. Obviously, the best for Robinson is to choose to

produce and consume at the point where the indifference curve is tangent to the transformation
curve. At this point, the two curves have a common tangent, P-P. This is the role played by
convexity. It guarantees that the indifference curve and the production set can be separated by a
straight line. Without convexity, we cannot guarantee that. The slope of this tangent can be
interpreted as the relative price of y in terms of x.

Separation theorems

two convex sets, of which at least one has interior points, and with no interior points in common
can be separated by a hyperplane.

Decentralization
If Robinson the producer maximizes profit, he should choose the production bundle that
corresponds to the tangency of the price line P- P and the transformation curve T-T. If Robinson
the consumer is maximizing utility, he will choose the consumption bundle that corresponds to the
tangency of the price line P-P and the indifference curve I-I. These points are the same. Therefore,
we can decentralize the decisions: we let the producer choose the production bundle, only
knowing the relative prices and let the consumer choose the consumption bundle, only knowing
the relative prices. Thus the assumptions of convexity of preferences and convexity of production
allow decentralized decision making that still achieve the social optimum. This is the intuitive
background for the second welfare economics theorem.

Non-convexity

Let us also see what happens if the production set is not convex.
In the diagram below, the production set defined by the curve T-T is not convex. Robinsons
optimum is at point A, where the indifference curve I-I and the transformation curve T-T are
tangent to each other.

However, at the prices defined by the slope of the tangent at A, Robinson, the producer could
make higher profits at other output combinations, for example he could make a profit
corresponding to the dotted line if he produces at B. Thus, with this non-convexity, the
production and the consumption decisions cannot be separated by using prices, and the second
theorem of welfare economics does not hold. Thus, if there are non-convexities, it may not be
possible to decentralise decisions between consumers and producers and still achieve a social
optimum in equilibrium!
Non-convexity may arise from many different reasons:
1.
increasing returns to individual factors of production
2.
increasing returns to scale
3.
synergistic effects in natural systems
4.
satiation

Continuity

Continuity is almost completely a mathematical device and very often (but not always) without
significant economic meaning and we will not dwell on this concept.

Property rights

Without well defined property rights, markets will not be established for all goods and services
and incentives will be distorted as a result. The reason is that well-defined property rights define
responsibilities in such a way that the owner of the rights has incentives to manage the resource in
a socially efficient way. A person who owns an asset, such as a piece of land, will have strong
incentives to manage that asset efficiently because he will himself bear the cost of
mismanagement. When the property rights are not well defined, someone else will bear this cost.

We do not have private ownership of the atmosphere. I will therefore not bear the full cost of the
environmental damage when I pollute the air. Due to the lack of property rights, an externality has
been created. The result will be too much pollution. If there are no well-defined property rights to
a particular grazing land, there will be overgrazing, because no single herder has to take the full
social cost of bringing cattle to the land into account. If the grazing land would be a common
property with access only for the members of a particular community, there would still be
overgrazing because each member of the community would have incentives to bring too many
cattle to graze. However, if the common land is managed by social norms that are well anchored
in the community, then the grazing land may very well be managed efficiently. Similarly, if the
land is divided into pieces and there would be individual ownership of the land, each land owner
would limit the number of animals in such a way as to be able to use the land in the future. Once
again, we will achieve efficient management. Thus, environmental problems are to a large extent
due to property rights failures.
There are two basic reasons for the absence of well-defined property rights - policy decisions and
costs of establishing property rights. In many countries, some resources are regarded as publically
owned. For example, land that has not been claimed by anyone else can be regarded as open for
anyone interested in using the land. Because of that there are incentives to overuse this land. This
is an example of failures in the property right structure, introduced by bad policies. However, for
many resources, the costs of introducing property rights are very high and sometimes it is
impossible even to define individual rights. For example, it is difficult to think of how the global
climate could be assigned individual property rights. The reason is that a change in the climate
that affects me will also affect you. The climate is a public good (or bad, depending how you look
at it). Of course, we could think of individual rights to emit green house gases, but the climate
itself will continue to be a public good.

Environmental economics

Environmental economics is to a very large extent the analyses of two of the three conditions
under which the second theorem holds: convexity and property rights.
Convexity cannot be taken for granted when we study environmental problems. There are two
reasons for this: first, nature may not be convex, that is the ecosystems may not produce bundles
of services to man that can be described by convex production sets, and second, the absence of
property rights can generate non-convex production sets. This is of utmost importance for the
design of institutions that can manage environmental resources well.

Decision making

Valuation is a tool for organising information in an efficient way. We can look at a stylised picture
of decision making in the following way.

Alternatives

The first thing to remember is that we have a set of actions, and that the whole decision making
problem is to choose one action which is best in one way or the other. So it is absolutely
necessary to define the set of actions, i.e. the choice alternatives.
! The alternatives - or the definition of commodities - must be very precise!
! The alternatives must be very well understood!
! The implications of the alternatives, including the uncertainties, must be fully understood!
This set can sometimes be very simple and consist of only two alternatives - build a project or
dont. This presumes that the project is well defined and cannot be altered. In other situations, the
set of actions may be much more complex. If the problem is about choosing a structural
adjustment plan to increase economic efficiency, there are many parameters such as tax rates,
subsidy rates, exchange rates, trading rules, etc that must be defined and most of these parameters
can take almost an infinite number of values. Irrespectively of the complexity of the action set, it
must be defined, in order to make the valuation exercise interesting. Too often, one can find
studies that are technically brilliant but completely devoid of any meaning because the decision
making situation has not bee defined.
Mappings

The next step is to make an impact statement. What are the consequences of a particular action?

consequences: x = N(a)
N corresponds to environmental impact assessment.
Note that x may be a probability distribution
Estimation of N requires ecological, geophysical, geological, meteorological, economic and
technological knowledge.
Sometimes, this is rather simple. If the problem is to decide whether the beach should be cleaned
once a year or never, the impact statement is basically in the case of cleaning the beach a
description of the clean beach and the cost of cleaning it. Sometimes, one can go further and add
the possible ecological side effects a clean beach may have if there are any outside effects. In
the other alternative, with no cleaning, the impact is a description of the polluted beach, perhaps
with some information on the ecological side effects. The cost of cleaning is obviously zero. In
other cases it may be much more difficult to make an impact statement. In the case with structural
adjustment, we must estimate the effects from the plan on production in different sectors, the
consequences on the environment from these changes in production structures, the impact from
price changes on different socioeconomic groups etc.In general this would require the use of a
Computable General Equilibrium (CGE model in order to trace all the primary, secondary ,
tertiary etc. effects of one particular structural adjustement plan. Obviously, the CGE model must
be constructed in such a way that it incorporates the property rights failures that cause
environmental problems.
In many cases, it will be impossible to come up with one particular impact from a chosen action.
There are many reasons for this. For example, if one action leads to higher air pollution, this has
effects on morbidity and mortality. However, it will in general be impossible to say who will be
affected. In the best case, we may be able to say something about exposure and the increased risk
for deseases and even for death because of the increased air pollution. Thus, we have to represent
the impact by a probability distribution of different impacts. In other cases, the scientific
knowledge is not enough to predict precisely the consequences from an action. Once again we
may have to rely on information in terms of probabilities of different impacts.
Valuing the alternatives

Once the impacts of different actions have been mapped, one should rank the different actions by
valuing the impacts. In other words, we want to give values W = W(x) to different impacts.
If the change affects only one individual one can use the utility function:
W = U(x),
An impact y is better than an impact x if U(y) > U(x)
If several individuals are affected the problem is less simple.
Valuing the alternatives: several individuals

Some may be better off, others worse off, from choosing one alternative instead of another. The
gains for the winners must be compared with the losses for the losers.
Two approaches to do that:
! Compensation tests
! Social welfare functions

Compensation tests

Kaldor criterion

Consider a change from social state A to social state B. Individual 1 will gain and individual 2 will
loose from the change.
Kaldor criterion says that potential welfare will increase if 1 can compensate 2 for the loss he has
incurred and still be better off.
Note that the compensation is purely hypothetical.

Hicks criterion

Consider the same change from A to B. If in B, 2 cannot bribe 1 to accept to move back to A, and
not being worse off compared to B, B has higher potential welfare.

Utility possibility curves

Assume we are at point A. Then by redistributing income, all utility levels on the curve can be
attained. This curve is known as the utility possibility curve.

Compensation tests

Consider the change from A to B. Individual 2 can compensate individual 1 by moving from B to
D along the utility possibility curve through B. Kaldors test is satisfied.
But 1 can also bribe 2 to abstain from the change by moving to C where both are better than at B.
Hicks test shows that change from A to B reduces the potential welfare!

Problems with compensation tests

Such tests result in most cases to intransitivities. They consider hypothetical compensations - so
there may be ethical problems

Social welfare functions

Assume the existence of a social welfare function:

W(u1, ..., uH)
Does such a social welfare function exist?

Arrows (im)possibility theorem

When can we aggregate individual preferences into a social welfare function in a reasonable way?
Define reasonability as follows:
! Unrestricted domain, i.e. all possible profiles of individual preference order can be
aggregated.
!
Independence of irrelevant alternatives, i.e. if we only consider choices between two
alternatives, A and B, then the aggregated order should only depend on the individual
preferences on these two alternatives.
! Weak Pareto principle, i.e. if for any pair A and B, all individuals prefer A to B, then the
social ordering should also prefer A to B
! No dictatorship, i.e. there is no individiual h such that for all possible profiles of preference
orders, the social order coincides with the preference order of individual h.

Theorem

Assume that there are at least three individuals and there are at least three alternatives over which
society must make decisions. Then there is no mechanism by which individual preferences can be
aggregated and satisfying simultaneously the four conditions.

Condorcets paradox

It is an example of Arrows impossibility theorem

! Let there be three individuals, 1, 2, 3, who have to choose between three alteratives, A, B,
and C. Assume the individuals rank the alternatives as follows
!
Individual
1
A, B, C
2
B, C, A
3
C, A, B
! In majority voting, A would win against B, B would win against C, and C would win
against A. Majority voting does not create a social order.

Bergson-Samuelson social welfare function

The existence of a social welfare function

W(u1, ..., uH)

will violate one of the Arrow conditions. It implies comparability of different individuals utilities
and therefore it expresses value judgements of some special group of individuals - the policy
makers. Thus its main role is as an objective function for public policy making. It comprises the
ethical values on the distribution of well-being.
We will assume that W satisfies the Pareto criterion, i.e.
MW/Muh > 0
for all h.
Social welfare functions

The welfare function

W(u1(x), ..., uH(x))

is defined for a particular choice of utility representation of the underlying preferences. If we
change this representation by making a monotonic increasing transformation of the utility
functions, we have to make corresponding transformation of the welfare function in order to make
the social preferences invariant.
If W(u1, ..., uH) represents a particular social order and we make monotonic transformations of
the utilities, f(.), then the welfare function must be transformed accordingly:
W =W(f-1(f(u1)), ..., f-1(f(uH)))
in order make the social ordering invariant for these mononic transformations.
Thus, we transform uh(x) to vh(x)=f(uh(x)). The new welfare function is
W=W(f-1(v1(x)), ...,f-1(vH(x))))

Linear approximation

Consider a change in society from A to B. This change implies that the individual utility levels will
change from uhA to uhB, and that the social welfare will change with
)W =W(u1B, ..., uHB) - W(u1A, ..., uHA)
We make a linear approximation
)W = Eh wh )uh,
where wh = MW/Mu
w , h=1, 2, ..., H are the income distribution weights
h

Social welfare measurements

How can the W function be identified and estimated?

How do individual utilities )u change?
h

Measurements of individual utility changes

The diagram shows the idea behind measuring individual utility. We search for the income, which
at given, constant prices can support a certain utility level.
In order to carry out this argument more rigorously we need to discuss demand analysis.
Choose a simple representation of the preference order!

Utility maximization

The individual chooses the bundle of commodities that he finds best. This is represented by utility
maximization under a budget constraint:
max u(x , ..., x , Q)
subject to
px
px #I
where p , i = 1, ..., n are the prices, Q the supply of public goods which the individual has no
control over and I the (lump sum) income.
If the utility function is strictly quasi-concave, there will be a unique solution and that solution will
obviously depend on prices, public goods, and income:
x = x (p , ..., p , Q, I) i = 1, ...., n
These are the Marshallean demand functions.
1

1 + ... +

Demand functions
The demand functions have four properties. The first two are:
! satisfying the budget constraint
!
homogenous of degree zero in prices and income (no money illusion)
We will come back to the remaining properties later.
The indirect utility function

If we substitute for the xs (the Marshallean demand functions) in the utility function we obtain
u(x1(p,Q, I), ..., xn(p, ..., Q, I), Q) / v(p, Q, I)
v is known as the indirect utility function.
One can easily prove:

Roys theorem:

x (p1, ..., pn, Q, I) / - [Mv/Mpi]'[Mv/MI]

i

Individual utility changes

The expenditure function is calculated in the following way:

m = min 31n pixi
s.t.
u(x, Q) $ u
To solve this problem we form the Lagrangean
L = 31n pixi - (u(x, u Q) -u).
Necessary conditions:

Mu/Mxi = pi
m is the expenditure function or the cost of utility function

Hicksean compensated demand functions

The solution to the cost minimization yields the Hicksean compensated demand functions
x = xc(p, Q, u)
This gives the demand for different prices and different supplies of public good if the individual is
so compensated that he remains on the same indifference curve (or at the same utility level).

Marshallean and Hicksean compensated demand functions

Properties connecting compensated and non-compensate demand functions

xc(p, Q, u) / x(p, Q, m(p, Q, u)),
xc(p, Q, v(p, Q, I)) / x(p, Q, I)

Properties of compensated demand functions

The compensated demand functions have several properties:

! symmetry: Mxci/Mpj = Mxj/Mpi
! negativity: Mxci/Mpi #0
! homogeneity of degree 0 in p
! adding-up property: 3ipixic = m(p,u)
u(xc(p, Q, u) / u
Differentiate with respect to pj
3i(Mu/Mxi )(Mxic/Mpj) = 0
From necessary conditions for cost minimization follows
Mu/Mxi = (1/)pi
put 1/=
( Lagrangean multiplier) and therefore
3i pi(Mxic/Mpj) = 0

The expenditure or the cost of utility function

The minimum expenditure to achieve utility level u is given by

m(p, Q, u) = 31n pixic(p, Q, u).
m is known as the expenditure function or the cost of utility function.
! m(p, Q, u) / 3pixic(p, Q, u)
! m is homogenous of degree one in prices
! m is increasing in u
! m is concave in prices
! Mm/Mpi = xci(p, Q, u) / xi(p, Q, m) (Because 3i pi(Mxic/Mpj) = 0)

Slutsky equation
From

xci(p, Q, u) / xi(p, Q, m(p, Q, u))

follows after differentiating with respect to pj
Mxci/Mpj = Mxi/Mpj + Mxi/MI Mm/Mpj
or
Mxci/Mpj = Mxi/Mpj + xj Mxi/MI
This is the Slutsky equation
In the same way
Mxcj/Mpi = Mxj/Mpi + xi Mxj/MI
and therefore
Mxi/Mpj + xj Mxi/MI = Mxj/Mpi + xi Mxj/MI

The indirect utility function and the expenditure function

The expenditure function can also be defined from the indirect utility function:
v(p, Q, m) = u
yields
m = m(p, Q, u)

Properties of the demand functions

We have earlier seen that

! demand functions satisfy the budget constraint
! they are homogenous of degree zero in income and prices
We can now add the following two properties
! the substitution effect is symmetric, Mxi/Mpj + xj Mxi/MI = Mxj/Mpi + xi Mxj/MI
! the matrix of substitution effects, Mxi/Mpj + xj Mxi/MI , is negative semi-definite (concavity of
the expenditure function in prices

Consumer surplus

Consumer surplus is meant to be an approximate way of recovering preferences from revealed

behaviour, i.e. demand functions.
Price equals marginal utility. At prices high (p) the marginal utility is then given by the demand
curve. When quantity increases, the marginal utility falls. Therefore, the total excess utility when
price = p is equal to the shaded area. This is the Marshallean consumer surplus.

Recovery of the expenditure function

Assume we have only two goods, x and y, and that we have estimated econometrically the demand
functions for them:
x = x(px, py, I)
y = y(px, py, I)
Can we recover the expenditure function from this information? Yes, if the demand functions are
such that the substitution effects are symmetrical , i.e.
Mxi/Mpj + xj Mxi/MI = Mxj/Mpi + xi Mxj/MI
and the matrix of substitution effects is negative semi-definite.
We do this by solving the system of differential equations:
Mm/Mpx = x(px, py, m)
Mm/Mpy = y(px, py, m)
The symmetric substitution effects guarantee a solution. The negative semi-definitness of the
matrix of substitution effects guarantees that the solution has the properties of the expenditure
function.
Recovery of the preferences

By observing individual behavior we can, at least in theory, reveal their preferences and therefore
also define utility functions for them. We will next see how this is done in practice.
Utility representations

The previous analysis is not rigorous because it does not consider income effects. The following
will correct for that.
Keep p and Q fixed at levels p and Q.
m(p, Q, u) is then an monotonic increasing transformation of u. Therefore,

m(p, Q, u)
is a valid utility function, representing the same underlying preference order as u.

M with fixed prices and supply of public goods measures the income corresponding to the parallel
price lines
Equivalent variation

Consider a change from A(p, Q, I) to B(p, Q, I). The utilities in A and B are u and u
respectively. Taking A for the fixed prices and fixed supply of public goods, the utility change can
be written
m(p, Q, u) - m(p, Q, u) = m(p, Q, u) - I =
m(p, Q, u) - I + (I - I) = m(p, Q, u) - m(p, Q, u) + ) I = EV (equivalent variation)

EV is the change in income that would give the individual the utility change in A as would
the change from A to B.
! If u > u, then EV is the minimum willingness to accept in compensation the status quo,
that is situation A.
! If u < u, then EV is the maximum willingness to pay for avoiding the change.
Let p = 1.
Then y=m(p, Q,u), y=m(p, Q, u) and EV=y-y
y

The original equilibrium is at A. After an increase in price, we are at C. The same indifference
curve could have been reached by reducing income with y-y = -EV
Remember that Mm/Mp = x . Assume only p changes from p ' to p ". Then
EV = m(p ", Q, u) - m(p ', Q, u) =
= IMm/Mp dp
= Ix dp
c

1 =

where the integration is from p ' to p ".

The shaded area in the figure below is therefore the equivalent variation.
1

Compensating variation

Use the prices and supply of public goods in B (the final position) for measuring utility. Then the
utility change is
m(p, Q, u) - m(p, Q, u) =
I - m(p, Q, u) =
I + )I - m(p, Q, u) =
m(p, Q, u) - m(p, Q, u) + )I = -CV
CV is the Compensating variation

"
"
"

Compensating variation is the amount of change in income necessary to keep the

individual at the same indifference curve as in A after the change to B.
If u < u, then CV is the minimum willingness to accept the change.
If u > u, then CV is the maximum willingness to pay for the change.

Only price change is on x. y=m(p, Q, u)

y=m(p, Q, u)
CV=y-y.
The original equilibrium is A. After an increase in price the new equilibrium is at B. In order to be at
the same indifference curve with new price, income must be y. The individual needs y-y=CV in
compensation for the price fall.

Remember that Mm/Mp = x . Assume only p changes from p ' to p ". Then
CV = m(p ", Q, u) - m(p ', Q, u) =
= IMm/Mp dp =
= Ix (p , u')d p1,
where the integration is from p1' to p1".
The compensating variation CV is equal to the shaded area in the figure above.
c

Consumers surpluses

We can now compare EV, CV and Marshallean consumers surplus for a price increase.
The EV is equal to the squared area.
The CS (consumers surplus) is equal to the squared plus the waved area.
The CV is the sum of all filled areas.

Further comparisons between CV, EV, and CS

The reason why there are two compensated demand curves is the inco
me effect. In the original point A real income and therefore also utility are greater than in the final
point B. So the compensated demand curve through A is further to the left than the one through
point B. The waved and dotted areas are therefore determined by the income effect or the income
elasticities. If they are small, the three measures will be approximately equal.

Contents
Welfare . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
An introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Individual preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Transitivity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Reflexivity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Completeness or connectedness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Continuity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Utility functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
The existence of a utility function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
The lexicographic order . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Monotonic transformations of utility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Ordinal utility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Utility functions and well-being . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Properties of utility functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Preferences among risky choices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Existence of the expected utility function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Probabilistic equivalence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Probabilistic independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Many individuals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
The Pareto criterion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Pareto optimality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Utility possibility frontiers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Competitive equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
The first theorem of welfare economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Second theorem of welfare economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Convexity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Convex production sets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Quasi concave functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Separation theorems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Decentralization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Non-convexity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Continuity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Property rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Environmental economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Decision making . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Alternatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Mappings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Valuing the alternatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Valuing the alternatives: several individuals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Compensation tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Kaldor criterion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Hicks criterion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Utility possibility curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Compensation tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Problems with compensation tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Social welfare functions
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Arrows (im)possibility theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Condorcets paradox . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Bergson-Samuelson social welfare function . . . . . . . . . . . . . . . . . . . . . . 15
Social welfare functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Linear approximation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Social welfare measurements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Measurements of individual utility changes . . . . . . . . . . . . . . . . . . . . . . 16
Utility maximization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Demand functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
The indirect utility function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Individual utility changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Hicksean compensated demand functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Marshallean and Hicksean compensated demand functions . . . . . . . . . . . . . . . . 18
Properties of compensated demand functions . . . . . . . . . . . . . . . . . . . . . . . . . . 18
The expenditure or the cost of utility function . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Slutsky equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
The indirect utility function and the expenditure function . . . . . . . . . . . . . . . . . 19
Properties of the demand functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Consumer surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Recovery of the expenditure function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Recovery of the preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Utility representations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Equivalent variation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Compensating variation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Consumers surpluses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Further comparisons between CV, EV, and CS . . . . . . . . . . . . . . . . . . . . . . . . . 25
Contents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26