Economics of the Public Sector

Lecture 4: Efficiency and Equity

Alfa Farah

Department of Economics
Diponegoro University

The 2nd Semester of 2019/2010

Efficiency and Equity

Focus Questions
I How do economists think systematically about how to make
social choices where trade-offs, that is, when after finding all
possible Pareto improvement, gains to welfare of one
individual must come at expense of the welfare of others?
What is the social welfare function, and why do economists
find this concept useful?
I How do economists think systematically about trade-offs
between efficiency and inequality? How do they measure
efficiency?
I As a practical matter, how do government translate these
general principles into a form which can actually be used in
decision making?

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 I Under certain conditions, the competitive market results in a
Pareto efficient resource allocation.
I When the conditions required for this are not satisfied, a
rationale for government intervention in the market is
provided.
I Government is required to establish and enforce property
rights and enforce contracts. Without this, markets by
themselves cannot function.
I Government activities aimed at protecting citizens and
property, enforcing contracts, and defining property rights can
be thought of as providing the foundation on which all market
economies rest.

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Edgeworth-Bowley Box

Question 1
Is the distribution efficient? Why?
Is the distribution equitable? Why

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The Trade-Off between Equity and Efficiency

I Since the distribution seems inequitable, the government

attempt to transfer oranges and apples from Friday to Crusoe.
I But in the process, some apples and oranges get lost
I In this case inequity is eliminated at the expense of losing
some apples and oranges
I Hence, there is a trade-off between efficiency and equity

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The Trade-Off between Equity and Efficiency
I The trade-off between equity and efficiency is at the heart of
many discussions of public policy
I Two question are debated:
1. To reduce inequality, how much efficiency do we have to give
up? (Trade-off)
2. Is inequality is the central issue in the society? or efficiency is
the central issue?
I Inequality is the central issue: we should simply minimize the
extent of inequality, regardless of the consequences to
efficiency
I Efficiency is the central issue: if one wishes to help the poor,
in the long run, the best way to do that is not to worry about
how the pie is to be divided but to increase the size of the
pie—to make it grow as rapidly as possible—so that there are
more goods for everyone
I These disagreements relate to social choices between equity
and efficiency.

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Analyzing Social Choice

To analyze social choice, economists use the consumer choice

framework

Consumer Theory
I Budget Constraint: the opportunity set of individual
I Indifference Curve: Consumer preference
Social Choice
I Utility Possibility Curve: the highest level of utility (welfare) of
an individual, given the level of utility of others. Along UPC,
economy is Pareto efficient
I Social Indifference Curve: how society makes trade-offs
between utility levels of individuals

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Analyzing Social Choice

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Analyzing Social Choice
I Assume the current competitive market equilibrium is
represented by the point A on the UPC
I Suppose society decides to move from point A to point B
along the UPC, implying an increase in Friday’s utility and a
reduction in Crusoe’s utility.
Two Central Questions of Welfare Economics
1. The first question is: What is the trade-off?
I The UPC gives the answer by showing the increase in Friday’s
utility from U0F and U1F and the decrease in Crusoe’s utility
from U0C and U1C
2. The second question concerns social preferences: How does
society evaluate the trade-off?
I The slope of the SCV gives the trade-offs for which society is
indifferent.
I Point B is on the SCV S1 , which is tangent to the UPC, and
lies on a higher indifference curve than S0 . Point B is therefore
preferred by society
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Analyzing Social Choice: Determining the Trade-Off
The trade-off is determined by the shape of UPC

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Analyzing Social Choice: Determining the Trade-Off

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Analyzing Social Choice: Determining the Trade-Off

The trade-off is also determined by the efficiency of transferring

resources from one individual to other individuals.
I We transfer resources from the rich to the poor is by taxing
the rich and subsidizing the poor.
I This normally interferes with economic efficiency
I The rich may work less hard than they would otherwise
because they reap only a fraction of the returns for their effort,
I The poor may work less hard because by working harder, they
may lose eligibility for benefits.
I The magnitude of these disincentives affects the entire shape
of the UPC

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Analyzing Social Choice: Evaluating the Trade-Off

I To analyze social choice, economists employ Social Indifferent

Curve and Social Welfare Function
I SIC :The set the set of combinations of utility of different
individuals (or groups of individuals) that yields equal levels of
welfare to society
I SWF gives the level of social welfare corresponding to a
particular set of levels of utility attained by members of society
I The SWF has the same value along the SIC

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Analyzing Social Choice: Evaluating the Trade-Off

I The SWF provides a basis for ranking any allocation of

resources
I We choose the allocations that yield higher levels of social
welfare, that is an allocations in which at least some
individuals are better-off and no one is worse off (Pareto
Improvement)
I In the figure: the combinations to the north-east of A make
everyone better off

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Analyzing Social Choice: Evaluating the Trade-Off

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Analyzing Social Choice: Evaluating the Trade-Off

I Unfortunately, most choices involve trade-offs, with some

individuals being made better off and others worse off.
I At point B, the second group is better off than at A, but the
first group is worse off.
I We thus need a stronger criterion, and this is what the SWF
provides.
I The SIC provide a convenient diagrammatic way of thinking
about the kinds of trade-offs society faces in these situations.
I All combinations of the utilities of Groups 1 and 2 that are on
the SIC W2 yield a higher level of social welfare than those on
W1 . Thus, B is preferred to A

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Analyzing Social Choice: Evaluating the Trade-Off

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Analyzing Social Choice: Evaluating the Trade-Off

I SWFs can be thought of as a tool economists use to

summarize assumptions about society’s attitudes toward
different distributions of income and welfare
I If society is very concerned about inequality, it might not care
that efficiency is reduced
I On the other hand, society might not care at all about
inequality
I This difference in attitude can be illustrated in different
shapes of SWF

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Shapes of Social Welfare Function: Utilitarian
I The straight line implies that
no matter what the level of
utility of Friday and Crusoe,
society is willing to trade off
one “unit” of Friday’s utility
against one unit of Crusoe’s
I What the utilitarian social
welfare function says is that
the utility of any individual
should be weighted equally
to the utility of any other
individual
I Social welfare is equal to the
sum of utilities of the
individuals in society

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Shapes of Social Welfare Function: Rawlsian

I welfare of society depends

only on the welfare of the
worst-off individual.
I Society is better off if we
improve the poor’s welfare,
but gains nothing from
improving the rich’s (or
there is no trade-off)

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Social Choice in Practice

I Identify and measure net benefits received by groups

I Is the project a Pareto improvement?
I If yes, project goes ahead
I If no, make overall judgment
I Measure of Efficiency
I Sum of gains and losses of all individuals
I Measure of Inequality (distributional effects)
I The poverty index
I The poverty gap

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Measuring Benefits of a Project

I Consumer Surplus : The difference between the price a

consumer is willing to pay for a good and the price actually
paid (A measure of consumer’s gain)
I Net efficiency effect of a govt project
I Consumer surplus summed over all individuals
I If total willingness to pay ¿ total costs, project goes ahead

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Social Choices if project is not a Pareto improvement

1. The compensation principle

Aggregate willingness to pay ¿ cost, but there are some losers
2. Trade-offs across measures of efficiency and equality
Evaluate if an increase in efficiency is worth an increase in
inequality, vice versa
3. Weighted net benefits
Assign weights to the net gains of different groups

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