Economics 1010a Microeconomic Theory Fall semester, 2010 Jeff Borland Lecture 27 – General equilibrium and welfare – Welfare

0. Readings • Varian – Start of ch.33 to 33.6 1. Lecture outline • Review of general equilibrium analysis • The idea of a welfare function • Aggregating preferences • A social welfare function • Welfare maximisation • Fair allocations, envy and equity 2. Review of general equilibrium analysis • The first theorem of welfare economics • The second theorem of welfare economics 3. The idea of a welfare function For judging the desirability of different allocations of resources in a society, or for choosing government policy to alter resource allocation, we need to have some way of evaluating society’s well-being with different resource allocation outcomes. One way of making this evaluation is by using the criterion of efficiency – for example, comparing the total amount of surplus associated with different allocations of resources, or using Pareto efficiency. However, in addition to efficiency (‘making the pie as big as possible’), in most cases it would be expected that a society will also care about equity (‘what share of the pie each person receives’). Hence, we need a way of evaluating alternative allocations of resources that incorporate both efficiency and equity considerations. Generally this will involve a welfare function, a way of ‘adding together’ the utilities of the individual members of a society.

this turns out not to be possible. We can make assumptions about the properties of those orderings – for example. just as in the same way as we can move from a preference ordering for an individual consumer to a utility function. One way that we might try to construct a welfare function for a society is by building directly from preferences of the individual members of that society. y and z denote possible allocations. in a way that preserves the properties of the individual preferences – such as transitivity.4. Aggregating preferences a. If this is possible then. Let x. . as shown below: Person A x y z Person B y z x Person C z x y Suppose that the society decides to use majority voting to decide on which is the most preferred allocation. We can then ask whether it is possible to aggregate the individual preference orderings to an ordering for society. Building from individual preferences Suppose we want to compare between alternative allocations of resources – where an allocation tells us how much of each good each member of society will receive. Suppose that each member of society has a preference ordering over allocations. we might assume that each individual’s preferences over allocations are transitive. y and z. we could move from the aggregated preference ordering to a welfare function for society. Unfortunately. Suppose there are 3 members of society who have preferences over allocations x.

This result is known as Arrow’s Impossibility Theorem. but then z is preferred to x by a majority. and majority voting. then the social preferences should rank x ahead of y. the outcome will be for y to be chosen. and then votes on the winner of that contest against y. the outcome from majority voting could be manipulated by a member of society to get their preferred outcome – for example. society’s aggregated preferences will not satisfy the condition of transitivity – x is preferred to y by a majority. and then votes on the winner of that context against z. reflexive and individual preferences. the outcome will be for z to be chosen…but… . b. Arrow’s impossibility theorem The example of a failure of the condition of transitivity of individual preferences to carry over to a social aggregation of preferences with majority voting exemplifies a more general problem – It turns out there is no method for aggregating individual preferences to social preferences where the social preferences have properties that would generally be thought suitable for a social welfare function.With this set of individual preferences. This failure of transitivity in society’s preferences means that the outcome from majority voting will depend on the structure of the voting – for example: . the social decision mechanism should result in social preferences that satisfy the same properties.Where the society votes first on z versus x. and . Hence. (ii) If every member of a society prefers alternative x to alternative y. person C would always try to have the structure of voting that would achieve z as the outcome. Consider the following conditions that it might be thought desirable for a social preferences to satisfy: (i) Given any set of complete.Where the society votes first on x versus y. y is preferred to z by a majority.

Recall that the allocations x and y represent the allocation of each good across each member of society.. and not on how they rank other alternatives. A social welfare function A social welfare function is some function of the utility functions of the individual members of a society: W(u1(x). However.un ) = min{u1.... The Arrow Impossibility Theorem states that: If a social decision mechanism satisfies properties (i). (ii) and (iii) then it must be a dictatorship: all social rankings are the rankings of one individual.. (This implies that if all members of society prefer x to y. 5... the social welfare function will depend on the particular utility function that has been chosen to represent each individual’s preferences.) Examples of social welfare functions are: (i) Additive .. It is justified as long as we are willing to accept an ordering that does not meet property (iii) above.un ) =  u i=1 n i i (iii) Minimax/Rawlsian .. it has the disadvantage of incorporating the arbitrariness of individual utility functions.... The Arrow Impossibility Theorem tells us that we need to find ‘weaker’ approaches for deriving social rankings of alternative allocations of resources.un ) = u i=1 n i (ii) Benthamite .. .un } A social welfare function does provide one way of making a social ranking of resource allocations.W(u1.(iii) The preferences between x and y should depend only on how people rank x versus y. then social preferences will prefer x to y..W(u1.un (x)) which is increasing in each individual’s utility. Therefore.. There is no unique representation of an individual’s preferences in a utility function...W(u1....

Let xij represent the amount of good j that is consumed by individual i. The boundary of this set is referred to as the utility possibilities frontier.. Then we can express a welfare maximisation problem for society as: Max. . the intercepts with the u1 and u2 axes show (respectively) the utility that would be received by persons 1 and 2 if they were allocated all of the goods available in society.. and then calculating the amount of utility each member of society would receive from each allocation.un (x)) Subject to:  x1i = X1 . then it is possible to analyse the optimal choice of allocation for society. and X j represent the total quantity of good j available in society. i=1 n x i=1 n k i = Xk b. The diagram below shows the utility possibilities set for a 2-member society... Graphical representation The ‘budget constraint’ of the amounts of goods available can be translated into a utility possibilities set. W(u1(x). Welfare maximisation a. The case of isowelfare curves for a 2-member society is shown in the diagram below. Suppose there are n consumers and k goods in a society. The welfare maximization problem If we accept the social welfare function as a way of representing society’s preferences over resource allocations. The ‘social welfare function’ can be represented in isowelfare curves which show combinations of utilities which give the same social welfare to society. For example.….6. This involves considering each possible allocation of resources between the members of society..

i i i=1 2 Then by varying 1 and  2 it is possible to vary the utility combinations that are socially optimal – from where person 1 receives maximum utility and person 2 receives utility ( 1 = 1 and  2  0 ). But the social welfare function is an increasing function of each individual’s utility. Any Pareto efficient allocation is a welfare maximizing allocation for some social welfare function. Therefore we could improve society’s welfare by shifting to that allocation. and some individual strictly higher utility.) 2. u2 ) =  u . Only on that frontier is it not possible to make one person better off without making the other person worse off. . Analysis The welfare-maximizing resource allocation for society is the combination of utilities for person 1 and person 2 that achieves the highest level of welfare for society given the utility possibilities set. Why? If it were not. It must be Pareto efficient. We can derive two main properties of the welfaremaximizing resource allocation: 1. (Note that Pareto efficient allocations are on the utility possibilities frontier.u2 Society’s welfare maximum Iso-welfare curve Utility possibilities frontier u1 c. then there is some other allocation that gives everyone at least as high utility. to where person 1 receives zero utility and person 2 receives maximum utility ( 1 = 0 and  2  1). Why? Suppose we adopt the formulation of social welfare function that W(u1.

we say that i envies j. 2 =1 Iso-welfare curve: 1=1. We say an allocation is equitable is no individual in society prefers any other individual’s bundle of goods to his or her own. Fairness An alternative approach to characterising socially optimal resource allocation is to begin with some condition we regard as ethically desirable. An allocation which is both equitable and Pareto efficient is described as fair. One such approach uses the concept of fairness. 2 =0 u1 7. Fair allocations.u2 Iso-welfare curve: 1=0. If some individual i does prefer some other individual j’s bundle of goods. and examine its implications for the resource allocation. envy and equity a. .

Good 1 . a fair allocation is at the tangency between the indifference curves of person A and person B.b. we know from the First welfare theorem that this new allocation must be Pareto efficient. suppose we start with an equal division of goods between each member of society. Second. it is Pareto efficient. An example Person B Good 2 Fair allocation ICA Swapped allocations ● ICB Person A In this example. c. To see this. because trade has occurred through a competitive market. since neither individual can be made better off without the other being made worse off. First. If the individuals swapped allocations they would both be made worse off (since both would be on lower indifference curves). hence neither envies the other individual’s allocation. Will fair allocations exist? The answer is yes (in general). and then allow the individuals to trade through a competitive market to a new allocation. First. it is equitable.

will be a fair allocation. Suppose it is not. So if person A cannot afford this bundle. Hence it is impossible for person A to envy person B.xB ) . it must be that: 2 p1w1 + p2 w 2 )  p1x1 + p2 xB A A B where w1 and w 2 are person A’s endowments of the A A goods. This 2 means: (x1 . But person A and person B started with the same endowment. it will be equitable. and that for example. then person B cannot either. and her own bundle is the best she can afford.Second.x 2 )  A (x1 . that follows from an initial equal division of resources. person A envies person B. . But if person A prefers A A B person B’s bundle. So we have a result which is that the allocation in a competitive equilibrium.