Public Finance

Welfare economics

Sun Go

Chung-Ang University
Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

Overview

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

Overview

I To understand the basic concepts of welfare economics

Textbook
I Ch. 3

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

Welfare economics

Definition
I The branch of economic theory concerned with the social
desirability of alternative economic states

Issues
I Welfare: a measure of the group’s happiness
I An individual’s happiness is utility
I A group’s utility is an weighted sum of individual utilities
I Issues
I How to define individual utility
I How to aggregate them
I Compare the welfares across different states

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

Questions and topics

Questions
I When do markets perform well?
I When do markets fail to produce desirable results?

Topics
I Efficiency
I The first and second welfare theorems
I Social welfare function
I Market failure

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

Pure exchange economy

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

Setting

Let’s begin with a pure exchange economy

I Two people: Adam & Eve
I Two commodities (Apple & Fig leaves) with fixed supplies
I The only economic problem:
I Allocating apples and fig leaves between Adam and Eve

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

Adam and Eve’s consumption

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The Edgeworth box

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The choices of Adam and Eve

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Pareto efficiency

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

Pareto efficiency

A “Pareto efficient” allocation

I An allocation at which the only way to make one person better
off is to make another person worse off
I Pareto efficiency is often used as the standard for evaluating
the desirability of an allocation of resources
I There are several Pareto efficient allocations

A Pareto Improvement
I A reallocation of resources that makes one person better off
without making anyone else worse off

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

A Pareto Improvement

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The contract curve

I The locus of all the Pareto efficient points

I At Pareto efficient allocations

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

The contract curve

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

Production economy

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

Production economy

Now consider production

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

The production possibility curve

I A graph that shows the maximum quantity of one output that

can be produced, given the amount of the other output
I The absolute value of the slope is the Marginal rate of
transformation (MRT)
I The rate at which the economy can transform one good into
another good
I Note: Marginal cost = the incremental cost of producing one
more unit of output

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

The production possibility curve

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Efficiency conditions with variable production

A numerical example
I Adam = 1/3
If MRTa,f = 2/3 > MRSa,f
I Adam could be better off without making no one else worse off

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

The first fundamental theorem of

welfare economics

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

The 1st theorem

The first fundamental theorem of welfare economics

I As long as producers and consumers act as price takers and
there is a market for every commodity, the equilibrium
allocation of resources is Pareto efficient

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

Sketch of the proof

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Question

Does the first welfare theorem imply that a minimal government is

the best?
I Fairness
I Market failures

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

Taking fairness into consideration

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Efficiency vs. equity

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Utility possibility curve

I A graph shows the maximum amount of one person’s utility

given each level of utility attained by the other person
I The maximum feasible amount of one person’s utility given the
other person’s utility level
I Pareto efficient if on the curve, not inside the curve

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

Utility possibility curve

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

A social welfare function

I A function reflecting society’s views on how the utilities of its

members affect the well-being of society as a whole.

Social indifference curves

I Curves showing how society is willing to trade off one person’s
utility for the others

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

Utility possibility curve

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

Social indifference curves

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

Social welfare functions

The Utilitarian (or Benthamite) social welfare function

Pn
I W =
i=1 Yi

The Max-Min (or Rawlsian) social welfare function

I W = min(Y1 , Y2 , Y3 , Y4 , Y5 , . . . , Yn )

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Maximizing social welfare

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Government

Getting to the welfare-maximizing point

I Roughly speaking, by redistributing income suitably and then
getting out of the way and letting markets work, the
government can attain any point on the utility possibilities
frontier

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

The 2nd theorem

The second fundamental theorem of welfare economics

I Provided that all indifference curves and isoquants are convex
to the origin, for each Pareto efficient allocation of resources
there is a set of prices that can attain that allocation as a
general competitive equilibrium
I Society can attain any Pareto efficient allocation of resources
by making a suitable assignment of initial endowments and
then letting people freely trade with each other
I A lump-sum tax or transfer
I Assuming no behavioral changes

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

The 2nd theorem

Tim Harford (2006)

I This theorem is important because it shows that, at least in
theory, the issues of efficiency and distributional fairness can
be separated
I To improve distributional unfairness, a society need only
transfer resources among people in a way deemed to be fair,
and let the market work
I An idea of the decentralized market mechanism

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Market failure

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Overview Pure exchange economy Production economy The 1st theorem The 2nd theorem Market failure Summary

Market failure

I Market power
I Monopoly
I Nonexistence of markets
I Asymmetric information
I Externality
I Public goods

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Summary

Re-cap
I Basic welfare economics
I The 1st and 2nd welfare theorems
I Market failures

Three key questions for assessing public policy

I Will it have desirable distributional consequences?
I Will it enhance efficiency?
I Can it be done at a reasonable cost?

Next class
I Public goods (Ch. 4)

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