Welfare economics

Lecture note 5
 Warning
• Much of what follows if not in the course
textbook
• Some of it comes from the far more
advances Mas-Collel, Whinston & Green
textbook
• Some of it comes from too many
dispersed sources
• So come to class!
 Goals
• Want to make normative statements
• First, without any cardinality assumptions
– Pareto efficiency
– Welfare theorems
• Next, with cardinality assumptions
– Consumer surplus
– Social welfare functions
– Social choice functions
 Basic question
• In GE framework
– Allocation:
• Consumption/production vector

– Feasible allocation

• How do we compare feasible allocations?

– Which one do we pick?
Edgeworth box and utility possibility frontier
 No interpersonal comparisons
• Originally, utility fn only ordinal
– Building blocks

• Implications for interpersonal comparisons

– Are tradeoffs possible?
 Pareto efficiency
• Can still eliminate subset of feasible
allocations
• Definition of Pareto efficient allocation
Diagram on UPF
Diagram on Edgeworth box
 Pareto superiority
• Definition of superiority

• Pareto efficiency does not imply

superiority

– Major stumbling block for potential policies

• E.g., lobbying
 Other problems
• Information requirements

• Still doesn’t yield unique prescription

• Silent on distribution

• So need something else

 Competitive markets
• Despite problems, still desirable property

• However given info problems, how to

implement it?
 FFTWE
• Statement

• Assumptions
– Price-taking
– Perfect information
– No externalities/complete markets
 FFTWE – sketch proof
• Consumers
– Relative prices = MRS
• = desirability of switching
• Producers
– Relative prices = TRS
• = ability to switch
• Breakdowns
 FFTWE diagram
• Edgeworth box
– Note previous diagram

• Exchange economy: MRS equalised

 FFTWE
• Implication
– Can trust market

• However
– Equity?
– Doesn’t always Pareto dominate alternative
• Also
– Assumptions
 Need interpersonal comparisons
• Even under ideal conditions, FFTWE is
silent on distribution
– Need refinement
• Social welfare fn
– Definition
• Domain

• Range
 Social welfare fns
• Under ordinal utility, extent of preference
did not exist

• For non-degenerate social welfare fn to

exist

– need cardinal utility

 Social welfare fns
• Examples
– Rawlsian

– Convex

– Utilitarian
• Equal weights

• Different weights
 Social welfare fns
• Typical features
– Increasing

– Symmetric

– Convex
 First-best planner problem
• Statement

• Q: how does Pareto efficiency relate to the

solution?

– Which properties define link?

 Standard procedure in micro
• Previously (positive economics)
1. Make assumptions
• Action space
• Payoff functions
2. Solve for behaviour
3. Derive testable predictions
4. Empirically evaluate model
• Now add one step (normative economics)
– Solve planner problem
• Check if system is efficient
• Make prescriptions
Problems with social choice theory
• Arrow critique
– Impossibility theorem

• Sen critique
– Questions Pareto efficiency

• Operationalisability critique
 Application: cost-benefit analysis
• Easiest social welfare fn is pure utilitarian

• Need to cardinalise utility

– Q: what’s the easiest unit?
 Monetising utility
• How to get from utility to money?
• Easiest way
– Have a base and an alternative allocation
• Typically status quo and potential policy alternative

– E.g., a price change

 CV & EV
• Compensating variation

• Equivalent variation
CV diagram
EV diagram
 CV vs. EV
• Cause of difference

• Which is preferred?
 Measurement
• Direct survey

• Revealed preference method

• Q: pros and cons?

 Consumer surplus
• One alternative is consumer surplus
– Definition

– Intuition on definition
Consumer surplus diagram
 CS vs EV vs CV
• How are they related

• When are they all the same

 Why use CS?
• Main advantage is potential additional
method of quantification
 Producers surplus
• Definition:

• Intuition:

• Less complicated than CS because:

PS diagram
 Recap on CS and PS
• CS and PS allows us to measure welfare
effects of price changes
– Allow interpersonal comparison

• Also allow winner/loser breakdown

Example: imposing a tax
Example: price ceiling